‘Any	customer	can	have	a	car	painted	any	colour	that	he	wants	so	long	as	it	is	black.’
HENRY	FORD
‘Let	a	hundred	flowers	bloom,	let	a	hundred	schools	of	thought	contend.’
MAO	ZEDONG
The	One	Ring	to	Rule	Them	All?:	The	Diversity	of	Approaches	to	Economics
Contrary	to	what	most	economists	would	have	you	believe,	there	isn’t	just	one	kind	of	economics	–
Neoclassical	economics.	In	this	chapter,	I	introduce	no	less	than	nine	different	kinds,	or	schools,	as	they
are	often	known.*
These	schools	are	not	irreconcilable	enemies,	however;	the	boundaries	between	schools	are	actually
fuzzy.1	But	it	is	important	to	recognize	that	there	are	distinctive	ways	of	conceptualizing	and	explaining
the	economy,	or	‘doing’	economics,	if	you	like.	And	none	of	these	schools	can	claim	superiority	over
others	and	still	less	a	monopoly	over	truth.
One	reason	is	the	nature	of	theory	itself.	All	theories,	including	natural	sciences	like	physics,
necessarily	involve	abstraction	and	thus	cannot	capture	every	aspect	of	the	complexity	of	the	real	world.2
This	means	that	no	theory	is	good	at	explaining	everything.	Each	theory	possesses	particular	strengths	and
weaknesses,	depending	on	what	it	highlights	and	ignores,	how	it	conceptualizes	things	and	how	it	analyses
relationships	between	them.	There	is	no	such	thing	as	one	theory	that	can	explain	everything	better	than
others	–	or	‘the	one	ring	to	rule	them	all’,3	if	you	are	a	fan	of	The	Lord	of	the	Rings.
Added	to	this	is	the	fact	that,	unlike	things	that	are	studied	by	natural	scientists,	human	beings	have	their
own	free	will	and	imagination.	They	do	not	simply	respond	to	external	conditions.	They	try	–	and	often
succeed	–	to	change	those	very	conditions	by	imagining	a	utopia,	persuading	others	and	organizing	society
differently;	as	Karl	Marx	once	eloquently	put	it,	‘[m]en	make	their	own	history’.*	Any	subject	studying
human	beings,	including	economics,	has	to	be	humble	about	its	predictive	power.
Moreover,	unlike	the	natural	sciences,	economics	involves	value	judgements,	even	though	many
Neoclassical	economists	would	tell	you	that	what	they	do	is	value-free	science.	As	I	will	show	in	the
following	chapters,	behind	technical	concepts	and	dry	numbers	lie	all	sorts	of	value	judgements:	what	is
the	good	life;	how	minority	views	should	be	treated;	how	social	improvements	should	be	defined;	and
what	are	morally	acceptable	ways	of	achieving	the	‘greater	good’,	however	it	is	defined.4	Even	if	one
theory	is	more	‘correct’	from	some	political	or	ethical	points	of	view,	it	may	not	be	so	from	another.
Cocktails	or	the	Whole	Drinks	Cabinet?:	How	to	Read	This	Chapter
While	there	is	a	good	reason	for	the	reader	to	learn	about	different	schools	of	economics,	I	accept	that
being	suddenly	asked	to	taste	nine	different	flavours	of	ice	cream	when	you	had	thought	that	there	is	only
plain	vanilla	can	be	quite	overwhelming.
Even	though	I	simplify	things	a	lot,	readers	may	still	find	the	discussion	too	complicated.	In	order	to
help	them,	I	preface	my	presentation	of	each	school	with	a	one-sentence	summary.	These	summaries	are,
of	course,	far	too	simplistic,	but	at	least	they	will	help	you	overcome	the	initial	fear	that	you	are	about	to
walk	into	a	new	city	without	a	map,	or,	rather,	a	smart	phone.
Now,	even	those	who	are	willing	to	learn	about	more	than	one	school	may	feel	that	nine	schools	is	six
or	seven	too	many.	I	agree.	For	them,	I	offer	in	the	box	below	a	number	of	‘cocktails’	made	up	of	two	to
four	different	schools,	each	of	which	covers	particular	issues	well.	Some	of	these	cocktails,	such	as
CMSI	or	CK,	will	be	like	Bloody	Mary	with	a	lot	of	Tabasco	sauce,	given	the	disagreements	present.
Some	others,	such	as	MDKI	or	CMDS,	may	taste	like	a	Planter’s	Punch,	with	different	flavours
complementing	each	other.
My	hope	is	that	tasting	one	or	two	of	those	cocktails	may	even	make	you	want	to	taste	the	whole	drinks
cabinet.	Even	if	you	don’t	want	to	go	the	whole	length,	tasting	one	or	two	of	them	will	still	have	shown
you	that	there	is	more	than	one	way	to	‘do’	economics.
ECONOMICS	COCKTAILS
Ingredients:	A,	B,	C,	D,	I,	K,	M,	N	and	S
or
Austrian,	Behaviouralist,	Classical,	Developmentalist,	Institutionalist,	Keynesian,	Marxist,	Neoclassical	and	Schumpeterian.
	
On	diverging	views	of	the	vitality	and	the	viability	of
capitalism,	take	CMSI.
If	you	want	to	know	why	we	sometimes	need	government
intervention,	take	NDK.
	
To	discover	different	ways	of	conceptualizing	the	individual,
take	NAB.
In	order	to	learn	that	there	is	a	lot	more	to	the	economy	than
markets,	take	MIB.
	
If	you	want	to	see	how	groups,	especially	classes,	are
theorized,	take	CMKI.
To	study	how	technologies	develop	and	productivities	rise,	take
CMDS.
	
To	understand	economic	systems,	rather	than	just	their
components,	take	MDKI.
If	you	want	to	find	out	why	corporations	exist	and	how	they
work,	take	SIB.
	
If	exploring	how	individuals	and	society	interact	is	your	thing,
take	ANIB.
For	debates	surrounding	unemployment	and	recession,	take
CK.
	
For	various	ways	of	defending	the	free	market,	take	CAN.
	
Health	warning:	On	no	account	drink	only	one	ingredient	–	liable	to	lead	to	tunnel	vision,	arrogance	and	possibly
brain	death.
The	Classical	School
One-sentence	summary:	The	market	keeps	all	producers	alert	through	competition,	so	leave	it	alone.
Today,	the	Neoclassical	school	dominates.	As	you	will	have	guessed,	there	was	Classical	economics
before	Neoclassical	economics,	of	which	the	latter	is	the	supposed	heir	(although	the	Marxist	school	has
an	equally	good	claim	to	be	its	heir,	as	I	shall	explain).
The	Classical	school	of	economics	–	or,	rather	the	Classical	school	of	political	economy,	as	the
subject	was	then	called	–	emerged	in	the	late	eighteenth	century	and	dominated	the	subject	until	the	late
nineteenth	century.	Its	founder	is	Adam	Smith	(1723–90),	who	we	have	discussed	already.	Smith’s	ideas
were	further	developed	in	the	early	nineteenth	century	by	three	near-contemporaries	–	David	Ricardo
(1772–1823),	Jean-Baptiste	Say	(1767–1832),	and	Robert	Malthus	(1766–1834).
The	invisible	hand,	Say’s	Law	and	free	trade:	the	key	arguments	of	the	Classical	school
According	to	the	Classical	school,	the	pursuit	of	self-interests	by	individual	economic	actors	produces
a	socially	beneficial	outcome,	in	the	form	of	maximum	national	wealth.	This	paradoxical	outcome	is	made
possible	by	the	power	of	competition	in	the	market.	In	their	attempts	to	make	profits,	producers	strive	to
supply	cheaper	and	better	things,	ultimately	producing	their	products	at	the	minimum	possible	costs,	thus
maximizing	national	output.	This	idea	is	known	as	the	invisible	hand	and	has	become	arguably	the	most
influential	metaphor	in	economics,	although	Smith	himself	used	it	only	once	in	The	Wealth	of	Nations
(TWON)	and	did	not	accord	it	a	prominent	role	in	his	theory.*
Most	Classical	economists	believed	in	the	so-called	Say’s	Law,	which	states	that	supply	creates	its
own	demand.	The	reasoning	was	that	every	economic	activity	generates	incomes	(wages,	profits,	etc.)
equivalent	to	the	value	of	its	output.	Therefore,	it	was	argued,	there	can	be	no	such	thing	as	a	recession
due	to	a	shortfall	in	demand.	Any	recession	had	to	be	due	to	exogenous	factors,	such	as	a	war	or	the
failure	of	a	major	bank.	Since	the	market	was	incapable	of	naturally	generating	a	recession,	any
government	attempt	to	counter	it,	say,	through	deliberate	deficit	spending,	was	condemned	as	disturbing
the	natural	order.	This	meant	that	recessions	that	could	have	been	cut	short	or	made	milder	became
prolonged	in	the	days	of	Classical	economics.
The	Classical	school	rejected	any	attempt	by	the	government	to	restrict	the	free	market,	say,	through
protectionism	or	regulation.	Ricardo	developed	a	new	theory	of	international	trade,	known	as	the	theory
of	comparative	advantage,	further	strengthening	the	argument	for	free	trade.	His	theory	showed	that,
under	certain	assumptions,	even	when	a	country	cannot	produce	any	product	more	cheaply	than	another
country	can,	free	trade	between	them	will	allow	both	to	maximize	their	outputs.	They	can	achieve	this	by
specializing	in,	and	exporting,	products	in	which	they	have	comparative	advantage	–	those	with	the
largest	relative	cost	advantages	in	the	case	of	the	more	efficient	country	and	those	with	the	smallest
relative	cost	disadvantages	in	the	case	of	the	less	efficient	country.*
The	Classical	school	viewed	the	capitalist	economy	as	being	made	up	of	‘three	classes	of	the
community’,	in	Ricardo’s	words	–	that	is,	capitalists,	workers	and	landlords.	The	school,	especially
Ricardo,	emphasized	that	it	is	in	the	long-term	interest	of	everyone	that	the	greatest	share	of	national
income	go	to	the	capitalist	class	(that	is,	profits),	because	it	is	the	only	class	that	invests	and	generates
economic	growth;	the	working	class	was	too	poor	to	save	and	invest,	while	the	landlord	class	was	using
its	income	(rents)	on	‘unproductive’	luxury	consumption,	such	as	the	employment	of	servants.	According
to	Ricardo	and	his	followers,	the	growing	population	in	Britain	was	forcing	the	cultivation	of	increasingly
lower-quality	land,	constantly	raising	the	rents	for	existing	(higher-quality)	land.	This	meant	that	the	share
of	profit	was	gradually	falling,	threatening	investment	and	growth.	His	recommendation	was	to	abolish	the
protection	for	grain	producers	(called	the	Corn	Laws	in	Britain	at	the	time)	and	import	cheaper	food	from
countries	where	good-quality	land	was	still	available,	so	that	the	share	going	to	profits,	and	thus	the
ability	of	the	economy	to	invest	and	grow,	could	be	raised.
Class	analysis	and	comparative	advantage:	the	Classical	school’s	relevance	for	today
Despite	being	an	old	school	with	few	current	practitioners,	the	Classical	school	is	still	relevant	for	our
time.
