Old Problems in a New context – Excerpts from the New Ways of Thinking in Economics after the Global Financial Crisis1

Posted on:Apr 5,2019

Summary: The global financial crisis highlighted the limitations and gaps in the mainstream economic thinking. For the time being, the post-crisis reflection has not resulted in any new paradigm, however, the economic thought and the theory of public finances have undergone significant transformation, especially in respect of the roles and interaction between the market and the state, the added value of economic policy co-operation, the concepts of hysteresis and high-pressure economy, and the presumed human behaviour providing the basis of both the institutional environment and the various economic models. Recently, the focus has shifted again to anthropocentric economic philosophy, which assigns primary significance among economic axioms to linking the economy with morals and the alignment of man with virtue.

Key words: economics, crisis, paradigm, economic theory

JEL: A11, E00, H11

Introduction – Economic Thought and the Crisis in Public Finances

After the crisis that erupted in 2007-2008, a repository of a wide range of regulatory and supervisory interventions evolved, with the economic policy makers in the vanguard of seeking new methods (Godin, 2018). However, before a comprehensive theoretical and methodological renewal is achieved in economics, which provides the ideological basis for financial governance, and a new academic methodology is identified to cover (at least) practice, the sustainability of the results may be called into question.

During the economic crises of the century behind us, we could witness intensive theoretical and methodological renewals in the field of social sciences, especially economics and law. To prevent even deeper economic recessions and simultaneously boost upturn, new economic paradigms were created, while legislation and law enforcement were reinforced on a regular basis in adjustment to the new theories. During the 1929-1933 global crisis, in his theses John Maynard Keynes laid the foundation of modern macro-economy, in other words, the methodology of recovering from a crisis, thus setting the frame of economic thought for a period up to the mid-1970s, which was essentially manifest in the methodology and laying the theoretical basis of active state intervention. A paradigm change of a similar magnitude took place at the turn of the 1980s, after the oil crisis, when the theoretical framework that had evolved at that time lasted until 2007-2008 collapse in the Anglo-Saxon mortgage markets. Once the bipolar world order came to an end, the neoliberal philosophy of economics, which may be summed up in the principles of the neoclassical synthesis and the “Washington Consensus” built on its theoretical basis – the preference of deregulation, overshadowing the role of state ownership, the freedom of capital operations, the non-application of protectionist actions and the removal of limitations from derivative transactions – came to dominate nearly the entire world economy.

For several decades, the neoclassical school shifted macro-economy towards mathematics and abstract models. Partly based on the economic policy experiences of the 1970s, and partly due to the presumptions included in reasonable expectations, mapping the state’s active involvement is nearly completely missing from the neoclassical reflection. In their models, fiscal policy is, for the most part, seen as an institution endeavouring to ensure an accounting alignment between expenditures and incomes, while monetary policy focuses exclusively on the achievement of price stability – central bank’s single mandate (objective) was for the most part characteristic of the central banks in continental Europe, not the Anglo-Saxon systems -, both participants independent of the government. Since the methodology and the theoretical bases of the neoliberal-neoclassical school of economics failed to prove any essential progress or to offer alternatives for decades, the crisis that set in during 2007-2008 caused a major “intellectual panic” – and based on the experiences of the recent years, it also triggered substantial changes in thinking.

In this study the main changes in the economic and public finance thinking are listed with special focus on the revaluation of the roles of the market and the state, the way the active state polity has gained ground, the significance of economic policy cooperation, the concept of a high-pressure economy, the importance of understanding the institutional environment and genuine human behaviour, and the spread of anthropocentric economic philosophy.

Reassessed Markets, Novel Role for the state and Active Polity

One of the significant characteristics of years following the start of the 2007-2008 crisis was a rethinking of the role of the state. The governmental and central banking interventions, used in crisis management, which were definitely more powerful and affected a wider scope, also appreciated the rearrangement of social sciences, including the role of statecraft, a discipline that analyses the operation of the state.

In crisis management the state was granted increased authorisation to regulate and control the markets. Thus the power that focused on the prevention of the crisis from deepening and on consolidation also paid special attention to budget procedures and financial markets. The coordination, influencing and control of business organizations can only be successful through a well-organized economic governance. In other words, crisis management can be successful if in public finances and the general government sub-systems are clear and transparent. To this end the state uses the means available for it to create a legal framework, demands and enforces disciplined business and guarantees control.

As a clear experience of the recent years, state operation and the provision of state services cannot be expeditious on an exclusively market basis. The economic philosophy of the “New Public Management (NPM)” and the DPM paradigm built on decentralisation, privatisation and the management and profit oriented approach to public services came under heavy criticism. Things are moving towards proactive polity and the concomitant new economic paradigm, including centralisation, naturalisation and the approach increasingly enforcing the service of public good. In the European space, these processes may be interpreted as a partial revival of the étatistic concept of the social welfare state described by Ludwig Erhard and put into practice by Konrad Adenauer and De Gaulle after World War II and are especially palpable in Central and Eastern European countries.

