Darwin and Economic Reforms

Frequently science advances by the proposition of theories that are able to explain certain phenomena under a certain ideological framework. Evolution theory is one of the greatest examples. Darwin proposed a reasonable mechanism that could explain life under a strictly materialistic framework of biological nature. The early enthusiasm about the theory did not derive from its empirical accomplishments, but from the attractiveness of its underlying ideological framework. It was now possible to adhere to all-encompassing materialism without any plausible rational objection. Nonetheless, the theory made very broad predictions about the nature of life, the nature of heritage, the possibility of mutations, the continuity of specie differentiation and the power of a natural selection optimization algorithm. The ultimate vindication of the theory dependent on the adequate confirmation of each of those bold predictions. Ideology in itself would hardly have been sufficient for one of the greatest scientific achievement of all time.

It is important to recognize that even though ideological reasoning can be a plausible motivation for advancement of knowledge it cannot be sufficient in itself. The inner logic of a theory, often sufficient to convince adherents of that specific ideology, cannot form the basis of proper scientific knowledge. Any theory based on ideology must be able to either make new factual predictions or explain other phenomena that are somewhat alien to the original scope of the theory.

The so-called New Institutional Economics is a good example of an ideology-based theory. By invoking high transaction costs and partial information, it proposed a mechanism, from which a system of rational self-interested agents could create, by the imposition of those with bargaining power, sub-optimal institutional frameworks. From a strictly theoretical point of view, it was nothing more than giving enough degrees of freedom to a new classical model in order to allow it to accept stable sub-optimal equilibrium. However, from an ideological point of view it was a major achievement: it was now possible to adhere to neoclassical economics without any plausible rational objection. In theory, any historical institution of societies could result by this mechanism. Even more important, it introduced the possibility of path dependency on economic development: it was plausible for an economy to be stuck in a sub-optimal equilibrium because those with bargaining power were able to devise stable institutions to serve their own interests. Just like evolution theory, it became mainstream almost overnight by those captivated by the neoclassical ideology. Both the IMF and the World Bank were eager to implement its prescriptions to their programs. It gave them as an institution, and their bureaucracy as ideologues, a new reason for existence. The era of economic reforms began: every country should be “forced” to reform their existing institutional framework to make them more like those of developed economies. It was the stairway to heaven. The global general equilibrium of all nations was within grasp.

The theory made bold predictions, or at least as bold as we can get from social sciences. First, since there is still a general equilibrium without transaction costs, there are potentially perfect institutions. Those economies that were able develop continually should be closer to those institutions. Moreover, as consequence, they should be much less subject to abnormal economic cycles than those predicted by traditional neoclassical economic models. In addition, even though there is no unique path to approach the optimal equilibrium, on the long run those idiosyncratic paths should more or less converge to each other. In other words, there should be no sustained development strategy very different from those pursued by the developed economies. Small variations in accordance to the historical idiosyncrasies of each economy are reasonable, but a radical deviation would be a huge anomaly.

How then could the 2008 economic crisis happened? How such a divergent outcome be possible? Even more shocking: it was very clearly caused by the state-of-the art institutions (like Basel capital rules). Even more shocking: how could China find a sustained development trajectory so alien to those of the past? How could an economy so far away from neo-liberal political and social institutions be the best performing economy for so long? In its bold predictions new institutional economics failed badly. Nonetheless, it continues to be preached as sacred scripture all over the developing world. Reform, reform, reform. Basle II failure? Bring us Basle III. The ultimate irony is that those proponents of the theory seem to be stuck in a suboptimal methodological equilibrium: the theory seemed too beautiful to be false.