The	notion	of	the	economy	as	being	made	up	of	classes,	rather	than	individuals,	allows	us	to	see	how
an	individual’s	behaviour	is	strongly	affected	by	her	place	in	the	system	of	production.	The	fact	that
marketing	companies	still	use	class	categories	in	devising	their	strategies	suggests	that	class	is	still	a	very
relevant	category,	even	though	most	academic	economists	may	not	use	the	concept	or	even	actively	deny
its	existence.
Ricardo’s	theory	of	comparative	advantage,	while	having	clear	limitations	as	a	static	theory	that	takes	a
country’s	technologies	as	given,	is	still	one	of	the	best	theories	of	international	trade.	It	is	more	realistic
than	the	Neoclassical	version,	known	as	the	Heckscher-Ohlin-Samuelson	theory	(henceforth	HOS),	which
is	today	the	dominant	version.*	In	HOS,	it	is	assumed	that	all	countries	are	technologically	and
organizationally	capable	of	producing	everything.	They	choose	to	specialize	in	different	products	only
because	different	products	use	different	combinations	of	capital	and	labour,	whose	relative	endowments
differ	across	countries.	This	assumption	leads	to	unrealistic	conclusions:	if	Guatemala	isn’t	producing
things	like	BMWs,	it	is	not	because	it	cannot	but	because	it	is	not	economical	to	do	so,	given	that	their
production	uses	a	lot	of	capital	and	little	labour,	when	Guatemala	has	a	lot	of	labour	and	little	capital.
Sometimes	wrong,	sometimes	outdated:	limitations	of	the	Classical	school
Some	of	the	theories	of	the	Classical	school	were	simply	wrong.	The	school’s	adherence	to	Say’s	Law
made	it	incapable	of	dealing	with	macroeconomic	problems	(namely,	problems	that	are	to	do	with	the
overall	state	of	the	economy,	such	as	recession	or	unemployment).	Its	theory	of	the	market	at	the
microeconomic	level	(namely,	the	level	of	individual	economic	actors)	was	also	severely	limited.	It	did
not	have	the	theoretical	tools	to	explain	why	unrestrained	competition	in	the	market	might	not	produce
socially	desirable	outcomes.
Some	Classical	theories,	even	if	not	wrong	in	the	logical	sense,	have	limited	applicability	today
because	they	were	designed	for	a	world	very	different	from	ours.	A	lot	of	‘iron	laws’	of	Classical
economics	turned	out	to	be	no	such	things.	For	example,	the	Classical	economists	thought	that	population
pressure	would	raise	agricultural	rents	and	squeeze	industrial	profits	to	such	an	extent	that	investment
might	cease,	because	they	did	not	–	and	could	not	–	know	how	much	the	technologies	for	food	production
and	birth	control	would	develop.
The	Neoclassical	School
One-sentence	summary:	Individuals	know	what	they	are	doing,	so	leave	them	alone	–	except	when
markets	malfunction.
The	Neoclassical	school	arose	in	the	1870s,	from	the	works	of	William	Jevons	(1835–82)	and	Leon
Walras	(1834–1910).	It	was	firmly	established	with	the	publication	of	Alfred	Marshall’s	Principles	of
Economics	in	1890.
Around	Marshall’s	time,	Neoclassical	economists	also	succeeded	in	changing	the	name	of	the
discipline	from	the	traditional	‘political	economy’	to	‘economics’.	The	change	signalled	that	the
Neoclassical	school	wanted	its	analysis	to	become	a	pure	science,	shorn	of	political	(and	thus	ethical)
dimensions	that	involve	subjective	value	judgements.
Demand	factors,	individuals	and	exchanges:	differences	with	the	Classical	school
The	Neoclassical	school	claimed	to	be	the	intellectual	heir	of	the	Classical	school	but	felt	itself	to	be
sufficiently	different	to	attach	the	prefix	‘Neo’.	The	key	differences	are	as	follows.
It	emphasized	the	role	of	demand	conditions	(derived	from	the	subjective	valuation	of	products	by
consumers)	in	the	determination	of	the	value	of	a	good.	Classical	economists	believed	that	the	value	of	a
product	is	determined	by	supply	conditions,	that	is,	the	costs	of	its	production.	They	measured	the	costs	by
the	labour	time	expended	in	producing	it	–	this	is	known	as	the	labour	theory	of	value.	Neoclassical
economists	emphasized	that	the	value	(which	they	called	the	price)	of	a	product	also	depends	on	how
much	the	product	is	valued	by	potential	consumers;	the	fact	that	something	is	difficult	to	produce	does	not
mean	that	it	is	more	valuable.	Marshall	refined	this	idea	by	arguing	that	demand	conditions	matter	more	in
determining	prices	in	the	short	run,	when	supply	cannot	be	changed,	while	supply	conditions	matter	more
in	the	long	run,	when	more	investments	(disinvestments)	can	be	made	in	facilities	to	produce	more	(less)
of	what	is	demanded	more	(less).
The	school	conceptualized	the	economy	as	a	collection	of	rational	and	selfish	individuals,	rather	than
as	a	collection	of	distinct	classes,	as	the	Classical	school	did.	The	individual	as	envisaged	in
Neoclassical	economics	is	a	rather	one-dimensional	being	–	a	‘pleasure	machine’,	as	he	was	called,
devoted	to	the	maximization	of	pleasure	(utility)	and	the	minimization	of	pain	(disutility),	usually	in
narrowly	defined	material	terms.	As	I	shall	discuss	in	Chapter	5,	this	severely	limits	the	explanatory
power	of	Neoclassical	economics.5
The	Neoclassical	school	shifted	the	focus	of	economics	from	production	to	consumption	and	exchange.
For	the	Classical	school,	especially	Adam	Smith,	production	was	at	the	heart	of	the	economic	system.	As
we	saw	in	Chapter	2,	Smith	was	deeply	interested	in	how	the	changes	in	the	organization	of	production
were	transforming	the	economy.	He	had	a	view	of	history	in	which	societies	develop	in	stages	according
to	the	dominant	form	of	production	–	hunting,	pastoralism,	agriculture	and	commerce	(this	idea	was
further	developed	by	Karl	Marx,	as	I	shall	discuss	below).	In	contrast,	in	Neoclassical	economics,	the
economic	system	is	essentially	envisaged	as	a	web	of	exchanges,	ultimately	driven	by	choices	made	by
‘sovereign’	consumers.	There	is	little	discussion	of	how	actual	processes	of	production	are	organized	and
changed.
Self-interested	individuals	and	self-equilibrating	markets:	similarities	with	the	Classical	school
Despite	these	differences,	the	Neoclassical	school	inherited	and	developed	two	central	ideas	of	the
Classical	school.	The	first	is	the	idea	that	economic	actors	are	driven	by	self-interest	but	that	the
competition	in	the	market	ensures	that	their	actions	collectively	produce	a	socially	benign	outcome.	The
other	is	the	idea	that	markets	are	self-equilibrating.	The	conclusion	is,	as	in	Classical	economics,	that
capitalism	–	or,	rather,	the	market	economy,	as	the	school	prefers	to	call	it	–	is	a	system	that	is	best	left
alone,	as	it	has	a	tendency	to	revert	to	the	equilibrium.
This	laissez-faire	conclusion	of	the	Neoclassical	school	was	further	intensified	by	a	critical	theoretical
development	in	the	early	twentieth	century,	intended	to	allow	us	to	judge	social	improvements	in	an
objective	way.	Vilfredo	Pareto	(1848–1923)	argued	that,	if	we	respect	the	rights	of	every	sovereign
individual,	we	should	consider	a	social	change	an	improvement	only	when	it	makes	some	people	better
off	without	making	anyone	worse	off.	There	should	be	no	more	individual	sacrifices	in	the	name	of	the
‘greater	good’.	This	is	known	as	the	Pareto	criterion	and	forms	the	basis	for	all	judgements	on	social
improvements	in	Neoclassical	economics	today.6	In	real	life,	unfortunately,	there	are	few	changes	that	hurt
no	one;	thus	the	Pareto	criterion	effectively	becomes	a	recipe	to	stick	to	the	status	quo	and	let	things	be	–
laissez	faire.	Its	adoption	thus	imparted	a	huge	conservative	bias	to	the	Neoclassical	school.
The	anti-free-market	revolution:	the	market	failure	approach
Two	theoretical	developments	in	the	1920s	and	the	1930s	severed	the	apparently	unbreakable	link
between	Neoclassical	economics	and	the	advocacy	of	free-market	policies.	After	these	developments,	it
has	become	impossible	to	equate	Neoclassical	economics	with	free-market	economics,	as	some	people
still	mistakenly	do.
The	more	fundamental	of	these	was	the	birth	of	welfare	economics,	or	the	market	failure	approach,
developed	by	Cambridge	professor	Arthur	Pigou	in	the	1920s.	Pigou	argued	that	there	are	occasions	when
market	prices	fail	to	reflect	the	true	social	costs	and	benefits.	For	example,	a	factory	may	pollute	air	and
water	because	air	and	water	have	no	market	prices	and	thus	it	can	treat	them	as	free	goods.	But	as	a	result
of	such	‘over-production’	of	pollution,	the	environment	is	destroyed,	and	the	society	suffers.
The	problem	is	that	the	effects	of	some	economic	activities	are	not	priced	in	the	market	and	thus	not
reflected	in	economic	decisions	–	this	is	known	as	an	externality.	In	this	case,	it	would	be	justified	for
the	government	to	make	the	factory,	which	is	said	to	create	a	negative	externality,	pollute	less	through
pollution	taxes	or	regulations	(e.g.,	a	fine	on	excessive	release	of	effluents).	Conversely,	there	may	be
activities	that	have	a	positive	externality.	An	example	may	be	research	and	development	(or	R&D)
activities	by	a	company.	By	generating	new	knowledge	that	can	be	used	by	others,	R&D	creates	more
value	than	what	accrues	to	the	company	conducting	it.	On	this	occasion,	the	government	would	be	justified
to	pay	subsidies	to	anyone	who	does	R&D	so	that	there	would	be	more	of	it.	Subsequently,	other	types	of
market	failure	were	added	to	Pigou’s	externality,	as	I	will	discuss	in	Chapter	11.
A	more	minor	yet	important	modification	came	in	the	1930s,	in	the	form	of	the	compensation	principle.
The	principle	proposes	that	a	change	may	be	deemed	a	social	improvement	even	when	it	violates	the
Pareto	criterion	(in	the	sense	of	there	being	some	losers),	if	the	total	gains	for	the	gainers	are	large	enough
to	compensate	all	the	losers	and	still	leave	something	behind.	By	allowing	them	to	endorse	a	change	that
may	hurt	some	people	(but	can	fully	compensate	for	their	damages),	the	compensation	principle	has
allowed	Neoclassical	economists	to	avoid	the	ultra-conservative	bias	of	the	Pareto	criterion.	Of	course,
the	trouble	is	that	the	compensation	is	rarely	made	in	reality.*
The	counter-revolution:	the	renaissance	of	the	free-market	view
With	these	modifications,	there	was	no	reason	for	the	Neoclassical	school	to	remain	committed	to	free-
market	policies	any	more.	Indeed,	between	the	1930s	and	the	1970s,	many	Neoclassical	economists	were
not	free-market	economists.	The	current	state	of	affairs	in	which	the	predominant	majority	of
Neoclassical	economists	are	of	free-market	leaning	is	actually	due	more	to	the	shift	in	political	ideology
since	the	1980s	than	to	the	absence	or	the	poor	quality	of	theories	within	Neoclassical	economics
identifying	the	limits	of	the	free	market.	If	anything,	the	arsenal	for	Neoclassical	economists	who	reject
free-market	policies	has	been	expanded	since	the	1980s	by	the	development	of	information	economics,
led	by	Joseph	Stiglitz,	George	Akerlof	and	Michael	Spence.	Information	economics	explains	why
asymmetric	information	–	the	situation	in	which	one	party	to	a	market	exchange	knows	something	that	the
other	does	not	–	makes	markets	malfunction	or	even	cease	to	exist.7
However,	since	the	1980s,	many	Neoclassical	economists	have	also	developed	theories	that	go	so	far
as	to	deny	the	possibility	of	market	failures,	such	as	the	‘rational	expectation’	theory	in	macroeconomics
or	the	‘efficient	market	hypothesis’	in	financial	economics,	basically	arguing	that	people	know	what	they
are	doing	and	therefore	the	government	should	leave	them	alone	–	or,	in	technical	terms,	economic	agents
are	rational	and	therefore	market	outcomes	efficient.	At	the	same	time,	the	government	failure	argument
was	advanced,	to	argue	that	market	failure	in	itself	cannot	justify	government	intervention	because
governments	may	fail	even	more	than	markets	do	(more	on	this	in	Chapter	11).