The crisis has overwritten numerous economic relationships. The one that has had the most widespread effect is that the crisis has clearly undermined confidence in market self-regulation and in the presumption that “the market always acts in public interest”. Economic recession and the market turmoil resulted exactly from dysfunctions and things could only got sorted out by a powerful and efficient state intervention. This recognition upset the quasi consensus that preceded the crisis and was based on the very assumption that state intervention in market processes were harmful as they gave no effect to market incentives. If the market is considered as a nearly perfect self-regulating mechanism, the economy is accepted to work as a kind of a “machinery”. And machines rule out personal responsibility: a machine works according to the applicable rules, in a predetermined order, and the participants do not have any influence on its operation. In this respect the concept of market self-regulation is not merely incorrect but even harmful, as evidenced by numerous examples during the most recent crisis. If the market is a machine, we can do just about anything to enforce our interests, because the market’s self-regulation will somehow turn individual activities into ultimately serve public good. Thus the “market concept” relieves all human activities from responsibility, while recently it has been highlighted that individual decisions do have a relevance, and the market cannot turn bad decisions into good ones by aggregation. As smartly put by Nobel Prize winner Joseph Stiglitz: the invisible hand mentioned by Adam Smith is not only invisible, but does not exist, in other words, the decisions following from individual interests will not automatically result in public good. Gorton goes even further to the point of affirming that the global financial crisis has made the invisible hand only too perceptible: the world economy received a – hopefully sobering – slap from this hand (Gary Gorton, 2010). Another major change included the start of rehabilitation for the word “populism”, previously used as a kind of a pejorative swear word among economists. According to Dani Rodrik (2018), economic populism, in other words, the demolition of the framework that limits economic policy and does not arise from the electorate’s intention, may be justified, as in numerous cases these frameworks do not serve the interests of the majority of the society, but protect the privileged positions of the beneficiaries of the previous economic regime.

Recently, geopolitical and geostrategic factors have been increasingly taken into consideration in thinking about the economy. Geopolitics has been included in daily economic policy decisions for a long time already, but the theory of economics is only beginning to re-discover that economic policy decisions and responses include more than purely economic arguments. Although the sustainability of an economic policy decision may heavily depend on geopolitical impacts and consequences, traditional economic models have not considered these factors. In this respect, it would be justified to overview the entire flow of globalization, with special regard to the question if the current very fast spread of globalization is sustainable or not. Globalization has placed international coordination in focus, as certain (larger) countries trigger external impacts in the other (smaller) states by each single decision they make: a good example includes the quantitative easing programme of the United States, its tapering and the re-start of the interest rate rising cycle, which has a major impact on the other leading economies, especially the emerging markets.

The operation of central banks, constituting part of the state, has also undergone transformation. In the 20 to 30 years preceding the crisis, reflections about the central bank policy were rather single-minded. In their studies, Robert J. Barro and David B. Gordon (1983), on the one hand, and Finn E. Kydland and Edward C. Prescott (1977), on the other, determined the basic frame of mind in relation to central banks’ independence. More complex approaches more susceptible to realities was put on hold till today, despite the fact that already back in 1983 Woolley set up a typology of the factors having their effects felt through the government and those beyond the government, as well as the structural and the less embedded factors that may influence central banks’ decisions (John Woolley, 1983).

Based on the practice of the globalcentral banks, it is beyond doubt that the former monetary policy consensus (Olivier Blanchard et al., 2012) has been overridden by the crisis (Joseph Stiglitz, 2012). It turned out that flexible inflation indexing did not necessarily create a stable monetary framework (Mallinguh, Zeman, Kecskés, 2018), and it was unreasonable to narrow monetary policy (central banking) decision-making exclusively to shaping consumer prices, as the zero percentage interest threshold, considered as a merely theoretical limit for a long time, may be an important monetary policy problem, and monetary and fiscal policies need to be handled together, in a coordinated manner already over the medium term. Several examples show and it has once again became obvious that the real economic costs of financial instability and the resultant crises may be considerably higher than the costs of a moderated inflation (see the establishment of the Federal Reserve, acting as the central bank of the US, which was not justified by a fast price increase, but the 1907 collapse of the banking sector and the following financial panic). In addition to the prevention of excessive risk assumption and abuse and ensuring transparency, the state (the central bank) should enable the banking system to fulfil its social function, i.e. forward savings to investors and manage the resulting risks at low transaction costs. This is neither self-evident nor automatic because similarly to all other organisations operating on a market basis, the bank sector is interested in profit maximisation, which does not necessarily coincide with community interests. It seems to be an operative matter, but it suggests a strategic change that before the crisis central banks characteristically focussed on the management of short-term interest rates, but today it is generally accepted that other monetary policy factors can also affect macroeconomic developments, especially credit crunch and credit rationing. For this reason the post-crisis central banking models and strategies frequently recommend the mixed and complementary, or even joint application of the potential implements, including micro- and macroprudential means. According to Stiglitz (2012), these means could even have been used to prevent the evolution of the credit bubble in the US housing market, which ultimately lead to the crisis, however, the decision-makers were unable to get rid of the idea of market self-regulation. The reason is that if markets are efficient, bubbles cannot evolve, and up to the market collapse we had been unable to tell if we were facing a bubble or something else. Some even were of the position that the state does not need to intervene in market developments because restricting market operation is more harmful and costs more than “cleaning up” after the crisis. By now these approaches have proven to be false.

