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European Journal of Political Economy Vol. 13 (1997) 389-392
ECONOMY
Book Review Stefan Voigt, Max Planck-Institute for Research Into Economic Systems, D-07743 Jena, Germany. Fax: + 49-3641-624016; e-mail: [email protected]. Review of Avinash K. Dixit; The Making of Economic Policy: A Transaction-Cost Politics Perspective, The MIT Press 1996 (Munich Lectures in Economics; Center for Economic Studies) The theory of economic policy had come out of fashion. The optimism concerning the possibilities to steer entire societies that had blossomed in the 50's and 60's was dismissed in the 70's and 80's when problems like unemployment, slow growth, environmental damages and gaps in the financing of the welfare state, which still await their solution, became relevant. In the meantime, new research areas have come to the fore in economics: Public choice has done away with the fiction of the benevolent dictator and has endogenized the political process. Constitutional economics has proposed to look for efficiency not in end-states or outcomes but in the rules or processes of the game. The New Institutional Economics stresses time and again that we live in a world of positive transaction costs and that institutions, including internal ones which are not enforced by the state, can help to cope with the corresponding uncertainty. The time to pull those approaches together and ask whether they can form the nucleus of a modified, or even entirely new, theory of economic policy seems to have come as various recent attempts in this direction confirm. Avinash Dixit's short monograph is especially interesting because he considers himself a beginner in the field yet is beyond doubt an expert in various other fields such as the theory of international trade or information economics. 'The Making of Economic Policy: A Transaction-Cost Politics Perspective' has developed out of a series of lectures that Dixit gave as the first 'Distinguished Fellow' of the Munich-based Center for Economic Studies. They thus make for an enjoyable reading. The author's basic presumption is that transaction costs are a useful concept for analyzing not only economic exchange but also economic policymaking. He advances two hypotheses: Within the framework of transaction 0176-2680//97//$17.00 Published by Elsevier Science B.V. P H SO 176-2680(97)00011-6
390
Book Review
cost politics, a term he borrows from Douglass C. North, the relevance of multitask agencies as well as multiprincipal agencies has hitherto not been sufficiently recognized. If they and the interdependences between the political and the economic process are adequately taken into account, the usual dichotomy between markets and governments largely vanishes, which is his second hypothesis. Concerning the relevance of transaction costs, Dixit confirms North's dictum that they are even more important in politics than in economics. He concludes by expressing his hope for a revival of the 'Einheit der Staatswissenschaften' (the unity of the sciences of the state). Dixit is to be congratulated for trying to pull together different research strands such as the above-mentioned. He stresses the relevance of historical time and path dependence. He further stresses the relevance of the second best which might be the realizable first best if the constraints whose consequences are positive transaction costs are properly taken into account. He thus echoes Demsetz' demand to prevent committing the Nirvana fallacy. This demand has entered into the New Institutional Economics by way of the methodological tool of comparative institutional analysis which demands to compare only realized or at least realizable policy options. Although all this is quite deserving, some shortcomings remain. In his first chapter, Dixit strives for a synthesis of the two approaches that have been dominant in economic policy analysis over the last couple of decades. On the one hand, there is neoclassical welfare theory which reduces policy making to an engineering problem. Given a Bergson-Samuelson welfare function, a benevolent dictator chooses a policy-mix which brings about the highest possible utility level on the social welfare function. Dixit even attributes (partial) positive status to the theory because it could be interpreted as a theory that predicts the emergence of government in those areas in which the market fails. But since it remains silent on the actual functioning of government, the theory would remain normative in its operational content. On the other hand, there is 'the positive view of political economy' in which Dixit includes public choice as well as contractarian constitutional economics ~ la Buchanan. Dixit proceeds by proposing a synthesis between the two approaches which he describes as an 'evolutionary perspective'. The starting point for the proposed synthesis is the observation that constitutional economists often overstate the dichotomy between the choice of rules on the one hand and the choice within rules on the other. Constitutional rules often get substantially modified although they remain formally unchanged. Policy acts, i.e. choices within rules, however, often have long-term effects due to path dependance, the 'reliance doctrine' and the like. From the observation that the difference between the choice of rules and the choice within rules is one of degree rather than one of kind, Dixit deduces the demand that the appropriate framework for analysis should be dynamic or evolutionary, i.e. the framework should not only allow for the analysis of evolutionary processes but should itself be evolutionary. Although Dixit names valuable reasons for why the effects that constitutional rules can bring about might at times be impossible to distinguish sharply from the