Precision	and	versatility:	the	strengths	of	the	Neoclassical	school
The	Neoclassical	school	has	some	unique	strengths.	Its	insistence	on	breaking	phenomena	down	to	the
individual	level	gives	it	a	high	degree	of	precision	and	logical	clarity.	It	is	also	versatile.	It	may	be	very
difficult	for	someone	to	be	a	‘right-wing’	Marxist	or	a	‘left-wing’	Austrian,	but	there	are	many	‘left-wing’
Neoclassical	economists,	such	as	Joseph	Stiglitz	and	Paul	Krugman,	as	well	as	very	‘right-wing’	ones,
like	James	Buchanan	and	Gary	Becker.	To	exaggerate	only	slightly,	if	you	are	clever	enough,	you	can
justify	any	government	policy,	any	corporate	strategy,	or	any	individual	action	with	the	help	of
Neoclassical	economics.
Unrealistic	individuals,	over-acceptance	of	the	status	quo	and	neglect	of	production:	limitations	of	the	Neoclassical	school
The	Neoclassical	school	has	been	criticized	for	assuming	too	strongly	that	people	are	selfish	and
rational.	From	soldiers	selflessly	taking	bullets	for	their	comrades	to	highly	educated	bankers	and
economists	believing	in	the	fairy	tale	of	never-ending	financial	boom	(until	2008),	there	is	simply	too
much	evidence	against	this	assumption	(see	Chapter	5	for	details).
Neoclassical	economics	is	too	accepting	of	the	status	quo.	In	analysing	individual	choices,	it	accepts	as
given	the	underlying	social	structure	–	the	distribution	of	money	and	power,	if	you	will.	This	makes	it
look	at	only	choices	that	are	possible	without	fundamental	social	changes.	For	example,	many
Neoclassical	economists,	even	the	‘liberal’	Paul	Krugman,	argue	that	we	should	not	criticize	low-wage
factory	jobs	in	poor	countries	because	the	alternative	may	be	no	job	at	all.	This	is	true,	if	we	take	the
underlying	socio-economic	structure	as	given.	However,	once	we	are	willing	to	change	the	structure
itself,	there	are	a	lot	of	alternatives	to	those	low-wage	jobs.	With	new	labour	laws	that	strengthen	worker
rights,	land	reform	that	reduces	the	supply	of	cheap	labour	to	factories	(as	more	people	stay	in	the
countryside)	or	industrial	policies	that	create	high-skilled	jobs,	the	choice	for	workers	can	be	between
low-wage	jobs	and	higher-wage	ones,	rather	than	between	low-wage	jobs	and	no	jobs.
The	Neoclassical	school’s	focus	on	exchange	and	consumption	makes	it	neglect	the	sphere	of
production,	which	is	a	large	–	and	the	most	important,	according	to	many	other	schools	of	economics	–
part	of	our	economy.	Commenting	on	this	deficiency,	Ronald	Coase,	the	Institutionalist	economist,	in	his
1992	Nobel	Economics	Prize	lecture,	disparagingly	described	Neoclassical	economics	as	a	theory	fit
only	for	the	analysis	of	‘lone	individuals	exchanging	nuts	and	berries	on	the	edge	of	the	forest’.
The	Marxist	School
One-sentence	summary:	Capitalism	is	a	powerful	vehicle	for	economic	progress,	but	it	will	collapse,	as
private	property	ownership	becomes	an	obstacle	to	further	progress.
The	Marxist	school	of	economics	emerged	from	the	works	of	Karl	Marx,	produced	between	the	1840s
and	the	1860s,	starting	with	the	publication	of	The	Communist	Manifesto	in	1848	(co-authored	with
Friedrich	Engels	(1820–95),	his	intellectual	partner	and	financial	patron)	and	culminating	in	the
publication	of	the	first	volume	of	Capital	in	1867.8	It	was	further	developed	in	Germany	and	Austria	and
then	in	the	Soviet	Union	in	the	late	nineteenth	and	the	early	twentieth	centuries.*	More	recently,	it	was
elaborated	in	the	US	and	Europe	during	the	1960s	and	the	1970s.
Labour	theory	of	value,	classes,	and	production:	The	Marxist	school	as	the	truer	heir	of	the	Classical	school
As	I	mentioned	earlier,	the	Marxist	school	inherited	many	elements	from	the	Classical	school.	In	many
ways,	it	is	truer	to	the	Classical	doctrine	than	the	latter’s	self-proclaimed	successor,	the	Neoclassical
school.	It	adopted	the	labour	theory	of	value,	which	was	explicitly	rejected	by	the	Neoclassical	school.	It
also	focused	on	production,	whereas	consumption	and	exchange	were	the	keys	for	the	Neoclassical
school.	It	envisioned	an	economy	comprised	of	classes	rather	than	individuals	–	another	key	idea	of	the
Classical	school	rejected	by	the	Neoclassical	school.
Developing	the	Classical	school,	Marx	and	his	followers	came	up	with	a	type	of	economics	very
different	from	that	offered	by	its	half-brother,	the	Neoclassical	school.
Production	at	the	centre	of	economics
Taking	the	Classical	school’s	production-based	view	of	the	economy	further,	the	Marxist	school	argued
that	‘production	is	…	the	basis	of	social	order’,	in	the	words	of	Engels.	Every	society	is	seen	as	being
built	on	an	economic	base,	or	the	mode	of	production.	This	base	is	made	up	of	the	forces	of	production
(technologies,	machines,	human	skills)	and	the	relations	of	production	(property	rights,	employment
relationship,	division	of	labour).	Upon	this	base	is	the	superstructure,	which	comprises	culture,	politics
and	other	aspects	of	human	life,	which	in	turn	affect	the	way	the	economy	is	run.	In	this	sense,	Marx	was
probably	the	first	economist	to	systematically	explore	the	role	of	institutions	in	the	economy,	presaging	the
Institutionalist	school.
Further	developing	Adam	Smith’s	‘stages	of	development’	theory,	the	Marxist	school	saw	societies	as
evolving	through	a	series	of	historical	stages,	defined	in	terms	of	their	mode	of	production:	primitive
communism	(‘tribal’	societies);	antiquarian	mode	of	production	(based	on	slavery,	as	in	Greece	and
Rome);	feudalism	(based	on	landlords	commanding	semi-slaves,	or	serfs,	tied	to	their	lands);	capitalism;
communism.*	Capitalism	is	seen	as	but	one	stage	of	human	development	before	we	reach	the	ultimate
stage	of	communism.	This	recognition	of	the	historical	nature	of	economic	problems	is	a	great	contrast	to
the	Neoclassical	school,	which	considers	the	‘economic’	problem	of	utility	maximization	universal	–	for
Robinson	Crusoe	in	a	desert	island,	for	participants	in	a	weekly	market	of	medieval	Europe,	for
subsistence	farmers	in	Tanzania	and	for	an	affluent	German	consumer	in	the	twenty-first	century,	you	name
it.
Class	struggle	and	the	systemic	collapse	of	capitalism
The	Marxist	school	took	the	class-based	view	of	society	of	the	Classical	school	to	another	level.	It
viewed	class	conflicts	as	the	central	force	of	history	–	summarized	in	the	declaration	in	The	Communist
Manifesto:	‘The	history	of	hitherto	existing	society	is	the	history	of	class	struggles.’	Moreover,	the	school
refused	to	see	the	working	class	as	a	passive	entity,	as	did	the	Classical	school,	and	accorded	it	an	active
role	in	history.
Classical	economists	viewed	workers	as	simple	souls	unable	to	even	control	their	biological	urges.	As
soon	as	the	economy	expands	and	the	demand	for	labour	grows	and	higher	wages	are	paid,	workers	have
more	children.	This	means	more	workers,	bringing	the	wages	again	down	to	subsistence	level.	Only	a	life
of	misery	lay	ahead	of	them,	those	economists	believed,	unless	they	learned	to	exercise	restraint	and	stop
producing	so	many	children	–	a	highly	unlikely	prospect,	those	economists	surmised,	given	their	base
nature.
Marx	had	a	totally	different	view.	For	him,	workers	were	not	the	powerless	‘huddled	mass’	in
Classical	economics	but	active	agents	of	social	change	–	the	‘grave	digger	of	capitalism’	in	his	words	–
whose	organizational	skills	and	discipline	were	being	forged	in	the	harsh	hierarchy	within	factories	of
ever-growing	size	and	complexity.
Marx	did	not	believe	that	workers	could	start	a	revolution	and	topple	capitalism	at	will.	The	time	had
to	be	ripe.	This	would	come	only	when	capitalism	has	developed	sufficiently,	leading	to	a	heightened
contradiction	between	the	technological	requirements	of	the	system	(forces	of	production)	and	its
institutional	set-up	(relations	of	production).
With	the	continuous	development	of	technologies,	spurred	by	the	need	on	the	part	of	capitalists	to	invest
and	innovate	in	order	to	survive	the	unrelenting	competition,	the	division	of	labour	becomes	increasingly
more	‘social’,	making	capitalist	firms	become	more	dependent	on	each	other	as	suppliers	and	buyers.
This	makes	coordination	of	activities	among	those	related	firms	increasingly	more	necessary,	but	the
persistence	of	private	ownership	of	the	means	of	production	makes	such	coordination	very	difficult,	if	not
totally	impossible.	The	result	is	increasing	contradiction	in	the	system,	finally	leading	to	its	collapse.
Capitalism	would	be	replaced	by	socialism,	in	which	the	central	planning	authority	fully	coordinates	the
activities	of	all	the	related	enterprises,	now	collectively	owned	by	all	workers.
Fatally	flawed,	but	still	useful:	theories	of	the	firm,	work,	and	technological	progress
The	Marxist	school	has	many	fatal	flaws.	Above	all,	its	prediction	that	capitalism	will	collapse	under
its	own	weight	has	not	come	true.	Capitalism	has	proved	far	more	capable	of	reforming	itself	than	the
school	had	predicted.	Insofar	as	socialism	emerged,	it	did	so	in	countries	like	Russia	and	China,	where
capitalism	was	hardly	developed,	rather	than	in	the	most	advanced	capitalist	economies,	as	Marx	had
predicted.	Because	it	was	so	intertwined	with	a	political	project,	along	the	way,	many	of	its	followers
developed	blind	faith	in	whatever	Marx	said	or,	even	worse,	what	the	Soviet	Union	said	was	the	right
interpretation	of	his	ideas.	The	collapse	of	the	socialist	bloc	has	revealed	that	the	Marxist	theory	of	how
the	alternative	to	capitalism	should	be	organized	was	highly	inadequate.	The	list	goes	on.