As a crisis is always unpredictable and volatile, it is almost natural, that in times of difficulty, stability is appreciated, and the reduction of vulnerability comes into focus. According to Nassim Taleb (2012), as the world is characterized by significant risks and limited predictability, clearly evidenced by the current crisis, the correct social operation is not to build as robust structures as possible, but the develop ‘anti-fragility’. One of the tragedies of modernity is that even on state levels we behave as unduly anxious parents who want to wrap their child in cotton wool, as they fail to prepare it for the dangers it is to face and the conflicts it must learn to handle. Along this logic, Taleb criticizes the fundamental propositions of mainstream economics. Among the economic causes of social vulnerability, NassimTaleb and Gregory F. Treverton (2015) highlight excessive specialization, and point out that although David Ricardo, honoured as one of the fathers of liberal economics, may be rightly assuming that capitalization on comparative advantages increases efficiency, however, this also increases vulnerability in the given national economy. The main deficiency of Ricardo’s theory, used to this day as the foundation of the global order, is that it fails to consider the rapid and drastic change in the market conditions, however, society must prepare for such low-probability events with serious repercussions (black swans, tail risk events). The same holds true to indebtedness and to financial systems characterized by high capital leverage: until the economy keeps expanding, there is no problem, but when it is hit by recession, the various impacts multiply. Taleb’s ideas may alter the very foundations of the general view of stability, sustainability and vulnerability, as the economist and writer of several best-selling books claims that the majority of the structures believed to be stable are only balanced on the surface, while the fundamentals are frequently wobbly, as a system is genuinely stable only if it is able to respond to shocks. In this respect, the operation of the public policy system is of outstanding significance, as adaptability often requires and means decision-making efficiency in the political system.

Efficiency in financial policy and high-pressure economy

In order to accomplish the economic policy objectives, a coherent operation of the fiscal and monetary areas is required with a predominant trend in a single direction. The crisis management adopted after the initial years of the 2007-2008 crisis confirmed that economic growth does not only depend on the tax regime and on fiscal regulation, but also on investment-boosting central bank schemes and on cheaper commercial bank loans triggered by low central bank base rates. Although the moderation of inflation and its maintenance at a low level are classical central banking goals, the facts that in the years after the crisis the enforcement of governmental price control and reducing direct taxes were also able to significantly cut prices within a short time and anchor inflationary expectations, also important for the inflationary trend, at a permanently low level may not be overlooked. On the other hand, the requirements regarding the modernisation of the national economy can also be met as an aggregate result of the active use of governmental money and asset policy means and central banking instruments to guarantee the stability of the value of funds, incomes and savings that facilitate state operation. After the 2007-2008 crisis it became obvious that financial / economic policy can no longer be interpreted within the framework of the government’s fiscal policy. In the years that followed the 2007-2008 crisis the four objectives (growth, equilibrium, moderated inflation and ability to renew the economy, the society and the institutional environment) public finance authorities characteristically endeavour to orchestrate to achieve could only be accomplished with the intensive and coordinated contribution of the government and the central bank.

During the years of crisis management it was clearly proven that a state capable of building a cooperative relationship with its citizens, with the business sector, with banks and with all other affected parties (collectively referred to as stakeholders) can be more successful than the one that is incapable of doing so. Based on the extended conceptual model by Ulrike Mandl, AdriaanDierx, and Fabienne Ilzkovitz (2008), the output and outcome of economic policy actions can be substantially improved by the provision of incentive for the stakeholders, especially the market and other public participants (1) to make them interested in the success of state actions, (2) to identify themselves with the objectives of state operation and the particular state action or programme, and (3) to commit to achieving the state objectives. Efficient state operation is the achievement of the above-described “condition”, as it means cooperation between the state and stakeholders in the broad sense, which is more efficient than the mode of operation built on the absence of cooperation. As the reinforcement of public confidence may result in a beneficial commonality of interests, the renewal of state operation should be conducive to cooperation and the reinforcement of public confidence at the level of basic principles, objectives, the target system and the targeted structure, as well as in practice, promoting change not only in specific action but also in the approach (frame of mind, attitude, value system) vis-a-vis the state. Presuming interaction between the conduct of the state and that of stakeholders, in order to achieve the condition of a cooperating state, the state needs to be sure that the response to its cooperative actions will be cooperation and the previous non-cooperative conduct is not carried on. As a precondition, this requires the reinforcement of the state, as permanent cooperation is only conceivable between equal parties: a weak state cannot develop a cooperative environment, only an efficient and powerful state is capable of “getting” the private sector to permanently cooperate. For this reason, in a social perspective, the optimum state of affairs is the “well-managed state”, representing cooperation between the state and its stakeholders, as both the cooperating parties and, indirectly, the entire society benefit from cooperation, because it contributes to the improvement of public confidence and to the implementation of public welfare as the utmost social goal.

