There may be an inverse relationship between the health of the economy and the quality of books published about economics.  In the 1980s, for example, the US economy was booming yet bestseller lists brimmed with gloomy and embarrassing tracts predicting America’s decline.  Today, the country struggles through the worst recession in decades, but a significant number of serious, thoughtful books on economic issues have reached a wide audience.

This could be an example of necessity being the mother of invention.  Sustained economic crises should prompt new thinking, particularly when they were generally unforeseen and have failed to respond to textbook solutions.  The current financial crisis has generated several excellent books examining the causes and long-term implications of our current economic environment.  More fortuitously, at least two recent books have looked deeper into economic methods and explore questions that economists have largely ignored for more than a century.

One of these is Bourgeois Dignity, the second in a series of six volumes by Deidre McCloskey examining the causes of the Industrial Revolution.  This topic may seem quaint and of limited relevance, but it’s easy to forget how significant this epoch was.  Before the Industrial Revolution, living standards for most of humanity had barely changed over 2000 years; since then, per capita incomes in the wealthiest nations have skyrocketed 15,000%.  The Industrial Revolution has arguably improved human welfare more than any other episode in history, yet economists have struggled to explain precisely why and where it happened (Britain and Holland, before spreading to Northern Europe).

That’s not to say they haven’t tried, and much of the value of Bourgeois Dignity lies in the way it carefully documents and summarizes every major explanation for the Industrial Revolution.  McCloskey then examines each of these accounts and argues, by and large persuasively, that they are all deficient.  Along the way, she takes the reader through an entertaining tour of economic history, informed by a stunning mastery of economic scholarship and experience from across the globe.

McCloskey believes the Industrial Revolution is explained by a change in values.  In particular, Britain and Holland were the first societies to confer dignity on merchants, a traditionally despised occupation.  Merchants’ “bourgeois” values became prized, and these ideals were diffused across each country through rhetoric and speech.  This unprecedented cultural shift increased attention to commercial pursuits and accelerated the division of labor, trade, and technological progress.

McCloskey’s book is fascinating partly because it appeals to factors economists are practically trained to ignore.   Standard economic analysis assumes that preferences are given, and people act rationally to satisfy those preferences.   The notion that rhetoric can persuade people to revalue certain activities and redirect their energies and behavior is alien to how most economists approach their work.  My only complaint with Bourgeois Dignity is that McCloskey makes an overwhelmingly negative case for her thesis (i.e. every other explanation for the Industrial Revolution is wrong) rather than providing much in the way of affirmative evidence.  However, she says this will be provided in volumes three through six of the series, so it’s safe to assume that McCloskey has data waiting in the wings that illustrates more precisely how rhetoric and speech have been central to economic development.

As interesting as McCloskey’s book is, Vernon Smith’s Rationality in Economics:  Constructivist and Ecological Forms is even better.  Smith was awarded the 2002 Nobel Prize in Economics for his pioneering work in designing laboratory experiments that test economic theories.  His findings have led him to rethink much of the fundamentals of economic methodology and what drives economic behavior.  In doing so, Smith reconnects with the Scottish Enlightenment tradition that informed so much early economic thinking but has long been abandoned by the field.

Because Smith’s book critically examines economic methodology, a brief digression is warranted both to explain this methodology, and how it came to dominate, to non-professional economists.  As most readers likely know, in 1776 Adam Smith completed The Wealth of Nations, the first book explicitly and exclusively devoted to economics.  Adam Smith was a Professor of Philosophy at Glasgow University in Scotland and a renowned figure because of his previous book, The Theory of Moral SentimentsThe Wealth of Nations synthesized a large amount of writing on economic topics, much of it produced by Scots like Hume, Mandeville and Ferguson.  Smith’s systematic treatment of issues such as the division of labor, competition and trade was masterful and laid a solid foundation for economics as a new intellectual discipline (although the field was called “political economy” until well into the 19th century).  Perhaps most famously, The Wealth of Nations describes how competitive markets unconsciously generate their own order, as individuals naturally pursuing their own self-interest are led as if by “an invisible hand” to create wealth that benefits their entire society.

Despite the cogency and influence of this achievement, some scholars have been puzzled by an apparent contradiction between Adam Smith’s two major books, since The Theory of Moral Sentiments emphasizes how moral sympathies give rise to human sociality while The Wealth of Nations apparently concentrates on isolated individuals motivated by selfishness.  A central point in Vernon Smith’s Rationality in Economics is that there is a unity in Adam Smith’s thought, but that fundamental human impulses take different forms in personal and marketplace interactions.  As Vernon Smith says:

The two works (by Adam Smith) are not inconsistent if we recognize that a universal feature for social exchange is a fundamental distinguishing feature of Homo Sapiens and that it finds expression in two distinct forms:  personal exchange in small-group interactions, and impersonal trade through markets.  Thus Smith was to some extent relying on the same behavioral axiom, “the propensity to truck, barter and exchange one thing for another,” where the items of exchange are interpreted to include not only commercial goods and services but also gifts, assistance and reciprocal favors out of sympathy….by interpreting personal local interactions and market participation as different expressions of the universal human propensity for engaging in exchange, we bring a unity of meaning to otherwise apparently contradictory forms of behavior.”