Despite	these	limitations,	the	Marxist	school	still	offers	some	very	useful	insights	into	the	workings	of
capitalism.
Marx	was	the	first	economist	to	pay	attention	to	the	differences	between	the	two	key	institutions	of
capitalism	–	the	hierarchical,	planned	order	of	the	firm	and	the	(formally)	free,	spontaneous	order	of	the
market.	He	described	capitalist	firms	as	islands	of	rational	planning	in	an	anarchic	sea	of	the	market.
Moreover,	he	foresaw	that	large-scale	enterprises	owned	by	multitudes	of	shareholders	with	limited
liability	–	which	were	called	‘joint	stock	companies’	in	his	time	–	would	become	the	leading	actors	of
capitalism,	at	a	time	when	most	free-market	economists	were	still	against	the	very	idea	of	limited
liability.
Unlike	most	other	economists,	Marx	and	some	of	his	followers	have	paid	attention	to	work	for	its	own
sake,	rather	than	as	a	disutility	that	people	have	to	put	up	with	in	order	to	earn	money	to	pay	for	their
consumption.	He	believed	that	work	can	allow	human	beings	to	express	their	inherent	creativity.	He
criticized	the	hierarchical	capitalist	firm	for	blocking	such	possibility.	He	emphasized	the	dehumanizing
and	mind-numbing	effects	of	the	repetitive	work	that	emanates	from	increasingly	fine	divisions	of	labour.
It	is	interesting	to	note	that,	while	praising	the	positive	productivity	effects	of	finer	divisions	of	labour,
Adam	Smith	had	also	worried	about	the	negative	impact	of	fragmented	work	on	individual	workers.
Last	but	not	least,	Marx	was	also	the	first	major	economist	who	truly	understood	the	importance	of
technological	innovation	in	the	process	of	capitalist	development,	making	it	the	central	element	in	his
theory.
The	Developmentalist	Tradition
One-sentence	summary:	Backward	economies	can’t	develop	if	they	leave	things	entirely	to	the	market.
A	neglected	tradition
Unbeknownst	to	most	people	and	rarely	mentioned	even	in	books	on	the	history	of	economic	thought,	there
is	a	tradition	in	economics	that	is	even	older	than	the	Classical	school.	It	is	what	I	call	the
Developmentalist	tradition,	which	started	in	the	late	sixteenth	and	the	early	seventeenth	centuries	–	two
centuries	or	so	before	the	Classical	school.
I	don’t	call	the	Developmentalist	tradition	a	school,	because	the	latter	term	implies	that	there	are
identifiable	founders	and	followers,	with	clear	core	theories.	This	tradition	is	very	dispersed,	with
multiple	sources	of	inspiration	and	with	a	complicated	intellectual	lineage.
This	is	because	policy-makers,	who	are	interested	in	solving	real-world	problems,	rather	than
intellectual	purity,	started	the	tradition.*	They	pulled	together	elements	from	different	sources	in	a
pragmatic,	eclectic	manner,	even	though	some	of	them	have	made	important	original	contributions	of	their
own.
But	the	tradition	is	no	less	important	for	that.	It	is	arguably	the	most	important	intellectual	tradition	in
economics	in	terms	of	its	impact	on	the	real	world.	It	is	this	tradition,	rather	than	the	narrow	rationalism
of	Neoclassical	economics	or	the	Marxist	vision	of	classless	society,	that	has	been	behind	almost	all	of
the	successful	economic	development	experiences	in	human	history,	from	eighteenth-century	Britain,
through	nineteenth-century	America	and	Germany,	down	to	today’s	China.9
Raising	productive	capabilities	to	overcome	economic	backwardness
The	Developmentalist	tradition	is	focused	on	helping	economically	backward	countries	develop	their
economies	and	catch	up	with	the	more	advanced	ones.	For	economists	belonging	to	the	tradition,
economic	development	is	not	simply	a	matter	of	increasing	income,	which	could	happen	due	to	a	resource
bonanza,	such	as	striking	oil	or	diamonds.	It	is	a	matter	of	acquiring	more	sophisticated	productive
capabilities,	that	is,	the	abilities	to	produce	by	using	(and	developing	new)	technologies	and
organizations.
The	tradition	argues	that	some	economic	activities,	such	as	hi-tech	manufacturing	industries,	are	better
than	others	at	enabling	countries	to	develop	their	productive	capabilities.	However,	it	argues,	these
activities	do	not	naturally	develop	in	a	backward	economy,	as	they	are	already	conducted	by	firms	in	the
more	advanced	economies.	In	such	an	economy,	unless	the	government	intervenes	–	with	tariffs,	subsidies
and	regulations	–	to	promote	such	activities,	free	markets	will	constantly	pull	it	back	to	what	it	is	already
good	at	–	namely,	low-productivity	activities,	based	on	natural	resources	or	cheap	labour.10	The	tradition
emphasizes	that	desirable	activities	and	appropriate	policies	depend	on	time	and	context.	Yesterday’s	hi-
tech	industry	(e.g.,	textiles	in	the	eighteenth	century)	may	be	today’s	dead-end	industry,	while	a	policy	that
is	good	for	an	advanced	economy	(e.g.,	free	trade)	may	be	bad	for	a	less	developed	country.
Early	strands	in	the	Developmentalist	tradition:	Mercantilism,	the	infant	industry	argument	and	the	German	historical	school
Although	the	policy	practice	started	earlier	(for	example,	under	Henry	VII,	who	reigned	between	1485
and	1509),	theoretical	writings	in	the	Developmentalist	tradition	started	in	the	late	sixteenth	and	the	early
seventeenth	centuries,	with	Renaissance	Italian	economists	like	Giovanni	Botero	and	Antonio	Serra,	who
emphasized	the	need	for	promotion	of	manufacturing	activities	by	the	government.
The	Developmentalist	economists	of	the	seventeenth	and	eighteenth	centuries	–	known	as	Mercantilists
–	are	these	days	typically	portrayed	as	having	been	solely	focused	on	generating	trade	surplus,	that	is,	the
difference	between	your	exports	and	imports	when	the	former	is	larger.	But	many	of	them	were	actually
more	interested	in	promoting	higher-productivity	economic	activities	through	policy	interventions.	At
least	the	more	sophisticated	of	them	valued	trade	surplus	as	a	symptom	of	economic	success	(that	is,	the
development	of	high-productivity	activities),	rather	than	as	a	goal	in	itself.
From	the	late	eighteenth	century,	shedding	the	Mercantilist	garb	and	its	interest	in	trade	surplus,	the
Developmentalist	tradition	became	more	clearly	focused	on	production.	The	critical	development	came
from	Alexander	Hamilton’s	invention	of	the	infant	industry	argument,	which	we	encountered	in	the	last
chapter.	Hamilton’s	theory	was	further	developed	by	the	German	economist	Friedrich	List,	who	is	these
days	often	mistakenly	known	as	the	father	of	the	infant	industry	argument.11	Alongside	List,	in	the	mid-
nineteenth	century,	the	German	Historical	school	emerged	and	dominated	German	economics	until	the
mid-twentieth	century.	It	also	heavily	influenced	American	economics.*	The	school	emphasized	the
importance	of	understanding	the	history	of	how	the	material	production	system	has	changed,	both
influencing	and	influenced	by	law	and	other	social	institutions.12
The	Developmentalist	tradition	in	the	modern	world:	Development	Economics
The	Developmentalist	tradition	was	advanced	in	its	modern	form	in	the	1950s	and	the	1960s	by
economists	such	as,	in	alphabetical	order,	Albert	Hirschman	(1915–2012),	Simon	Kuznets	(1901–85),
Arthur	Lewis	(1915–91)	and	Gunnar	Myrdal	(1899–87)	–	this	time,	under	the	rubric	of	Development
Economics.	Writing	mostly	about	the	countries	on	the	periphery	of	capitalism	in	Asia,	Africa	and	Latin
America,	they	and	their	followers	not	only	refined	the	earlier	Developmentalist	theories	but	also	added
quite	a	lot	of	new	theoretical	innovations.
The	most	important	innovation	came	from	Hirschman,	who	pointed	out	that	some	industries	have
particularly	dense	linkages	(or	connections)	with	other	industries;	in	other	words,	they	buy	from	–	and
sell	to	–	a	particularly	large	number	of	industries.	If	the	government	identified	and	deliberately	promoted
these	industries	(the	automobile	and	the	steel	industries	are	common	examples),	the	economy	would	grow
more	vigorously	than	when	left	to	the	market.
More	recently,	some	development	economists	have	emphasized	the	need	to	complement	infant	industry
protection	with	investments	in	building	an	economy’s	productive	capabilities.13	Trade	protection	only
creates	the	space	within	which	a	country’s	firms	can	raise	productivity,	they	argued.	The	actual	raising	of
productivity	requires	deliberate	investments	in	education,	training	and	R&D.
A	lot	more	than	meets	the	eye:	assessing	the	Developmentalist	tradition
As	I	have	pointed	out	earlier,	the	lack	of	a	coherent,	overarching	theory	is	a	crucial	weakness	of	the
Developmentalist	tradition.	Given	the	human	tendency	to	be	seduced	by	a	theory	that	supposedly	explains
everything,	this	has	put	the	tradition	in	seriously	lower	esteem	in	most	people’s	eyes	than	more	coherent
and	self-confident	schools,	such	as	the	Neoclassical	school	or	the	Marxist	one.
The	tradition	is	more	vulnerable	to	the	government	failure	argument	than	other	economic	schools	that
advocate	an	active	role	for	the	government.	It	recommends	a	particularly	wide-ranging	set	of	policies,
which	is	more	likely	to	stretch	the	administrative	capabilities	of	the	government.
Despite	these	weaknesses,	the	Developmentalist	tradition	deserves	more	attention.	Its	crucial
weakness,	namely	its	eclecticism,	can	actually	be	a	strength.	Given	the	complexity	of	the	world,	a	more
eclectic	theory	may	be	better	at	explaining	it.	The	success	of	Singapore’s	unique	combination	of	free-
market	policies	and	socialist	policies,	which	we	encountered	in	Chapter	3,	is	a	case	in	point.	Moreover,
its	impressive	track	record	in	generating	real	world	changes	suggests	that	there	is	a	lot	more	to	it	than
meets	the	eye.
The	Austrian	School
One-sentence	summary:	No	one	knows	enough,	so	leave	everyone	alone.
Oranges	are	not	the	only	fruit:	different	types	of	free-market	economics
Not	all	Neoclassical	economists	are	free-market	economists.	Nor	are	all	free-market	economists
Neoclassical.	The	adherents	of	the	Austrian	school	are	even	more	ardent	supporters	of	the	free	market
than	most	followers	of	the	Neoclassical	school.