According to the school advocating the primacy of free market, the state’s role is merely confined to developing and maintaining the framework of market operation, in other words, the lowest possible taxes, the laxest possible regulation, and ensuring the most flexible labour and financial market, thus excluding the need for any related capital investments by the government. Jeffrey Sachs recommends a completely new economic approach he has coined as “Sustainable Development Economics” (Jeffrey D. Sachs, 2014). In Sachs’ opinion, the neoclassical school is wrong as they misunderstand the role and nature of modern-age capital investments. In mainstream economics prime significance is attached to private investments, investments bolstered and supported by low taxes and lenient regulation, or high demand. However, it should be noted that nowadays there is no private investment without government or community investment, the private and the public sectors are complementary to each other. The reason is that the basis of private capital investments is investment by the government, in other words, infrastructure, roads, harbours, ports, the railway network, the public utility supply system, or the optical cables and education (see: Zeman, 2017a, 2017c), on par with the society’s overall level of knowledge and culture, the eco-system that provides the setting for the economy, and the creation and maintenance of social confidence to enable business transactions. Sachs thinks that the genuine novelty is not the need of these public capital investments, we have been aware of it for long, however, the considerable increase in the expectations related to the quality of public investments marks the opening up of a new era.

The quality of government investments is increasingly important, and consequently, the role of the state is becoming all the more important. Special mention should be made of the role of the state in two special areas: in retaining labour and in power supply.

Due to the liberalization of the labour market, poorer states are broadly characterized by an outflow of its workforce, which may in turn represent a serious fiscal pressure over the longer term. According to the market logic, the international levelling of wages solves this problem, however, in practice, this is limited, and in other words, the exodus may become permanent. Non-market based wage setting and may counteract Wage levelling may be counteracted if wages setting is not market-based and if the marginal productivity of labour is not all the same everywhere. The latter means that if the work performed by an engineer or a physician is worth more in a developed market environment (with advanced infrastructure, developed economy, rich citizens, responsible citizenship etc.) than in a less developed one (missing all these). Thus, theoretically wage levelling is ruled out, and he state must undertake an active role in the retention of labour, among others, through investments.

Certain government investments have higher added value than others: in addition to investing in the retention of labour, investment in the energy sector may be such a project. In the recent decades, primarily the difference between labour costs was the predominant factor in investment decisions, however, in the future, energy prices may assume this role. Today it is no longer sufficient to supply energy, it is also important to meet the sustainability criteria and supply energy cheap. According to John Gapper (2014) “cheap energy is the new cheap labour”, and he points out that energy price, as a production input, is of utmost significance for energy-intensive strategic industries – like the chemical, the oil, the aluminium and the steel industry.

The concept of “high-pressure economy” may change economic thought to the core, as it claims that recessions have permanently reduced the level of GDP (hysteresis) in two-thirds of the cases. The “high-pressure economy” concept comes from Okun (Arthur M. Okun, 1973), but the concept was also underpinned by the 2016 survey performed by Fatás and Summers (Antonio Fatás and Lawrence H. Summers, 2016), who concluded that the 1 per cent GDP drop resulting from fiscal restriction also reduces potential output by 1 per cent. The phenomenon of hysteresis appreciates counter-cyclical economic policy, as in addition to stabilising the economy around the trend, fiscal and monetary policies may have a substantial impact on GDP over the long term (Dosi et al., 2018). It is a general objection to the concept of high-pressure economy that it is risky in terms of inflation but rise in the output has a decreasing impact on inflation.

The crisis has rewritten the very bases of the propositions related to the economic sustainability of growth. Previously it was thought that the basic condition of sustainability was that no inflationary pressure should evolve in the economy even with the optimum utilization of the production factors, while due to the promotion of efficiency, “financial deepening” was considered as a factor supporting long-term growth. However, today we know that the above described conditions lead to serious financial imbalances and the accumulation of huge debts. For this reason, in addition to the stable price environment, the definition of sustainability should also be completed with the operational stability of the financial system, and in addition to business cycles, financial cycles should also be taken into consideration for the assessment of the sustainability of growth procedures. The aforementioned Taleb’s thought, however, goes even further: in his opinion, the desirable systems are not those that are statically stable but those that benefit from shocks, thrive and renew as a result of shocks. It follows from this that Taleb thinks the economy as a whole should be changed in the direction of ‘antifragility’. In this approach, smaller local businesses are more desirable than huge mammoth companies and banks, as the previous are only seemingly less efficient, because risks remain hidden in mammoth companies and sooner or later they need assistance (too big to fail), while small companies do not have such concealed costs and so bankruptcy reinforces the sector (the system learns from failures).