Book Review
391
choices within them, he still wants to synthesize the unsynthesizable. The central distinguishing criterion between neoclassical welfare economics and constitutional economics is not that one is normative and the other positive, as Dixit seems to assert. Rather, both are normative but are based on different premises. The efficiency test of the welfare economic approach is oriented at outcomes or results whereas that of constitutional economics is oriented at processes or rules. Whereas the social welfare function is objectively given, the potential (Pareto-)superiority of altemative or proposed constitutional rules has to be ascertained by achieving consensus among the governed. It is thus based on a subjective concept of utility. The welfare economic approach further has to assume that some benevolent dictator willing to implement those policies which will best improve a society's welfare will come along whereas the constitutional approach pretends that it can do without this fiction. The first approach remains within the 'allocation/distribution'-paradigm whereas the second could be interpreted to offer a competing ' cooperation' -paradigm. Dixit's synthesis is reflected in some of the mechanisms which he names in order to cope with transaction costs in politics. With commitments, the credibility versus flexibility-issue can become relevant. The welfare economic approach has solved the credibility-issue by way of assumption (namely the benevolent dictator) and would thus opt in favor of flexibility. Since constitutional economists refrain, at least conceptually, from evaluating single policy-outcomes, a trade-off between credibility and flexibility does not appear necessary. In their paradigm, rules are the name of the game and they would thus look for ways which make them credible. Here, Dixit's synthesis reads like this: "There does exist a halfway house that combines some of the simplicity with some of the advantages of both commitment and flexibility. This is to use an unconditional rule at some times, keep flexibility at others, and to define threshold levels of contingencies at which the policy would switch from one regime to the other" (p. 67). Constitutional economists would supposedly ask how one could credibly commit to this meta-rule. Hayek has commented upon the commitment versus flexibility debate (1964, 12): " I t may sound paradoxical that rationality should thus require that we deliberately disregard knowledge which we possess; but this is part of the necessity of coming to terms with our unalterable ignorance of much that would be relevant if we knew it". Concerning a possible reunification of the sciences of the state, Dixit expresses his hope that this might come about as a merger between equals and not as the result of economic imperialism. This is reflected in the consequences that the author suggests economists as well as policymakers could draw from his approach toward economic policy: Economists should accept the legitimacy of noneconomic goals and politicians "...should work to reduce informational asymmetries and improve mechanisms that can control opportunism. Conversely, they should try to avoid policies that create new transactions costs or increase existing ones" (p. 148). Working with 'economic' versus 'non-economic' goals means that incom-
392
Book Review
mensurables are introduced whose trade-off is not the business of economists. This leads directly back to the dichotomy between market and government that Dixit had set out to overcome. With the consequences for the policymakers, Dixit steps equally out of the economic discourse: He would have to show under what circumstances they have incentives to reduce informational asymmetries and improve mechanisms that can control opportunism. He would further have to show under what constraints policymakers do not have incentives to create new transaction costs or increase existing ones. Implicitly assuming that all the insights of public choice can be neglected if the economist only tries hard enough in moral suasion is not only no new insight but is almost equivalent to committing the same mistakes that made the 'old' theory of economic policy so little successful.
Reference Hayek, F.A., 1964. Kinds of Order in Society, New Individualist Review, 3(2), 3-12.