The	Austrian	school	was	started	by	Carl	Menger	(1840–1921)	in	the	late	nineteenth	century.	Ludwig
von	Mises	(1881–1973)	and	Friedrich	von	Hayek	(1899–1992)	extended	the	school’s	influence	beyond
its	homeland.	It	gained	international	attention	during	the	so-called	Calculation	Debate	in	the	1920s	and	the
1930s,	in	which	it	battled	the	Marxists	on	the	feasibility	of	central	planning.14	In	1944,	Hayek	published
an	extremely	influential	popular	book,	The	Road	to	Serfdom,	which	passionately	warned	against	the
danger	of	government	intervention	leading	to	the	loss	of	fundamental	individual	liberty.
The	Austrian	school	is	these	days	in	the	same	laissez-faire	camp	with	the	free-market	wing	(today	the
majority)	of	the	Neoclassical	school,	producing	similar,	if	somewhat	more	extreme,	policy	conclusions.
However,	methodologically	it	is	very	different	from	the	Neoclassical	school.	The	alliance	between	the
two	groups	is	due	more	to	their	politics	than	economics.
Complexity	and	limited	rationality:	the	Austrian	defence	of	the	free	market
While	emphasizing	the	importance	of	individuals,	the	Austrian	school	does	not	believe	that	individuals
are	atomistic	rational	beings,	as	assumed	in	Neoclassical	economics.	It	sees	human	rationality	as	severely
limited.	It	argues	that	rational	behaviour	is	only	possible	because	we	humans	voluntarily,	if
subconsciously,	limit	our	choices	by	unquestioningly	accepting	social	norms	–	‘custom	and	tradition	stand
between	instinct	and	reason’,	Hayek	intoned.	For	example,	by	assuming	that	most	people	will	respect
moral	codes,	we	can	devote	our	mental	energy	to	calculating	the	costs	and	the	benefits	of	a	potential
market	transaction,	rather	than	to	calculating	the	odds	of	being	cheated.
The	Austrian	school	also	argues	that	the	world	is	highly	complex	and	uncertain.	As	its	members
pointed	out	in	the	Calculation	Debate,	it	is	impossible	for	anyone	–	even	the	all-powerful	central	planning
authority	of	a	socialist	country	that	can	demand	any	information	it	wants	from	anyone	–	to	acquire	all	the
information	needed	to	run	a	complex	economy.	It	is	only	through	the	spontaneous	order	of	the
competitive	market	that	the	diverse	and	ever-changing	plans	of	numerous	economic	actors,	responding	to
unpredictable	and	complex	shifts	of	the	world,	can	be	reconciled	with	each	other.
Thus,	the	Austrians	say	that	the	free	market	is	the	best	economic	system	not	because	we	are	perfectly
rational	and	know	everything	(or	at	least	can	know	everything	that	we	need	to	know),	as	in	Neoclassical
theories,	but	exactly	because	we	are	not	very	rational	and	because	there	are	so	many	things	in	the	world
that	are	inherently	‘unknowable’.	This	defence	of	the	free	market	is	a	lot	more	realistic	than	the
Neoclassical	one,	based	on	the	assumption	of	absurd	degrees	of	human	rationality	and	on	the	unrealistic
belief	in	the	‘knowability’	of	the	world.
Spontaneous	vs.	constructed	order:	limits	to	the	Austrian	argument
The	Austrian	school	is	absolutely	right	in	saying	that	we	may	be	better	off	relying	on	the	spontaneous
order	of	the	market	because	our	ability	to	deliberately	create	order	is	limited.	But	capitalism	is	full	of
deliberately	‘constructed	orders’,	such	as	the	limited	liability	company,	the	central	bank	or	intellectual
property	laws,	which	did	not	exist	until	the	late	nineteenth	century.	The	diversity	of	institutional
arrangements	–	and	the	resulting	differences	in	economic	performances	–	between	different	capitalist
economies	is	also	in	large	part	the	result	of	deliberate	construction,	rather	than	spontaneous	emergence,	of
order.15
Moreover,	the	market	itself	is	a	constructed	(rather	than	spontaneous)	order.	It	is	based	on	deliberately
designed	rules	and	regulations	that	prohibit	certain	things,	discourage	others	and	encourage	still	others.
This	point	can	be	more	clearly	seen	when	we	recall	that	the	boundaries	of	the	market	have	been
repeatedly	drawn	and	redrawn	through	deliberate	political	decisions	–	a	fact	that	the	Austrian	school	fails
to,	or	even	refuses	to,	accept.	Many	once-legal	objects	of	market	exchange	–	slaves,	child	labour,	certain
narcotics	–	have	been	withdrawn	from	the	market.	At	the	same	time,	many	formerly	unmarketable	things
have	become	marketable	due	to	political	decisions.	‘Commons’,	the	grazing	lands	that	were	collectively
owned	by	communities	and	therefore	could	not	be	bought	and	sold,	became	private	land	through	the
Enclosure	in	Britain	between	the	sixteenth	and	eighteenth	centuries.	The	market	for	carbon	emission
permits	was	created	only	in	the	1990s.16	By	calling	the	market	a	spontaneous	order,	the	Austrians	are
seriously	misrepresenting	the	nature	of	the	capitalist	economy.
The	Austrian	position	against	government	intervention	is	too	extreme.	Their	view	is	that	any
government	intervention	other	than	the	provision	of	law	and	order,	especially	protection	of	private
property,	will	launch	the	society	on	to	a	slippery	slope	down	to	socialism	–	a	view	most	explicitly
advanced	in	Hayek’s	The	Road	to	Serfdom.	This	is	not	theoretically	convincing;	nor	has	it	been	borne	out
by	history.	There	is	a	huge	gradation	in	the	ways	market	and	the	state	combine	across	countries	and	within
countries.	Chocolate	bars	in	the	US	are	provided	in	a	much	more	market-oriented	way	than	is	primary
school	education.	South	Korea	may	rely	more	on	market	solutions	than	Britain	does	in	the	provision	of
health	care,	but	the	case	is	the	reverse	in	water	or	railways.	If	the	‘slippery	slope’	existed,	we	wouldn’t
have	these	kinds	of	diversity.
The	(Neo-)Schumpeterian	School
One-sentence	summary:	Capitalism	is	a	powerful	vehicle	of	economic	progress,	but	it	will	atrophy,	as
firms	become	larger	and	more	bureaucratic.
Joseph	Schumpeter	(1883–1950)	is	not	one	of	the	biggest	names	in	the	history	of	economics.	But	his
thoughts	were	original	enough	to	have	a	whole	school	named	after	him	–	the	Schumpeterian,	or	neo-
Schumpeterian,	school.*	(Not	even	Adam	Smith	has	a	school	named	after	him.)
Like	the	Austrians,	Schumpeter	worked	under	the	shadow	of	the	Marxist	school	–	so	much	so	that	the
first	four	chapters	of	his	magnum	opus,	Capitalism,	Socialism,	and	Democracy	(henceforth	CSD),
published	in	1942,	are	devoted	to	Marx.17	Joan	Robinson,	the	famous	Keynesian	economist,	once
famously	quipped	that	Schumpeter	was	just	‘Marx	with	the	adjectives	changed’.
Gales	of	creative	destruction:	Schumpeter’s	theory	of	capitalist	development
Schumpeter	developed	Marx’s	emphasis	on	the	role	of	technological	development	as	the	driving	force
of	capitalism.	He	argued	that	capitalism	develops	through	innovations	by	entrepreneurs,	namely,	the
creation	of	new	production	technologies,	new	products	and	new	markets.	Innovations	give	the	successful
entrepreneurs	temporary	monopolies	in	their	respective	markets,	allowing	them	to	earn	exceptional	profit,
which	he	called	the	entrepreneurial	profit.	Over	time,	their	competitors	imitate	the	innovations,	forcing
everyone’s	profit	down	to	the	‘normal’	level;	just	think	about	the	way	in	which	there	are	now	so	many
products	in	the	tablet	computer	market,	once	an	almost	exclusive	domain	of	the	Apple	iPad.
This	competition	driven	by	technological	innovations,	in	Schumpeter’s	view,	is	much	more	powerful
and	important	than	Neoclassical	price	competition	–	producers	trying	to	undercut	each	other	with	lower
prices,	by	increasing	the	efficiency	with	which	they	use	given	technologies.	He	argued	that	competition
through	innovation	is	‘as	much	more	effective	than	[price	competition]	as	a	bombardment	is	in
comparison	with	forcing	a	door’.
On	this,	Schumpeter	has	proven	prescient.	He	argued	that	no	firm,	however	entrenched	it	may	look,	is
safe	from	these	‘gales	of	creative	destruction’	in	the	long	run.	The	decline	of	companies	like	IBM	and
General	Motors,	or	the	disappearance	of	Kodak,	which	at	their	peaks	dominated	the	world	in	their
respective	industries,	demonstrates	the	power	of	competition	through	innovation.
Why	did	Schumpeter	predict	the	atrophy	of	capitalism	and	why	was	he	wrong?
Despite	being	such	a	believer	in	the	dynamism	of	capitalism,	Schumpeter	was	not	optimistic	about	its
future.	In	CSD,	he	observed	that,	with	the	growing	scale	of	capitalist	firms	and	the	application	of
scientific	principles	in	technological	innovation	(the	emergence	of	‘corporate	labs’),	entrepreneurs	were
making	way	for	professional	managers,	whom	he	disparagingly	called	the	‘executive	types’.	With	the
bureaucratization	of	the	management	of	its	firms,	capitalism	would	lose	its	dynamism,	which	ultimately
rests	on	the	vision	and	the	drive	of	charismatic	heroes	called	entrepreneurs.	Capitalism	would	slowly
wither	away	and	morph	into	socialism,	rather	than	meeting	the	violent	death	predicted	by	Marx.
Schumpeter’s	prediction	has	not	come	true.	Capitalism	has	become	actually	more	dynamic	since	his
gloomy	foretelling	of	its	death.	He	made	such	an	incorrect	prediction	because	he	had	failed	to	see	how
entrepreneurship	was	fast	becoming	a	collective	endeavour,	involving	not	just	the	visionary	entrepreneur
but	also	many	other	actors	inside	and	outside	the	firm.
Much	of	technological	progress	in	complex	modern	industries	happens	through	incremental
innovations	originating	from	pragmatic	attempts	to	solve	problems	arising	in	the	production	process.	This
means	that	even	production-line	workers	are	involved	in	innovation.	Indeed,	Japanese	automobile	firms,
especially	Toyota,	have	benefited	from	a	production	method	that	maximizes	worker	inputs	into	the
innovation	process.	Gone	are	the	days	when	a	genius	like	James	Watt	or	Thomas	Edison	could	(almost)
single-handedly	perfect	new	technologies.	That	is	not	all.	When	they	innovate,	firms	draw	on	research
output	and	research	funding	provided	by	various	non-commercial	actors	–	the	government,	universities
and	charitable	foundations.	The	whole	society	is	now	involved	in	innovation.
Having	failed	to	appreciate	the	role	of	all	these	‘other	guys’	in	the	innovation	process,	Schumpeter
came	to	the	mistaken	conclusion	that	the	diminishing	room	for	individual	entrepreneurs	will	make
capitalism	less	dynamic	and	atrophy.
Fortunately,	Schumpeter’s	intellectual	heirs	(sometimes	called	the	neo-Schumpeterian	school)	have
overcome	this	limitation	in	his	theory,	especially	through	the	national	system	of	innovation	approach,
which	looks	at	interactions	between	different	actors	in	the	innovation	process	–	firms,	universities,
governments,	and	others.*	Having	said	that,	the	(neo-)Schumpeterian	school	may	be	criticized	for
focusing	overly	on	technology	and	innovation	and	relatively	neglecting	other	economic	issues,	such	as
labour,	finance	and	macroeconomics.	To	be	fair,	other	schools	too	focus	on	particular	issues,	but	the
Schumpeterian	school	exhibits	a	narrower	focus	than	most.