Economics also considers the financing aspects of growth in a different perspective: the basis of economic growth on the liabilities side does make a difference. The models based on external financing have been replaced by solutions relying on internal resources, as external financing may be attractive in the short term, but it may carry serious sustainability and refinancing risks. In addition to their size and form, the utilisation of the funds raised have come into focus, as burning through consumer loans have a different impact than the evolution of asset price bubbles or the financing of production capacities. Both for households and at the level of the national economy, creditors’ responsibility has become an important consideration. There has been a conflict of interests between creditors and borrowers ever since the very first loan transaction was brokered about a thousand years ago, but in the past few decades we seem to have forgotten that responsibility does not only lie with the debtor in a lending transaction. It is true that the repayment of loans is the basic condition of normal lending, but when a loan is contracted, the creditor also has genuine responsibility, as only lending to a properly creditworthy client can be considered as economically and morally acceptable. The crisis has shown that the creditor-debtor relationship is complex, there is no ironclad rule, it is rather a regularly re-negotiated social “agreement” with the creditor involved just as much as the borrower and the community, i.e. the state (Robert Skidelsky [2014]).

The significance of understanding institutions and human behaviour

In the absence of appropriaterules and forms of collective behaviour, sustainable economic development is ruled out (see: Zeman, 2017b). Bad rules and forms of behaviour can cause serious damage. Well-constructed institutions that increase social welfare reduce transaction costs, uncertainties and external impacts, while a poorly developed institutional system may have just the opposite effects. Following in the footsteps of Thorstein Veblen, Walton Hamilton and John R. Commons, institutions can be considered as factors that influences economic decisions: formal rules, i.e. laws and other government regulations, and informal factors, i.e. culture and even the religious background. The scope of factors influencing the economy has broadened, their weighing has changed and these will not leave the institutional framework unaffected. The “institutional background” can be considered as efficient if the various institutional levels are inseparably cascaded: formal rules fit to informal ones, written statutes do not break with the community’s past, experiences and cultural endowments and especially, the confidence level characteristic of the community. (About the significance of social trust in general, see Francis Fukuyama, 1996.). Stable institutional foundations take into account that formal and for informal institutions (rules) have completely different paces of institutional development. Formal rules may be changed overnight, however, the informal restrictions giving the framework of individual and collective behaviour only allow a gradual evolution. Consequently, regulation is characteristically considered as good if it respects local conditions, and bad if it wants to press new forms of behaviour on the community, going against them. As formal regulation is the responsibility of political institutions, the precondition of good and efficient regulation is the establishment of a public political system that efficiently conveys the interests and preferences of wide social layers to the various decision-making forums. Arising from the peculiar features of community decision-making, the institutional environment, and especially the formal institutional matrix – is not necessarily shaped by the entire affected community, rather the pressure groups that have actual influence on decision-making. This is why the definition of the stakeholders’ specific interests is of paramount significance in understanding the processes. In most cases it can be derived from the social, economic, political and cultural position of the particular group, and in certain cases from their distinctive vision of the world.

It is a fundamental requirement that economic models should be more realistic and veritable, as expressed by the Keynesian professor of the Cambridge University, Miklós Káldor. This means that it is time to exceed the classical concept of man in microeconomy. To mention only the most obvious elements: (1) Due to the limits of his cognitive abilities and the absence of information, we are unable to make reasonable decisions with a pinpoint accuracy (limited rationality); (2) in the overwhelming majority of cases, the parties involved are not identically informed and do not have identical knowledge (informational asymmetry); (3) people optimise for a short term, i.e. when adopting decisions, they attribute less than the actual significance to long-term consequences (myopia). All these determine their decisions to a major extent and at the same time hamstring description of their genuine conduct in the standard models. How are individual decisions actually made in reality? What mechanisms actually determine community decision-making? These are the questions we need to find satisfactory answers for if we want to have models that work. The standard economic though has been far too oversimplifying in this field.

With the development of the neoclassical concept, economics increasingly shifted towards natural sciences, which entailed the fading away of the “link to psychology”: the idea of the homo oeconomicus, which comes in handy inmodels but is highly out-of-touch with reality, and distorted economic thought. However, the progress made in cognitive psychology started a new chapter and inspired economists to set up models built on a more sophisticated concept of humans (with Amos Tversky, the Nobel Prize winner Daniel Kahneman, and Richard Thaler spearheading in this field), ultimately paving the way to the renewal of understanding macroeconomic correlations and the evolution and strengthening of an economic thought that fits and maps reality.

