Bridging Old and New Institutional Economics: Gustav Schmoller, Leader of the Younger German Historical School, Seen with Neoinstitutionalists’ Eyes

Gustav Schmoller was born in Heilbronn, a small town on the River Neckar in the then Kingdom of Württemberg, in 1838. He studied Staatswissenschaften, a combination of public finance, statistics, economics, administrative science, history and sociology, at the Staatswirtschaftliche Fakukultät of the University of Tübingen for a couple of years until 1860. Four years later, in 1864, at the age of 26, Schmoller started his academic career as a professor of Staatswissenschaften at the University of Halle (Saale), in Prussia, which finally lead him via Strassburg (1872–1882) to Berlin (1882–1913). He died in 1917.

As a student in Tübingen, Schmoller must have read publications by Roscher, the leading figure of what later became the “Older Historical School.” The first volume of Roscher’s main work, System der Volkswirtschaft, appeared in 1854.⁴ Roscher adhered to what he called the “historical-physiological method,” as opposed to the “idealistic method” of classical economics (Schefold 1987, p. 221). He did, what we would call today, “comparative economics,” comparing the history of different economies and showing analogies in stages of their development.⁵ Apart from that he remained rather close to the theoretical system of the classics, different from the later “Younger Historical School” with, i.a., Brentano, Bücher, Held, Knapp—and Schmoller who is regarded as the founder and leader of this more radical school of thought.

Schmoller, without being a historian by training, was apparently fascinated by the research technique of historians evolving at that time in Germany. It was widely applied, not only in history itself but also in legal or philological studies, i.e., in the humanities in general. For a description of this technique see, e.g., Bernheim (1908), a book of which Schmoller (1889) himself quotes an earlier edition.⁶

Schmoller did not only “talk” about the historical method but did himself a considerable amount of historical research—at least during the first 10–15 years of his career. Among his most frequently quoted works are the following:

Schmoller’s conceptions or “theories” underlying these studies are roughly the following:

In his first study Schmoller (1870) tries to show that it would be a mistake to believe that freedom of trade⁷ would automatically result in fast growth. State activities are unavoidable, particularly in view of the large increase in population. He asks, “What can be done?” by the state. And he answers two things: “(1) education of the working classes, i.e. school education and if possible, a generally accessible technical education, and (2) [help with the] transition to the new circumstances and conditions [of the crafts] in so far as craftsmen cannot do this themselves because of an out-dated education.” (op. cit. 695).⁸ As a practical solution he demands obligatory schooling of apprentices (what later became the German Berufsschule) and some kind of ombudsmen of the working classes (the craftsmen in this case).

The emphasis on education, in particular of craftsmen and skilled workers, is echoed much these days in the USA and Britain.⁹

The conception or theory of the second study (Schmoller 1879) is the hypothesis that history is an evolutionary process, which moves quite slowly. His study is supposed to show

how large economic institutions…slowly develop through the centuries, how they establish themselves, only after long struggles, in the practical life of people [im praktischen Volksleben]. During such an equilibrium period [between social forces] the seemingly mighty institutions dominate economic life. Eventually, again in the course of several centuries, they make room for other institutions as a consequence of slow successive changes in economic demands, feelings, customs and legal convictions. (p. XI)

The aim of his book, he writes, is to show

that the basic views on social policy, for which I have been fighting for years, were developed on historic foundations and that, vice versa, only through them any historical question become understandable. (p. XII)

The purpose of the third book, a collection of articles he had written in earlier years on the evolution of the Prussian state (Schmoller 1898), culminates in stressing the importance of well-educated and trustworthy professional civil servants (the famous preussische Berufsbeamtentum) for the functioning of the modern “territorial state” in all its administrations: defence, justice, police, commerce and agriculture (op.cit., 301 ff.).¹⁰ It was perfectly clear to Schmoller, of course, that the “civil servant state” (der Beamtenstaat) could not become a permanent form of public life, but nevertheless was an important phase of German social life (op.cit. 312). The reason why he did these studies was, as he explains, that

I said to myself, only he who knows the formation of the present day’s state and today’s economic circumstances is able to judge them correctly and to help developing them further. (op.cit., VIII)

Not only the economist Schmoller, but also the historian Schmoller experienced mixed reactions among German scientists, in this case among German historians. Professional historians in the more narrow (“classical”) sense of the word did not think very highly of his work (Oestreich 1969, p. 340). Hartung (1938, p. 281) argues that this was due to his lack of methodical historicocritical training. “Methodical criticism [of sources] was not Schmoller’s thing.”(ibid.) His descriptions were frequently not exact despite his liking of the word “exact”. His ‘intimate enemy’ was the historian von Below (1904) who criticized Schmoller fiercely. In his opinion, Schmoller’s economic historical approach is “plainly unscientific” (loc.cit., 160) and he accuses Schmoller of being “politically tendentious.” (loc.cit., 328) As for the latter point, Schmoller certainly had stressed several times that his writings had a political purpose (see above), which does not necessarily mean they were ideologically corrupted.