European Journal of Political Economy Vol. 13 (1997) 389-392
ECONOMY
Book Review Stefan Voigt, Max Planck-Institute for Research Into Economic Systems, D-07743 Jena, Germany. Fax: + 49-3641-624016; e-mail: [email protected]. Review of Avinash K. Dixit; The Making of Economic Policy: A Transaction-Cost Politics Perspective, The MIT Press 1996 (Munich Lectures in Economics; Center for Economic Studies) The theory of economic policy had come out of fashion. The optimism concerning the possibilities to steer entire societies that had blossomed in the 50's and 60's was dismissed in the 70's and 80's when problems like unemployment, slow growth, environmental damages and gaps in the financing of the welfare state, which still await their solution, became relevant. In the meantime, new research areas have come to the fore in economics: Public choice has done away with the fiction of the benevolent dictator and has endogenized the political process. Constitutional economics has proposed to look for efficiency not in end-states or outcomes but in the rules or processes of the game. The New Institutional Economics stresses time and again that we live in a world of positive transaction costs and that institutions, including internal ones which are not enforced by the state, can help to cope with the corresponding uncertainty. The time to pull those approaches together and ask whether they can form the nucleus of a modified, or even entirely new, theory of economic policy seems to have come as various recent attempts in this direction confirm. Avinash Dixit's short monograph is especially interesting because he considers himself a beginner in the field yet is beyond doubt an expert in various other fields such as the theory of international trade or information economics. 'The Making of Economic Policy: A Transaction-Cost Politics Perspective' has developed out of a series of lectures that Dixit gave as the first 'Distinguished Fellow' of the Munich-based Center for Economic Studies. They thus make for an enjoyable reading. The author's basic presumption is that transaction costs are a useful concept for analyzing not only economic exchange but also economic policymaking. He advances two hypotheses: Within the framework of transaction 0176-2680//97//$17.00 Published by Elsevier Science B.V. P H SO 176-2680(97)00011-6
390
Book Review
cost politics, a term he borrows from Douglass C. North, the relevance of multitask agencies as well as multiprincipal agencies has hitherto not been sufficiently recognized. If they and the interdependences between the political and the economic process are adequately taken into account, the usual dichotomy between markets and governments largely vanishes, which is his second hypothesis. Concerning the relevance of transaction costs, Dixit confirms North's dictum that they are even more important in politics than in economics. He concludes by expressing his hope for a revival of the 'Einheit der Staatswissenschaften' (the unity of the sciences of the state). Dixit is to be congratulated for trying to pull together different research strands such as the above-mentioned. He stresses the relevance of historical time and path dependence. He further stresses the relevance of the second best which might be the realizable first best if the constraints whose consequences are positive transaction costs are properly taken into account. He thus echoes Demsetz' demand to prevent committing the Nirvana fallacy. This demand has entered into the New Institutional Economics by way of the methodological tool of comparative institutional analysis which demands to compare only realized or at least realizable policy options. Although all this is quite deserving, some shortcomings remain. In his first chapter, Dixit strives for a synthesis of the two approaches that have been dominant in economic policy analysis over the last couple of decades. On the one hand, there is neoclassical welfare theory which reduces policy making to an engineering problem. Given a Bergson-Samuelson welfare function, a benevolent dictator chooses a policy-mix which brings about the highest possible utility level on the social welfare function. Dixit even attributes (partial) positive status to the theory because it could be interpreted as a theory that predicts the emergence of government in those areas in which the market fails. But since it remains silent on the actual functioning of government, the theory would remain normative in its operational content. On the other hand, there is 'the positive view of political economy' in which Dixit includes public choice as well as contractarian constitutional economics ~ la Buchanan. Dixit proceeds by proposing a synthesis between the two approaches which he describes as an 'evolutionary perspective'. The starting point for the proposed synthesis is the observation that constitutional economists often overstate the dichotomy between the choice of rules on the one hand and the choice within rules on the other. Constitutional rules often get substantially modified although they remain formally unchanged. Policy acts, i.e. choices within rules, however, often have long-term effects due to path dependance, the 'reliance doctrine' and the like. From the observation that the difference between the choice of rules and the choice within rules is one of degree rather than one of kind, Dixit deduces the demand that the appropriate framework for analysis should be dynamic or evolutionary, i.e. the framework should not only allow for the analysis of evolutionary processes but should itself be evolutionary. Although Dixit names valuable reasons for why the effects that constitutional rules can bring about might at times be impossible to distinguish sharply from the