Today it is difficult to understand, for instance, why institutions were left out of the basic neoclassical schemes. Every model is based on simplification. The quality difference between the individual models arises, for the most part, from the factors taken into consideration: whether they are actually irrelevant for the outcome or not. The neoclassical school presumes that the price regime enables an efficient allocation and is free of charge, there are no transaction costs, and the economic decision-makers are fully informed and make reasonable decisions. In such an environment, institutions have no relevance, as they have an impact on economic developments primarily through influencing transaction costs and diverting individual–community decision-making. The institutional approach is the opposite: there are transaction costs and the institutions, i.e. the framework for and rules of economic activity, can reduce, and under a favourable scenario, institutional development serves exactly this purpose. In the development of the institutional environment, which has formal and informal elements, both the state and stakeholders outside the state have their own “assignments”.

According to the classification of Michel De Vroey and Luca Pensieroso (2016), economic thinking, which appeared at the end of the 18th and beginning of the 19th century (the best-known representatives being Adam Smith, Ricardo, Say, Malthus and Mill), developed in two distinct directions in the late 19th and early 20th century. One is the neoclassical approach, which may be considered as a precursor of today’s mainstream trend, and the other is the institutional one. For a long time these two approaches co-existed relatively peacefully side by side, giving an example of intellectual pluralism. After the “marginalist movement”, typically linked to Jevons, Menger, Walras and especially Marshall, who wrote the Principles of Economics and thus marked out the fundamentals of economic thinking, had achieved its full purpose, the gap grew between the equilibrium trends (classical and neoclassical) and the institutional school. The methodological differences between the neoclassical and the institutional approach were indeed significant. The economists supporting the institutional approach analysed society basically divided into major groups (classes); defined the market as a kind of a complex combination of rules changing over time (institution), and their analyses typically discussed collective decision-making, as against the neoclassical economists, who focussed primarily on individual decisions (methodological individualism) and had an equilibrium rather than an evolutionary approach.

The expression “institutional approach” appeared for the very first time in the economic jargon in Walton Hamilton’s article published in 1919 (Walton Hamilton, 1919), but the spread of institutional thinking is linked mainly to the works of Thorstein Veblen. One of Veblen’s principal hypotheses was that economics should develop into an evolutionary discipline (Thorstein Veblen, 1898) and should abandon thinking in equilibrium, as the economy is mostly an evolutionary system, rather than a structure that seeks to strike balance. Veblen was among the first economists to have a critical stance concerning the hedonistic-reasonable ideal called homo oeconomicus, representing the basis of neoclassical thinking. The reason is that in Veblen’s opinion these assumptions were unrealistic. As early as the end of the 19th century, psychology had already proven that human behaviour was far more complex and changed over time. Veblen thought that the evolutionary approach also meant that economics itself had to develop and integrate the achievements of other academic disciplines.

After World War II, the influence of the institutional approach declined, especially for the reason that a Cambridge economist, John Maynard Keynes created modern macroeconomy on the basis of classical economics, and this automatically led to the institutional theories, which had surfaced with a similar force in the 1920s, losing ground. After a few decades of interruption, in the 1970s institutions came to the foreground again. While the representatives of the early institutional school considered institutions as factors fundamentally restricting individual elbowroom, and moreover, in many cases the institutional features were blamed for economic and social backlogs, the new institutional economists emphasized the kinds of institutions required for development.

The new institutional school integrates institutions into the neoclassical framework and analyses institutions primarily according to their ability to reduce transaction costs and uncertainty and their assistance to the internalization of externalities. The institutions – established on account of the economic actors’ limited rationale – determine the transaction and production costs and consequently, they have a fundamental impact on the operational efficiency of an economic system. As formal institutional changes are under political control, the operation of the political system has an intrinsic impact on economic efficiency.

The new institutional school reflected at length on the requirements of economic development. In 2009, Nobel Prize winner Oliver E. Williamson distinguished four levels in the institutional environment, which determine economic performance in combination: (1) ethics, the “embeddedness” giving standards; (2) the “basic institutional environment” representing property rights and political and legal institutions; (3) the “governance structures”, including both internal organizations and corporate operation; and (4) “resource allocation”, analysed by standard microeconomy. These four levels interact, and the desired development can only be achieved if the various levels do not act against one another: in other words, if for example, the political system fits in the standards, the ethical foundations and customs of the given society (as frequently emphasized, for example, in China, which has chosen a course of development that differs from the western pattern). Institutions have a pivotal significance in economic development, and North even claimed that ultimately economic development is nothing else but the development of the institutional environment. In this approach, development is an incremental process, in which institutions change because in the affected decision-makers perception this may result in a Pareto optimum shift (the basis of development is thus a kind of a learning process). It is important that formal rules match the informal (cultural) endowments and that the system of political institutions is capable of detecting and implementing the required institutional changes.