The	Keynesian	School
One-sentence	summary:	What	is	good	for	individuals	may	not	be	good	for	the	whole	economy.
Born	in	the	same	year	as	Schumpeter	and	sharing	the	honour	of	having	a	whole	school	named	after	him	is
John	Maynard	Keynes	(1883–1946).	In	terms	of	intellectual	influence,	there	is	no	comparison	between	the
two.	Keynes	was	arguably	the	most	important	economist	of	the	twentieth	century.	He	redefined	the	subject
by	inventing	the	field	of	macroeconomics	–	the	branch	of	economics	that	analyses	the	whole	economy	as
an	entity	that	is	different	from	the	sum	total	of	its	parts.
Before	Keynes,	most	people	agreed	with	Adam	Smith	when	he	said,	‘What	is	prudence	in	the	conduct
of	every	private	family	can	scarce	be	folly	in	that	of	a	great	kingdom.’	And	some	people	still	do.	David
Cameron,	the	British	prime	minister,	said	in	October	2011	that	all	Britons	should	try	to	pay	off	their	credit
card	debts,	without	realizing	that	demand	in	the	British	economy	would	collapse	if	a	sufficient	number	of
people	actually	heeded	his	advice	and	reduced	spending	to	pay	off	their	debts.	He	simply	did	not
understand	that	one	person’s	spending	is	another’s	income	–	until	he	was	forced	by	his	advisors	to
withdraw	the	embarrassing	remark.
Rejecting	this	view,	Keynes	sought	to	explain	how	there	could	be	unemployed	workers,	idle	factories
and	unsold	products	for	prolonged	periods	when	markets	are	supposed	to	equate	supply	and	demand.
Why	is	there	unemployment?:	the	Keynesian	explanation
Keynes	started	from	the	obvious	observation	that	an	economy	doesn’t	consume	all	that	it	produces.	The
difference	–	that	is,	savings	–	needs	to	be	invested,	if	everything	that	has	been	produced	is	to	be	sold	and
if	all	productive	inputs,	including	the	labour	service	of	workers,	are	to	be	employed	(this	is	known	as	full
employment).
Unfortunately,	there	is	no	guarantee	that	savings	will	equal	investment,	especially	when	those	who
invest	and	those	who	save	are	not	one	and	the	same,	unlike	in	the	early	days	of	capitalism,	when
capitalists	mostly	invested	out	of	their	own	savings	and	workers	could	not	save,	given	their	low	wages.
This	is	because	investment,	whose	returns	are	not	immediate,	is	dependent	on	investors’	expectations
about	the	future.	In	turn,	these	expectations	are	driven	by	psychological	factors	rather	than	rational
calculation	because	the	future	is	full	of	uncertainty.
Uncertainty	is	not	simply	about	not	knowing	exactly	what	is	going	to	happen	in	the	future.	For	some
things,	we	can	rather	accurately	calculate	the	probability	of	each	possible	contingency	–	economists	call
this	risk.	Indeed,	our	ability	to	calculate	the	risk	involved	in	many	aspects	of	human	life	–	death,	fire,	car
accident	and	so	on	–	is	the	very	foundation	of	the	insurance	industry.	However,	for	many	other	things,	we
do	not	even	know	all	the	possible	contingencies,	not	to	speak	of	their	respective	likelihoods.	The	best
explanation	of	the	concept	of	uncertainty	was	given	by,	perhaps	surprisingly,	Donald	Rumsfeld,	the
defence	secretary	in	the	first	government	of	George	W.	Bush.	In	a	press	briefing	regarding	the	situation	in
Afghanistan	in	2002,	Rumsfeld	opined:	‘There	are	known	knowns.	There	are	things	we	know	that	we
know.	There	are	known	unknowns.	That	is	to	say,	there	are	things	that	we	now	know	we	don’t	know.	But
there	are	also	unknown	unknowns.	There	are	things	we	do	not	know	we	don’t	know.’	The	idea	of
‘unknown	unknowns’	nicely	sums	up	Keynes’	concept	of	uncertainty.
Active	fiscal	policy	for	full	employment:	the	Keynesian	solution
In	an	uncertain	world,	investors	may	suddenly	become	pessimistic	about	the	future	and	reduce	their
investments.	In	such	a	situation,	there	will	be	more	savings	than	are	needed	–	there	will	be,	in	technical
terms,	a	‘savings	glut’.	The	Classical	economists	thought	this	glut	would	be	sooner	or	later	eliminated,	as
the	lower	demand	for	savings	would	drive	the	interest	rate	(that	is,	the	price	of	borrowing,	if	you	like)
down,	making	investments	more	attractive.
Keynes	argued	that	this	does	not	happen.	As	investment	falls,	overall	spending	falls,	which	then
reduces	income,	as	one	person’s	spending	is	another’s	income.	A	reduction	in	income	in	turn	reduces
savings,	as	savings	are	essentially	what	are	left	after	consumption	(which	tends	not	to	change	much	in
response	to	a	fall	in	income,	being	determined	by	our	survival	necessities	and	habit).	In	the	end,	savings
will	contract	to	match	the	now	lower	investment	demand.	If	excess	savings	are	reduced	in	this	way,	there
will	be	no	downward	pressure	on	interest	rates	and	thus	no	extra	stimulus	for	investment.
Keynes	thought	that	investment	will	be	high	enough	for	full	employment	only	when	animal	spirits	–	‘a
spontaneous	urge	to	action	rather	than	inaction’,	as	he	defines	it	–	of	the	potential	investors	are	stimulated
by	new	technologies,	financial	euphoria	and	other	unusual	events.	The	normal	state	of	affairs,	in	his	view,
would	be	that	investment	is	equated	to	savings	at	a	level	of	effective	demand	(the	demand	that	is	actually
backed	up	by	purchasing	power)	that	is	insufficient	to	support	full	employment.	In	order	to	achieve	full
employment,	Keynes	argued,	the	government	therefore	has	to	use	its	spending	actively	to	prop	up	the	level
of	demand.18
Money	gets	a	real	job	in	economics:	the	Keynesian	theory	of	finance
The	prevalence	of	uncertainty	in	Keynesian	economics	means	that	money	is	not	simply	an	accounting
unit	or	merely	a	convenient	medium	of	exchange,	as	the	Classical	(and	the	Neoclassical)	school	thought.	It
is	a	means	to	provide	liquidity	(or	the	means	to	quickly	change	one’s	financial	position)	in	an	uncertain
world.
Given	this,	the	financial	market	is	not	just	a	means	to	provide	money	to	invest	but	also	a	place	to	make
money	by	taking	advantage	of	the	differences	among	people’s	views	about	returns	on	the	same	investment
projects	–	in	other	words,	a	place	for	speculation.	In	this	market,	the	buying	and	selling	of	an	asset	is
driven	not	mainly	by	the	ultimate	return	that	it	will	deliver	but	by	expectations	about	the	future	–	and,
more	importantly,	the	expectations	about	what	other	people	expect,	or,	as	Keynes	put	it,	the	‘average
opinion	about	the	average	opinion’.	This,	according	to	Keynes,	provides	the	basis	for	the	herd	behaviour
that	is	often	witnessed	in	financial	markets,	making	it	inherently	prone	to	bouts	of	financial	speculation,
boom	and	ultimately	bust.19
It	is	upon	this	analysis	that	Keynes	famously	warned	against	the	danger	that	the	speculation-driven
financial	system	can	pose:	‘Speculators	may	do	no	harm	as	bubbles	on	a	steady	stream	of	enterprise.	But
the	position	is	serious	when	enterprise	becomes	the	bubble	on	a	whirlpool	of	speculation.	When	the
capital	development	of	a	country	becomes	a	by-product	of	the	activities	of	a	casino,	the	job	is	likely	to	be
ill-done.’	He	should	know	–	he	was	a	very	successful	financial	speculator	himself,	amassing	a	fortune	of
over	£10	million	(or	$15	million)	in	today’s	money,	even	after	very	generous	donations	to	charitable
causes.20
An	economic	theory	fit	for	the	twentieth	century	–	and	beyond?
The	Keynesian	school	built	an	economic	theory	that	was	more	fit	for	the	advanced	capitalist	economy
in	the	twentieth	century	than	that	of	the	Classical	or	Neoclassical	schools.
Keynesian	macroeconomic	theory	is	built	on	the	recognition	that	the	structural	separation	of	savers	and
investors	that	emerged	from	the	late	nineteenth	century	has	made	the	equalization	of	savings	and
investment,	and	thus	the	achievement	of	full	employment,	more	difficult.
Moreover,	the	Keynesian	school	rightly	highlights	the	key	role	that	finance	plays	in	modern	capitalism.
The	Classical	school	did	not	pay	too	much	attention	to	finance,	as	it	was	developed	at	a	time	when	the
financial	market	was	primitive.	The	Neoclassical	theory	was	developed	in	a	world	which	was	already
quite	similar	to	the	one	Keynes	was	living	in,	but,	given	its	failure	to	acknowledge	uncertainty,	money	is
not	essential	in	it.	In	contrast,	finance	plays	a	key	role	in	Keynesian	theories,	which	is	why	it	has	been	so
useful	in	helping	us	understand	episodes	like	the	Great	Depression	of	1929	and	the	2008	global	financial
crisis.
‘In	the	long	run	we	are	all	dead’:	shortcomings	of	the	Keynesian	school
The	Keynesian	school	can	be	criticized	for	paying	too	much	attention	to	short-term	issues	–	as
summarized	in	the	famous	quip	by	Keynes	that	‘in	the	long	run	we	are	all	dead’.
Keynes	was	absolutely	right	in	emphasizing	that	we	cannot	run	economic	policies	on	the	hope	that	in
the	long	run	the	‘fundamental’	forces,	such	as	technology	and	demography,	will	somehow	sort	everything
out,	as	the	Classical	economists	used	to	argue.	Nevertheless,	its	focus	on	short-run	macroeconomic
variables	has	made	the	Keynesian	school	rather	weak	on	long-term	issues,	such	as	technological	progress
and	institutional	changes.21
The	Institutionalist	School	–	Old	and	New?
One-sentence	summary:	Individuals	are	products	of	their	society,	even	though	they	may	change	its
rules.
From	the	late	nineteenth	century,	a	group	of	American	economists	challenged	the	then	dominant	Classical
and	Neoclassical	schools	for	underplaying,	or	even	ignoring,	the	social	nature	of	individuals	–	that	is,	the
fact	that	they	are	products	of	their	societies.	They	argued	that	we	need	to	analyse	the	institutions,	or
social	rules,	that	affect,	and	even	shape,	individuals.	This	group	of	economists	are	known	as	the
Institutionalist	school	–	or	the	Old	Institutional	Economics	(OIE),	in	recognition	of	the	emergence	of	the
so-called	New	Institutional	Economics	(NIE)	since	the	1980s.