Book Review
391
choices within them, he still wants to synthesize the unsynthesizable. The central distinguishing criterion between neoclassical welfare economics and constitutional economics is not that one is normative and the other positive, as Dixit seems to assert. Rather, both are normative but are based on different premises. The efficiency test of the welfare economic approach is oriented at outcomes or results whereas that of constitutional economics is oriented at processes or rules. Whereas the social welfare function is objectively given, the potential (Pareto-)superiority of altemative or proposed constitutional rules has to be ascertained by achieving consensus among the governed. It is thus based on a subjective concept of utility. The welfare economic approach further has to assume that some benevolent dictator willing to implement those policies which will best improve a society's welfare will come along whereas the constitutional approach pretends that it can do without this fiction. The first approach remains within the 'allocation/distribution'-paradigm whereas the second could be interpreted to offer a competing ' cooperation' -paradigm. Dixit's synthesis is reflected in some of the mechanisms which he names in order to cope with transaction costs in politics. With commitments, the credibility versus flexibility-issue can become relevant. The welfare economic approach has solved the credibility-issue by way of assumption (namely the benevolent dictator) and would thus opt in favor of flexibility. Since constitutional economists refrain, at least conceptually, from evaluating single policy-outcomes, a trade-off between credibility and flexibility does not appear necessary. In their paradigm, rules are the name of the game and they would thus look for ways which make them credible. Here, Dixit's synthesis reads like this: "There does exist a halfway house that combines some of the simplicity with some of the advantages of both commitment and flexibility. This is to use an unconditional rule at some times, keep flexibility at others, and to define threshold levels of contingencies at which the policy would switch from one regime to the other" (p. 67). Constitutional economists would supposedly ask how one could credibly commit to this meta-rule. Hayek has commented upon the commitment versus flexibility debate (1964, 12): " I t may sound paradoxical that rationality should thus require that we deliberately disregard knowledge which we possess; but this is part of the necessity of coming to terms with our unalterable ignorance of much that would be relevant if we knew it". Concerning a possible reunification of the sciences of the state, Dixit expresses his hope that this might come about as a merger between equals and not as the result of economic imperialism. This is reflected in the consequences that the author suggests economists as well as policymakers could draw from his approach toward economic policy: Economists should accept the legitimacy of noneconomic goals and politicians "...should work to reduce informational asymmetries and improve mechanisms that can control opportunism. Conversely, they should try to avoid policies that create new transactions costs or increase existing ones" (p. 148). Working with 'economic' versus 'non-economic' goals means that incom-
392
Book Review
mensurables are introduced whose trade-off is not the business of economists. This leads directly back to the dichotomy between market and government that Dixit had set out to overcome. With the consequences for the policymakers, Dixit steps equally out of the economic discourse: He would have to show under what circumstances they have incentives to reduce informational asymmetries and improve mechanisms that can control opportunism. He would further have to show under what constraints policymakers do not have incentives to create new transaction costs or increase existing ones. Implicitly assuming that all the insights of public choice can be neglected if the economist only tries hard enough in moral suasion is not only no new insight but is almost equivalent to committing the same mistakes that made the 'old' theory of economic policy so little successful.
Reference Hayek, F.A., 1964. Kinds of Order in Society, New Individualist Review, 3(2), 3-12.