Mainstream economists typically think in terms of extreme solutions, leaving the solution of a problem to be solved by the market (through privatization) or the state (regulation). This wrong approach was interrupted by Elinor Ostrom, who was looking for a solution to the tragedy of public pastures and shared the Nobel Prize in economics with Williamson in 2009. She claimed that there were several solutions between two extreme solutions, as evidenced by numerous examples in community self-determination seen everywhere in daily life. The economic approach assuming a vacuum between individuals and the government is incorrect, as habits, social standards, personal relationships, and more or less formalized wider and narrower communities, voluntary organizations are all interposed between the two, and their existence and smooth operation are indispensable for economic development.

The increasing number of Nobel Prizes clearly show that the rehabilitation of the once powerful institutional thought has begun. There are, however, institutionalists who would not agree, as he appearance of the new institutionalist school has given way to the “critical institutionalist” school hallmarked by Geoffrey Hodgson and Ha-Joon Chang. Inspired, for the most part, by Veblen’s above-mentioned works and a book by Richard Nelson and Sidney winter (Richard Nelson and Sidney Winter, 1982), Hodgson claims no less than a complete break is needed, and we should dismiss the view of the profit maximizing individual as well as the invariable utility functions, which, with minor additions and supplements, constitute the foundation of microeconomy to this very day.

An old trend re-gaining ground in economics

With the labour pains of shaping new theoretical foundations, one of the pivotal phenomena is the economic philosophy expansion proposed by the intellectual circles of the Catholic Church. The most outstanding ancient think tanks – primarily Plato and Aristotle – and then St Augustin of Hippo and St. Thomas of Aquino were tapping into economic matters. They characteristically analysed economic phenomena in a moral perspective, and so they condemned speculation, for example. The Catholic Church reflected on economic issues in Rerum Novarum or “Rights and Duties of Capital and Labour”, an encyclical issued by Pope Leo XIII in 1891, which disapproves the liberalist principles claiming that the self-healing powers of the market are sufficient, the state needs not deal with social policy matters, and the government’s intervention in social processes is harmful. The most important duty of the state is to “serve the welfare of the community and of individuals”, and “workers’ activity is especially efficient and required” in implementation.

The instructions and academic theories elaborated by intellectual workshops in relation to the Catholic teaching (Helen J. Alford and Michael J. Naughton, 2001) provided a sound basis for reconsidering the mainstream thought built on Adam Smith’s ideas, including the invocation of Antonio Genovesi, the classic author of anthropocentric economics, after three hundred years of slumber and despite the fact that he was sidelined already by his contemporaries. In economics, emphasis on anthropocentrism is for the most part ascribed to Ernst Schumacher and the 1970s, however, several centuries earlier Genovesi had already written that linking the economy with morals and the alignment of man with virtue were of primary significance among economic axioms. The emphasis on bourgeois and civil values, focus on values, a social approach, cooperation, public happiness and an ethics based on virtues are all important in the economy, and the concept advocated by Aristotle and St Thomas along with the Catholic Church’s social teaching are very close to these ideas. A book by Lugigino Bruni and Stefano Zamangi (2007) carry forward Genovesi’s intellectual heritage and is aimed at broadening the horizon of thinking after the crisis. Their main proposition is that the prosperity of social organisations seen in the past few decades was merely accidental, and they are no exceptions to the ordinary course of capitalist economic development, rather they represent a dire symptom of a crisis in the capitalist economy and also hope for a new start. They demonstrate that the operation of the globalised society and economy requires the re-discovery of the fundamental relationship between the “principle of contract” and the “principle of reciprocity”. In their historical retrospection they confirm that market is “civilian” and has a “civilising” impact if and when it is characterised by reciprocity. Bruni and Zamagni think that a society that precludes the principle of reciprocity form its cultural horizon will become incapable of survival and of satisfying its members’ demand for happiness. The keywords in their theory are happiness and public welfare, which – in contrast to the mainstream approach – are categories not external to economic theory at all.

Among the teachings of religious dimensions mention should be made of Professor Paul. W. Dembinski’s oeuvre (Paul W. Dembinski, 2018), who thinks that with the post-crisis new awakening we are currently witnessing the twilight of “thirty euphoric years”. The neoliberal method of production was undermined by the subprime crisis that unfolded in the Anglo-Saxon mortgage markets from 2007, which was not primarily economic in nature, rather a failure in human self-control. Dembinski provides evidence for the existence of an alternative to the neoliberal method of production, which gives the opportunity for the unlimited satisfaction of a voracious quest for profit, and proves that the gap between ethics and responsibility is not insuperable. In Dembinski’s opinion human life may only be termed “mature and full” in the ethical sense, if it has regard for others, and “lives together with and for others”. This has four preconditions:

the harmony of intra-group existence and non-conflicting relationships,

service and reciprocity.