Individuals	are	shaped	by	society:	the	rise	of	the	Institutionalist	school
The	emergence	of	the	Institutionalist	school	can	be	traced	back	to	Thorstein	Veblen	(1857–1929),	who
made	his	name	for	questioning	the	notion	of	the	rational,	self-seeking	individual.	He	argued	that	humans
have	layers	of	motivations	behind	their	behaviours	–	instinct,	habit,	belief	and,	only	finally,	reason.
Veblen	also	emphasized	that	human	rationality	cannot	be	defined	as	a	timeless	thing	but	is	shaped	by	the
social	environment,	made	up	of	institutions	–	formal	rules	(e.g.,	laws,	internal	rules	of	companies)	and
informal	rules	(e.g.,	social	customs,	conventions	in	business	dealings)	–	that	surround	the	particular
individuals	that	we	are	observing.	Institutions,	Veblen	believed,	did	not	just	affect	the	way	in	which
people	behaved	but	actually	changed	them,	and	they	in	turn	changed	those	institutions.22
Taking	inspiration	from	Veblen’s	emphasis	on	institutions,	but	also	drawing,	overtly	and	covertly,	from
Marxism	and	the	German	Historical	school,	a	new	generation	of	American	economists	emerged	in	the
early	twentieth	century	to	establish	a	distinctive	economic	school.	The	school	was	officially	proclaimed
as	the	Institutionalist	school	in	1918	with	Veblen’s	blessing,	under	the	leadership	of	Wesley	Mitchell
(1874–1948),	Veblen’s	student	and	the	then	leader	of	the	group.*
The	school’s	shining	moment	was	the	New	Deal,	in	whose	design	and	administration	many	of	its
members	participated.	These	days	the	New	Deal	is	commonly	thought	of	as	a	Keynesian	policy
programme.	But,	when	you	think	about	it,	The	General	Theory	of	Employment,	Interest,	and	Money,
Keynes’s	magnum	opus,	did	not	come	out	until	1936,	which	is	one	year	after	the	second	New	Deal	of
1935	(the	first	was	in	1933).	The	New	Deal	was	much	more	about	institutions	–	financial	regulation,
social	security,	trade	unions	and	utilities	regulation	–	rather	than	about	macroeconomic	policy,	as	I
discussed	in	Chapter	3.	Institutional	economists,	such	as	Arthur	Burns	(chairman	of	the	Council	of
Economic	Advisors	to	the	US	President,	1953–6;	then	chairman	of	the	Federal	Reserve	Board,	1970–78),
played	important	parts	in	the	making	of	US	economic	policy	even	after	the	Second	World	War.
Individuals	are	not	fully	determined	by	society:	the	decline	of	the	Institutionalist	school
After	the	1960s,	the	Institutionalist	school	went	into	decline.	Part	of	this	was	due	to	the	rise	of
Neoclassical	economics	in	the	US	in	the	1950s.	The	Neoclassical	school’s	rather	narrow	view	of	what
economics	should	be	–	with	its	emphasis	on	individual-based	theory,	‘universal’	assumptions	and	abstract
modelling	–	made	it	regard	the	Institutional	school	as	not	just	different	but	intellectually	inferior.
But	the	decline	was	also	because	of	the	weaknesses	of	the	Institutional	school	itself.	The	school	failed
to	fully	theorize	the	diverse	mechanisms	through	which	institutions	themselves	emerge,	persist	and
change.	They	only	saw	institutions	as	outcomes	of	formal	collective	decisions	(e.g.,	legislation)	or	as
products	of	history	(e.g.,	cultural	norms).	However,	institutions	may	come	into	being	in	other	ways:	as	a
spontaneous	order	emerging	out	of	interactions	of	rational	individuals	(the	Austrian	school	and	the	New
Institutionalist	Economics);	through	attempts	by	individuals	and	organizations	to	develop	cognitive
devices	that	will	allow	them	to	cope	with	complexity	(the	Behaviouralist	school);	or	as	a	result	of	an
attempt	to	maintain	existing	power	relationships	(the	Marxist	school).
Another	big	problem	was	that	some	members	of	the	school	went	overboard	in	emphasizing	the	social
nature	of	individuals	and	effectively	adopted	a	structural	determinism.	Social	institutions	and	the	structure
they	create	were	everything;	individuals	were	seen	as	being	totally	determined	by	the	society	they	live	in
–	‘there	is	no	such	thing	as	an	individual’,	infamously	declared	Clarence	Ayres,	who	dominated	the
(declining)	Institutionalist	school	in	the	US	in	the	early	post-Second	World	War	period.
Transaction	costs	and	institutions:	the	rise	of	the	New	Institutional	Economics
From	the	1980s,	a	group	of	economists	with	Neoclassical	and	Austrian	leanings	–	led	by	Douglass
North,	Ronald	Coase	and	Oliver	Williamson	–	started	a	new	school	of	institutional	economics,	known	as
the	New	Institutional	Economics	(NIE).23
By	calling	themselves	institutional	economists,	the	New	Institutionalist	economists	made	it	clear	that
they	were	not	typical	Neoclassical	economists,	who	looked	at	only	individuals	but	not	the	institutions	that
affect	their	behaviour.	However,	by	emphasizing	the	adjective	new,	this	group	clearly	dissociated	itself
from	the	original	Institutionalist	school	–	now	called	the	Old	Institutional	Economics	(OIE).	The	main
point	of	departure	from	the	OIE	was	that	the	NIE	analysed	how	institutions	emerge	out	of	deliberate
choices	by	individuals.24
The	key	concept	in	the	NIE	is	that	of	transaction	cost.	In	Neoclassical	economics,	the	only	cost	is	the
cost	of	production	(costs	of	material,	wages,	etc.).	However,	the	NIE	emphasizes	that	there	are	also	costs
of	organizing	our	economic	activities.	Some	define	transaction	cost	rather	narrowly	as	the	cost	involved
in	market	exchange	itself	–	finding	out	about	alternative	products	(‘shopping	around’),	spending	time	and
money	actually	doing	the	shopping	and	sometimes	bargaining	for	better	prices.	Others	define	it	more
broadly	as	the	‘cost	of	running	the	economic	system’,	which	includes	the	cost	of	conducting	market
exchange	but	also	the	cost	involved	in	enforcing	the	contract	after	the	exchange	is	over.	So,	in	this	broader
definition,	transaction	cost	includes	the	cost	of	policing	against	thefts,	running	the	court	system	and	even
monitoring	workers	in	factories	so	that	they	put	in	the	maximum	possible	amount	of	labour	service
specified	in	their	contract.
Institutions	are	not	just	constraints:	contributions	and	limitations	of	the	New	Institutional	Economics
Deploying	the	concept	of	transaction	cost,	the	NIE	has	developed	a	wide	range	of	interesting	theories
and	case	studies.	One	prominent	example	is	the	question	as	to	why,	in	a	supposedly	‘market’	economy,	so
many	economic	activities	are	conducted	within	firms.	The	(simplified)	answer	is	that	market	transactions
are	often	very	costly	due	to	the	high	cost	of	information	and	contract	enforcement.	In	such	cases,	it	would
be	much	more	efficient	if	things	were	done	through	hierarchical	commands	within	the	firm.	Another
example	is	the	analysis	of	the	impacts	of	the	exact	nature	of	property	rights	(the	rules	on	what	owners
can	do	with	which	kinds	of	property)	on	patterns	of	investments,	choice	of	production	technologies,	and
other	economic	decisions.
Despite	these	very	important	contributions,	the	NIE	has	a	critical	limit	as	an	‘institutionalist’	theory.	It
sees	institutions	basically	as	constraints	–	on	unfettered	self-seeking	behaviour.	But	institutions	are	not
just	‘constraining’	but	can	also	be	‘enabling’.	Often	institutions	limit	our	individual	freedom	exactly	in
order	to	enable	us	to	do	more	collectively	–	traffic	rules,	for	example.	Most	members	of	the	NIE	would
not	deny	the	enabling	role	of	institutions,	but	by	not	talking	about	it	explicitly	and	continually	referring	to
institutions	as	constraints,	they	convey	a	negative	impression	of	institutions.	More	importantly,	the	NIE
fails	to	see	the	‘constitutive’	role	of	institutions.	Institutions	shape	the	motives	of	individuals	and	do	not
merely	constrain	their	behaviour.	Missing	out	on	this	critical	dimension	of	what	institutions	do,	the	NIE
falls	short	of	being	a	full-blown	institutional	economics.
The	Behaviouralist	School
One-sentence	summary:	We	are	not	smart	enough,	so	we	need	to	deliberately	constrain	our	own
freedom	of	choice	through	rules.
The	Behaviouralist	school	is	so	called	because	it	tries	to	model	human	behaviours	as	they	actually	are,
rejecting	the	dominant	Neoclassical	assumption	that	human	beings	always	behave	in	a	rational	and	selfish
way.	The	school	extends	this	approach	to	the	study	of	economic	institutions	and	organizations	–	for
example,	how	best	to	organize	a	firm	or	how	to	design	financial	regulation.	The	school	thus	has	a
fundamental	affinity,	and	some	overlap	in	membership,	with	the	Institutionalist	school.
The	Behaviouralist	school	is	the	youngest	of	the	schools	of	economics	that	we	have	so	far	examined,
but	it	is	older	than	most	people	think.	The	school	has	recently	come	to	prominence	through	the	fields	of
behavioural	finance	and	experimental	economics.	But	it	has	its	origins	in	the	1940s	and	the	1950s,
especially	in	the	works	of	Herbert	Simon	(1916–2001),	the	1978	Nobel	economics	laureate.*
Limits	to	human	rationality	and	the	need	for	individual	and	social	rules
Simon’s	central	concept	is	bounded	rationality.	He	criticizes	the	Neoclassical	school	for	assuming
that	people	possess	unlimited	capabilities	to	process	information,	or	God-like	rationality	(he	calls	it
‘Olympian	rationality’).
Simon	did	not	argue	that	human	beings	are	irrational.	His	view	was	that	we	try	to	be	rational	but	that
our	ability	to	be	so	is	very	limited,	especially	given	the	complexity	of	the	world	–	or	given	the	prevalence
of	uncertainty,	if	you	want	to	formulate	it	in	the	Keynesian	way.	This	means	that	often	the	main	constraint
on	our	decision-making	is	not	the	lack	of	information	but	our	limited	capability	to	process	the	information
we	have.
Given	our	bounded	rationality,	Simon	argued,	we	develop	mental	‘shortcuts’	that	allow	us	to
economize	on	our	mental	capabilities.	These	are	known	as	heuristics	(or	intuitive	thinking)	and	can	take
different	forms:	rule	of	thumb,	common	sense	or	expert	judgement.	Underlying	all	these	mental	devices	is
the	ability	to	recognize	patterns,	which	allows	us	to	abandon	a	large	range	of	alternatives	and	focus	on	a
small,	manageable	but	most	promising	range	of	possibilities.	Simon	often	used	the	chess	masters	as	an
example	of	someone	using	such	a	mental	approach	–	their	secret	lay	in	their	abilities	to	rapidly	eliminate
less	promising	search	paths	and	converge	on	a	sequence	of	moves	that	are	likely	to	yield	the	best
outcomes.