Regardless of this thematic unity, Adam Smith’s first book was overshadowed by The Wealth of Nations, and the economists that followed Smith built almost entirely on his later text.  Major figures like David Ricardo and John Stuart Mill elaborated on Adam Smith’s work and made important contributions to the emerging field.  By the mid-to-late 1800s, “classical” economics had taken form before the so-called “marginal revolution” took place in the 1870s.  William Stanley Jevons and his “marginalist” followers put more emphasis on the demand side of the marketplace and introduced the idea of marginal utility as a driving force for consumer behavior.  More generally, the marginalists conceived of economic behavior as the outcome of fully informed consumers and producers acting to maximize their objectives by examining the incremental (i.e. marginal) costs and benefits that result from small changes in their behavior.  It was obviously a short step from this vision to formally expressing economics in the language of mathematics and, more particularly, calculus.

This step was definitively taken by the middle of the 20th century, following Alfred Marshall’s synthesis of the classical and marginalist schools and Keynes’ bewitching macroeconomic critiques.  The defining figure here was Paul Samuelson, with important later contributions from fellow Keynesians like Kenneth Arrow and Gerard Debreu, as well as many others.  Economics was now formalized as a set of explicit, constrained optimization problems, where technology (on the supply side) and preferences (on the demand side) were economic ‘givens’ but reflected in the parameters of well defined cost and demand functions (which were themselves the outcome of explicit optimization problems).  Although he disagreed with Samuelson and other Keynesians on most substantive points, this basic methodological approach was approved by Milton Friedman and others in the market-oriented Chicago School.  Friedman’s view of “positive economics” was a discipline where a unified, mathematical theory is used to derive testable hypotheses which are then tested statistically using data generated by the real economy.  Empirical findings would sift the wheat from the chaff and lead to refinements in the underlying mathematical models of economic behavior.  Although this brief history of economic methodology naturally omits a great deal of nuance, this is essentially the view that dominates economics today, and it informs how nearly all practicing economists approach their work.

Drawing on his extensive experimental economics research, Vernon Smith argues that this methodological approach is deficient in important ways, since it misses much that is central rather than peripheral to economic behavior.  In particular, Smith faults the standard methodology for jumping immediately to the analysis of equilibrium outcomes rather than the dynamic processes that lead to those outcomes.  These processes involve repeated interaction among economic agents, which leads naturally to learning and behavioral modifications.

Interestingly, dynamic behavior shows people are interested in their long-run reputations and do not act strategically, or with tunnel-vision selfishness, to maximize their own immediate welfare.  Economic behavior is a long-run, dynamic process in which reciprocity and reputation are critical for helping individuals compensate for the fact that they are never fully informed of all relevant conditions, which would be necessary to identify “optimal” solutions.  Nevertheless, Smith’s findings show that repeated interactions often converge to competitive market outcomes that are consistent with “textbook” predictions, but these outcomes do not depend on explicit, maximizing behavior where individuals use all relevant information to calculate the costs and benefits of alternate courses of action.  In fact, having “complete” information often reduces individuals’ gains from exchange.

Smith believes the experimental research shows that economic behavior involves two distinct types of rationality.   Constructivist rationality is the type of deliberate, rationalizing behavior that modern economics focuses on almost exclusively; it involves the analysis and selection of modes of action that are determined to be preferable to alternate actions that might be chosen as means to achieve desired ends.  Ecological rationality, on the other hand, “refers to emergent order in the form of practices, norms and evolving institutional rules governing action by individuals that are part of our cultural and biological heritage and are created by human interactions, but not by conscious design.”  These two types of rationality operate simultaneously in every economy and, in fact, work together.  In an instrumental sense, constructivist rationality can be viewed as a mechanism for generating variations and innovations in economic arrangements, while ecological processes determine which of these innovations will endure.  If this discussion of the nature and purposes of ecological rationality reminds you of Hayek, it’s not a mistake; Smith acknowledges his debt to Hayek’s work, which (in spite of Hayek’s own Nobel Prize late in life) was largely shunned by mainstream economists for most of his career.

There is more, much more, in Smith’s book, but it’s important to recognize that it is not just a treatise on purely academic, methodological matters.  Rationality in Economics presents a new, richer framework for understanding all economic phenomena, as well as the strengths and weaknesses of the constructivist paradigm routinely used to assess economic issues.  One demonstration of the practical value of Smith’s perspective is his assessment of the work of two fellow Nobel Laureates (George Akerlof and Joseph Stiglitz), who were awarded the Prize for their work on the relationship between imperfect information and market “failures.”   Smith shows that the view that insurance and related markets fail to conform to the dictates of economic theory ultimately reveals that it is the theory rather than the markets that are flawed.   Economists’ standard, constructivist analyses fail to consider that distinct institutional features in insurance markets reflect ecological adaptations that allow firms to meet the challenges associated with providing these services.

One word of warning on Rationality in Economics, however:  it is sometimes not an easy read.  Smith’s audience appears to be other professional economists, not the general public.  While the book is not as technically complex as most professional economic publications (less than ten pages of equations, which can be easily skipped), Smith does presume a fair bit of knowledge on the part of readers, particularly with respect to game theory.  This is not to say that the educated, general public can’t understand Smith’s main points, but it may be tough sledding in places and you may want to skip over some of his detailed examples.

Nevertheless, Smith’s book is well worth the effort and, if you’re ambitious, you should read it in conjunction with McCloskey’s breezier, more entertaining Bourgeois Dignity.  Both books explore the importance of sociality, interaction, and learning in economic behavior.  This view is summed up eloquently by Smith, who says “the power behind the throne of the human career is our sociality, and the unintended mansions that are built by that sociality.”  Both Rationality in Economics and Bourgeois Dignity help to re-establish economics as a social science, not ersatz physics applied to economic phenomena.  This is not to deny that much can be and has been learned from the mechanistic, technical tools that economists have developed, but Smith and McCloskey show these methods also miss much that is not just important, but critical, for understanding economic behavior.