In his analysis of the ethical conundrums of financial intermediation, he studies the participants of the interrelationships of the financial system. He calls the first method of intermediation “spatial”, the second one “temporal”, while the third one tackles risk profiles. Dembinski thinks that this triple intermediation enables the financial sector’s performance to have double social benefit – namely, from capital and risk. In his description of the ethical conundrums relating to this area, first he focuses on the macroeconomic level to demonstrate the moral criteria and consequences of the two main traditions of financial organisations, and then proceeds to analyse the key ethical dogmas arising from the financial system taken in the narrow sense of the word. A comparison of the Anglo-Saxon and the Rhine traditions adds interest and colour to his analysis. In the Anglo-Saxon practice those who use people’s money and the owners of money are accountable, while in the Rhine tradition banks are considered to act as fathers in giving guidelines and advice. The typology of financial participants also differs. The Rhine tradition distinguishes between three layers: the general public having poor financial knowledge, the sophisticated “browsers” of financial service providers, who are capable of rising to the responsibility, and the specialists employed by financial institutions. In the Anglo-Saxon tradition, the first two layers are blended, and thus there are only two strata: service provider experts and service user clients. The collateral instruments that secure the financial system’s stability also differ. The most important element in financial markets is whether financial market prices are true and efficient. Consequently, the moral integrity of the market is pivotal. In the Rhine tradition, however, where banks’ reliability has a key role, the situation is different. The professionalism of intermediation lies in the reliability of the statement of the source and application of funds. Apart from the differences, the two traditions have a point in common: the health of the system depends on the honesty of financial specialists and the regulators’ good perception. The applicability of the history of the theory described by Dembinski, or at least its use as a guideline, is rendered more difficult by the fact that as a result of globalization, the operating mechanism of European banks (of the continental Rhine tradition) have practically “dissolved” in the banks of the Anglo-Saxon type. Thus, currently the former benefits of the banks of the Rhine tradition are worth nothing in today’s complex and globalised banking transactions (although it would be desirable).


We had to wait until the 2007-2008 global financial crisis for the deficiencies of the mainstream economic thought to surface. Nowadays there is an increasing number of indications suggesting that the scope of economic thought may widen and put special emphasis on the significance of institutional frameworks, the limits set by actual human conduct, the criteria of stability and sustainability taken in the broad sense of the words, and vulnerability to shocks, which require efficient and coordinated state action and intervention as indispensable prerequisites. It goes too far to assume that these key words were completely missing in the period preceding the crisis, but certainly less than justified attention was paid to these considerations before 2007. Fortunately and quite rightly, there is a good chance that in the future this will change. Ultimately, according Hyun Song Shin (2013), macroeconomy “cannot remain insensitive to the facts forever”.

Practice has cast doubt on the enforcement of the neoclassical synthesis underlying the crisis that erupted in 2007 in an unchanged form. This is reflected in the various efforts made at renewing economics. Perhaps the best known such initiative was the 33 reform theses displayed on the entrance of the London School of Economics in December 2017 (New Weather Institute, 2017), and in the academic circles in the strict sense, for example the 2018 spring and summer issue of the journal Oxford Review of Economic Policy, entitled “Rebuilding Macroeconomic Theory” (in this issue numerous renowned economists publish studies about macroeconomic prospects, special mention should be made of Blanchard (2018), Reis (2018), and Stiglitz (2018)). It is a fact, however, that although a decade has passed, the “amortised” mainstream theoretical framework has not been replaced by a new, complex and coherent theory despite the predominant social and academic legitimation. Not even a mapping of successful fiscal and monetary governance implemented in practice. This economic theory deficit, the theoretical debates made to this very date, and the resistance of the neoclassical school have an adverse impact on the other social disciplines built on economic theory, especially on law, political science and sociology, which all have an economic relevance. Thus the acts adopted to consolidate the economy have become ad hoc in nature and are forced to frequently adjust to regular changes in practice, in other words, the statutory regulations do not demonstrate sufficient stability, for the most part due to the absence of theoretical foundations.

According to Thomas Kuhn’s philosophy of science, before the establishment of a new paradigm, science continues to build on the existing one. However, the state policy and social requirements focusing on sustainability, financial stability and the moderation of economic and social vulnerability call for a new paradigm in economics and public finances. The shift in economics towards business sciences and business approach in the course of the forty years preceding the crisis and its confinement to the description of law and state operation have become obsolete content in today’s scientific policy. Preventive legislation, which places state operation on an efficient trajectory and avoids crises, and the changed economic content and social expectation regarding the operation of the state and of public services have become content-related and organisational attributes of statecraft, and their reflection in education and academic research have become one of the key intellectual challenges of our days.


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This study written in part of Lentner, C. in PADE Leader Expert Program

Csaba Lentner
full professor, head of institute, National University
of Public Service, Public Finance Research Institute

Pál P. Kolozsi
associate professor, National University of Public Service, Public Finance Research Institute