Focusing	on	a	subset	of	possibilities	means	that	the	resulting	choice	may	not	be	optimal,	but	this
approach	enables	us	to	handle	the	complexity	and	the	uncertainty	of	the	world	with	our	bounded
rationality.	Therefore,	Simon	argues,	when	they	make	their	choices,	human	beings	satisfice,	that	is,	we
look	for	‘good	enough’	solutions	rather	than	the	best	ones,	as	in	the	Neoclassical	theory.25
Market	economy	vs.	organization	economy
Even	though	it	starts	with	the	study	of	individual	decision-making,	the	interest	of	the	Behaviouralist
school	stretches	much	further.	According	to	the	school,	it	isn’t	just	at	the	individual	level	that	we	build
simplifying	decision	rules	that	help	us	operate	in	a	complex	world	with	our	bounded	rationality.
We	build	organization	routines	as	well	as	social	institutions	so	that	we	can	compensate	for	our
bounded	rationality.	Like	heuristics	at	the	individual	level,	these	organizational	and	social	rules	restrict
our	freedom	of	choice	but	help	us	make	better	choices	because	they	also	reduce	the	complexity	of	the
problem.	Particularly	emphasized	is	the	fact	that	these	rules	make	it	easier	for	us	to	predict	the	behaviour
of	other	related	actors,	who	would	follow	those	rules	and	behave	in	particular	ways.	This	is	a	point	that
the	Austrian	school	also	emphasizes	using	slightly	different	language,	when	they	talk	about	the	importance
of	‘tradition’	as	the	basis	for	reason.
Adopting	the	Behaviouralist	perspective,	we	begin	to	see	our	economy	in	a	way	that	is	very	different
from	the	dominant	Neoclassical	one.	The	Neoclassical	economists	usually	describe	the	modern	capitalist
economy	as	the	‘market	economy’.	The	Behaviouralists	emphasize	that	the	market	actually	accounts	for
only	a	rather	small	part	of	it.	Herbert	Simon,	writing	in	the	mid-1990s,	reckoned	that	something	like	80
per	cent	of	economic	activities	in	the	US	happen	inside	organizations,	such	as	the	firm	and	the
government,	rather	than	through	the	market.26	He	argued	that	it	would	be	more	appropriate	to	call	it	the
organization	economy.
Why	emotion,	loyalty	and	fairness	matter
The	Behaviouralist	school	also	provides	persuasive	reasons	as	to	why	human	qualities	like	emotion,
loyalty	and	fairness	matter	–	things	that	most	economists,	especially	the	Neoclassicals	and	the	Marxists,
would	dismiss	as	at	best	irrelevant	and	at	worst	as	distracting	people	from	rational	decisions.
The	theory	of	bounded	rationality	explains	why	our	emotion	is	not	necessarily	the	stumbling	block	to
rational	decision-making	but	may	be	often	a	useful	part	of	our	(bounded)	rational	decision-making
process.	According	to	Simon,	given	our	bounded	rationality,	we	need	to	focus	our	limited	mental
resources	on	solving	the	most	important	problem	at	hand.	Emotion	provides	such	focus.	The
Behaviouralists	argue	that	organizational	loyalty	of	their	members	is	essential	for	organizations	to	operate
well,	as	an	organization	full	of	disloyal	members	would	be	overwhelmed	by	the	costs	of	monitoring	and
punishing	their	selfish	behaviours.	The	issue	of	fairness	is	very	important	in	this	regard,	as	the	members
of	an	organization	or	a	society	will	not	develop	loyalty	to	it,	if	they	think	they	are	being	treated	unfairly.
Too	focused	on	individuals?:	assessing	the	Behaviouralist	school
The	Behaviouralist	school,	despite	being	the	youngest	school	of	economics,	has	helped	us	radically
rethink	our	theories	about	human	rationality	and	motivations.	Thanks	to	it,	we	have	a	much	more
sophisticated	understanding	of	how	people	think	and	behave.
The	Behaviouralist	school’s	attempt	to	understand	human	society	from	individuals	up	–	actually	from	a
place	‘lower’	than	that,	that	is,	from	our	thinking	process	up	–	is	both	its	strength	and	its	weakness.
Focusing	too	much	at	this	‘micro’	level,	the	school	often	loses	sight	of	the	bigger	economic	system.	This
does	not	have	to	be;	after	all,	Simon	wrote	a	lot	about	the	economic	system.	But	most	members	of	the
school	have	focused	too	much	on	individuals	–	especially	those	economists	who	are	engaged	in
experimental	economics	(trying	to	establish	whether	people	are	rational	and	selfish	through	controlled
experiments)	or	neuroeconomics	(trying	to	establish	links	between	brain	activities	and	particular	types	of
behaviour).	It	also	needs	to	be	added	that,	given	its	focus	on	human	cognition	and	psychology,	the
Behaviouralist	school	has	few	things	to	say	about	issues	of	technology	and	macroeconomics.
Concluding	Remarks:	How	to	Make	Economics	Better
Preserving	intellectual	diversity	and	encouraging	cross-fertilization	of	ideas
Recognizing	that	there	are	different	approaches	to	economics	is	not	enough.	This	diversity	needs	to	be
preserved,	or	even	promoted.	Given	that	different	approaches	emphasize	different	aspects	and	offer
different	perspectives,	knowing	a	range	of	schools,	and	not	just	one	or	two	of	them,	allows	us	to	have	a
fuller,	more	balanced	understanding	of	the	complex	entity	called	the	economy.	Especially	in	the	longer
run,	in	the	same	way	in	which	a	biological	group	with	a	more	diverse	gene	pool	is	more	resilient	to
shocks,	a	discipline	that	contains	a	variety	of	theoretical	approaches	can	cope	with	a	changing	world
better	than	one	characterized	by	intellectual	mono-cropping	can.	We	are	actually	living	through	a	proof	of
this	–	the	world	economy	would	have	experienced	a	collapse	similar	to	the	1929	Great	Depression,	had
the	key	governments	not	decided	to	ditch	their	free-market	economics	and	adopt	Keynesian	policies	in	the
early	days	of	the	2008	global	financial	crisis.
I	would	go	one	step	further	and	argue	that	preserving	diversity	is	not	enough.	We	shouldn’t	just	let	a
hundred	flowers	bloom.	We	need	to	have	them	cross-fertilized.	Different	approaches	to	economics	can
actually	benefit	a	lot	from	learning	from	each	other,	making	our	understanding	of	the	economic	world
richer.
Some	schools	with	obvious	intellectual	affinities	have	already	been	cross-fertilizing.	The
Developmentalist	tradition	and	the	Schumpeterian	school	have	interacted	to	the	benefit	of	both,	the	former
providing	theories	to	understand	the	bigger	context	in	which	technological	development	occurs	and	the
latter	providing	more	detailed	theories	of	how	technological	innovation	happens.	The	Marxist,	the
Institutionalist	and	the	Behaviouralist	schools	have	long	interacted	with	each	other,	often	in	hostile
manners,	in	relation	to	the	understanding	of	the	internal	workings	of	the	firm	and	especially	the	capitalist–
worker	relationship	in	it.	The	common	emphasis	on	psychological	factors	by	the	Keynesian	and	the
Behaviouralist	schools	has	always	existed	but	has	recently	produced	particularly	notable	cross-
fertilization	of	ideas	in	the	new	field	of	‘behavioural	finance’.
However,	cross-fertilization	can	happen	between	schools	that	most	people	think	are	incompatible	with
each	other.	Even	if	they	are	spread	across	the	political	spectrum,	the	Classicals	(right),	the	Keynesians
(centre)	and	the	Marxists	(left)	all	share	a	class-based	vision	of	the	society.	The	Austrians	and	the
Keynesians	may	have	locked	horns	since	the	1930s,	but	they	share	with	each	other	(as	well	as	with	the
Behaviouralists	and	the	Institutionalists)	the	view	that	the	world	is	a	very	complex	and	uncertain	place
and	that	our	rationality	to	deal	with	it	is	severely	limited.	The	Austrians,	the	Institutionalists	and	the
Behaviouralists	all	share	a	view	of	human	beings	as	layered	entities,	made	up	of	–	if	we	use	the
Institutionalist	formulation	–	instinct,	habit,	belief	and	reason,	even	though	some	Austrians	may	think	that
the	others	are	objectionable	left-wingers.
How	all	of	us,	not	just	professional	economists,	can	play	a	role	in	making	economics	better
Even	those	readers	who	have	been	persuaded	by	my	argument	for	intellectual	diversity	and	cross-
fertilization	in	economics	may	still	ask,	‘What	does	that	have	to	do	with	me?’	After	all,	only	a	very	small
number	of	readers	will	ever	have	a	chance	to	preserve	or	increase	the	diversity	of	economics	as
professional	economists.
The	fact	is,	we	all	need	to	know	something	about	diverse	approaches	to	economics	if	we	are	not	to
become	passive	victims	of	someone	else’s	decision.	Behind	every	economic	policy	and	corporate	action
that	affects	our	lives	–	the	minimum	wage,	outsourcing,	social	security,	food	safety,	pensions	and	what	not
–	lies	some	economic	theory	that	either	has	inspired	those	actions	or,	more	frequently,	is	providing
justification	of	what	those	in	power	want	to	do	anyway.
Only	when	we	know	that	there	are	different	economic	theories	will	we	be	able	to	tell	those	in	power
that	they	are	wrong	to	tell	us	that	‘there	is	no	alternative’	(TINA),	as	Margaret	Thatcher	once	infamously
put	it	in	defence	of	her	controversial	policies.	When	we	learn	how	much	intellectual	common	ground
there	is	between	supposed	‘enemy	factions’	in	economics,	we	can	more	effectively	resist	those	who	try	to
polarize	the	debate	by	portraying	everything	in	black	and	white.	Once	we	learn	that	different	economic
theories	say	different	things	partly	because	they	are	based	on	different	ethical	and	political	values,	we
will	have	the	confidence	to	discuss	economics	for	what	it	really	is	–	a	political	argument	–	and	not	a
‘science’	in	which	there	is	clear	right	and	wrong.	And	only	when	the	general	public	displays	awareness
of	these	issues	will	professional	economists	find	it	impossible	to	browbeat	them	by	declaring	themselves
to	be	custodians	of	scientific	truths.
Knowing	different	types	of	economics	and	knowing	their	respective	strengths	and	weaknesses,	thus
seen,	is	not	an	esoteric	exercise	reserved	only	for	professional	economists.	It	is	a	vital	part	of	learning
about	economics	and	also	a	contribution	to	our	collective	effort	to	make	the	subject	better	serve	humanity.
Further	Reading
G.	ARGYROUS	AND	F.	STILLWELL
Readings	in	Political	Economy	(Annandale,	NSW:	Pluto	Press,	2003).
P.	DEANE
The	State	and	the	Economic	System:	An	Introduction	to	the	History	of	Political	Economy	(Oxford:
Oxford	University	Press,	1989).
J.	K.	GALBRAITH
A	History	of	Economics:	The	Past	as	the	Present	(London:	Penguin,	1989).
R.	HEILBRONER
The	Worldly	Philosophers:	The	Lives,	Times,	and	Ideas	of	the	Great	Economic	Thinkers
(Harmondsworth:	Penguin,	1983).
G.	HODGSON
How	Economics	Forgot	History:	The	Problem	of	Historical	Specificity	in	Social	Science	(London:
Routledge,	2001).
E.	REINERT
How	Rich	Countries	Became	Rich,	and	Why	Poor	Countries	Stay	Poor	(London:	Constable,	2007).
A.	RONCAGLIA
The	Wealth	of	Ideas:	A	History	of	Economic	Thought	(Cambridge:	Cambridge	University	Press,	2005).
Appendix:	Comparing	Different	Schools	of	Economics