Ifo Viewpoint No. 108: The Triad of Theory, Econometrics and Knowledge of Institutions

The methodological debate that began with appeals signed by economists in the Frankfurter Allgemeine Zeitung and in Handelsblatt is useful as it helps us adjust our approach to doing economics. The two appeals contain good ideas that both sides should mutually take into consideration. But both also contain positions that I do not support.
Hans-Werner Sinn
Munich, 06 July 2009

The first appeal calls for a return to the old distinction between theory and policy. In Munich we abandoned this distinction as far back as the early 1990s. Policy without theory is just as useless as theory without policy implications. Lectures in economics should include both. Many theoreticians would be well-served if they concentrated their talent on topics that are of interest to policymakers. And policy-oriented economists would be well-advised to improve the theoretical foundations of their policy recommendations.

The second appeal attempts to defend contemporary economics by pointing out that the discipline contains both a theoretical as well as an econometric side. This defence is weak, however. To be sure, econometrics is the key methodology for a quantitative analysis of economic relationships and as such is as indispensable as economic theory for modern economic research. But equally important as theory and econometrics is knowledge of countries’ actual institutional rules as found in their business laws and regulations. In short, economics must be a balance of theory, econometrics and knowledge of institutions in order to provide policymakers and the public with well-founded recommendations.

A major deficit of our discipline is that too little attention is devoted to the knowledge of institutions. This unfortunately also applies to the best international journals in economics. The strength of the old field of economic policy and the German historical school was the knowledge of institutions; conversely its often frightening lack of theory was its weakness.

Laws and regulations, which set the framework for private-sector activity and create incentives, are important in explaining what is actually happening in an economy. We cannot understand the financial crisis, for example, if we do not know what non-recourse loans are, how structured securities are formed, what the Community Reinvestment Act stipulated, how the IFRS accounting rules are designed, how the Basel II system functions and what liability restrictions exist for the banks. This is all much more complicated and empirically much more important than using the latest econometric testing procedures to show how up-to-date one’s research is methodologically.

The mechanisms that drove the world into the worst crisis of the post-war era only partially lend themselves to a numerical-mathematical analysis or only as a second step, after the institutional complexity has been clarified in a verbal analysis. In many instances an economic explanation is only possible after studying the underlying legal mechanisms, which can be understandably described in words but which escape a purely mathematical or even numerical analysis. For this reason, the Ifo Institute began ten years ago to construct a database for international institutional comparisons that compares the relevant incentive structures in the legal systems of important countries in various areas of the economy. Together with the LMU Munich, Ifo will shortly announce a professorship in this area. The DICE Database (Database for Institutional Comparisons in Europe) is one of the most frequented sections of the Ifo Institute’s website.

Today economics again needs more economists who are prepared to examine the details of the regulatory framework and how state organs function. In most Western countries the state absorbs more than half of the national income for its own purposes by incurring debt and by collecting taxes and fees to finance transfers and public goods. In addition, with its laws and regulations it massively intervenes in the decision-making of its citizens and businesses. Despite this, in many economics faculties there is a trend to eliminate positions in public finance, the field that examines the role of the state. The reason frequently given is that this field is already dying out in America, which is true. But I would warn against adopting American priorities just because publishing in a top American journal ranks as one of the greatest accolades for an economist.

The attitude of many American economists to public finance and economic policy was once jokingly but aptly put to me by a well-known Chicago-school economist: “Public finance teaches how a benevolent state corrects market failures. Since there’s neither market failures nor a benevolent state the discipline is superfluous.” We really do not need to adopt this stance in Europe. Of course, the state does not always have good intentions. But market failures abound, such as the financial crisis, environmental problems and many others. And of course there are failures in the implementation of government policies. For this reason, the formulation of institutional reform programmes and discretionary policy measures for overcoming market and government failures remains a task that economics should not abandon despite politicians’ apparent “immunity” to advice.

Hans-Werner Sinn
Professor for Economics and Public Finance
President of the Ifo Institute

Published as “Der richtige Dreiklang der VWL”, Frankfurter Allgemeine Zeitung, No. 141, 22 June 2009, p. 12.