Schmoller was apparently a great organizer of research and successful in pursuing his social policy aims. He was a leading figure between the German Kathedersozialisten (socialists of the chair),¹¹ and the leading founder of the Verein für Socialpolitik (in 1872) that later became the German Economic Association.¹² In 1881 he became editor of the Jahrbuch für Gesetzgebung, Verwaltung und Volkswirtschaft im Deutschen Reiche (Yearbook of Legislation, Administration and National Economy in the German Empire) later known as Schmollers Jahrbuch. He was an academic champion of Bismarck’s social legislation (the early introduction of compulsory social and health insurance for the working classes—today much admired in the USA) and possibly became, in the course of the years, as Hutchison (1988, p. 527) put it, “a much too powerful academic empire-builder, who controlled appointments to chairs in the narrow interest of his own historical approach, or school.” This may have been the case, though it seems hard to believe that the rather strong German historical-economic movement of the last century was the product of Schmoller’s doings—either behind the scene controlling university appointments or scientific output as an editor. There was a great interest among German students for social issues, and the Historical School, being mindful of social justice issues,¹³ may have attracted a great number of students simply for that matter and thus gathered momentum on its own steam. Oestreich (1969) gives numerous examples of German universities where lectures on social and economic history were given with Berlin being at the top.

Note that in those days also in England Political Economy was seen as being closely connected with history and historical studies. At Cambridge, e.g., students preferred to study economics with historians and not necessarily with Marshall, who developed at that time what became later the academic educational program in economics (see Kadish 1989).

In 1900 Schmoller published the first volume of his Grundriss (“Outline”¹⁴) which, according to the foreword, is a collection of lectures he gave on general economics (Allgemeine Volkswirtschaftslehre) during the 36 years of his academic career, systematized and written in the style of a principles book.

The second part of his Grundriss appeared in 1904. It is, as Schmoller (1904, V f.) writes, in a sense the “facit” of his life as a scientist. It contains a detailed section on “The Fluctuations and Crises of the National Economy” (pp. 464–496). He follows the socialist¹⁵ literature by arguing that the crises are the result of coordination failures, as it would be called today, but, diverging from the socialists, he concludes: “Today’s economic order has its shortcomings and they appear most distinctly in hausse and over speculation, in crises and the subsequent depressions: but from these shortcomings does not follow the collapse of this order and its sudden replacement by a socialist one, but only the [need] for gradually combating these shortcomings.”(487) The section ends therefore with suggestions for, what we call today, stabilization policy. Since the book is a collection of lecture notes, Schmoller must have taught this already years before 1904, during the heydays of neoclassical economics, half a century before business fluctuations and stabilization policy (or “coordination failure and macroeconomic policy”) became a core issue of economics.

To return to the first part of Schmoller’s Grundriss: it was quite favourably received by the profession and sold very well. Most of its reviews were positive or enthusiastic.¹⁶ Among the few critical reviewers was, of course, Schmoller’s “intimate enemy” von Below (1904). As a historian he questioned the solidity of Schmoller’s historical research and asked: “What is the point of an economic science on a historical basis if the ‘historical basis’ is not solid?” (loc.cit. 182). And he continues, that if Schmoller’s Grundriss was really one of the most famous books on economics ever written (as Hasbach, a former student of Schmoller, had declared¹⁷) the historian would have to add: “But to be used with caution.”

Nevertheless, parts of just this book (the first volume of Schmoller’s Grundriss) will be used in our present retrospective.¹⁸

Both, the representatives of the German Historical School and of the New Institutional Economics, criticize the (at their time) current economic theory for its “too high level of abstraction” (Williamson 1975, p. 1). Schmoller and Coase use virtually the same metaphor to illustrate this point:

The old [classical] economics, submerged in the analysis of prices and the phenomena of circulation, represents the attempt to provide an economic physiology of the juices of the body without anatomy. (Schmoller 1900a, p. 64)

The objection [against what most economists have been doing] essentially is that the theory floats in the air. It is as if one studied the circulation of the blood without having a body. Firms have no substance. Markets exist without laws… (Coase 1984, p. 230).

Consistent with this thinking is Schmoller’s (1900, p. 64) insistence on the need of comparative institutional analysis—just as exponents of the NIE argue and work today.

Both, Schmoller and representatives of the NIE, concede that rational behaviour (the motive of self-interest as Schmoller calls it) plays an important role in economic life, but not the only one and both are sceptical with regard to (simple) utility maximization. (Schmoller speaks of “utilitarism” in this case).

Here are two quotations from Schmoller and North respectively, first Schmoller (1900, p. 33) who writes:

We must concede that economic behaviour of today and probably of all times is closely related with self-interest…To find out the truth, though, it will be necessary to go a step further than Hermann, Roscher and Knies [three members of the older German Historical School] did, who were content with two abstract principles [instead of only one], self-interest and civic-sense [Erwerbstrieb und Gemeinsinn], namely to analyze psychologically and historically, as we already started to do, the basic motives of economic actions [die Triebfedern des wirtschaftlichen Handelns überhaupt].

[On the other hand] The classical theory of economics [Schmoller calls it die Theorie der natürlichen Volkswirtschaft] is, in toto, based on an incomplete analysis of man… (1900, p. 92).

North (1990, p. 17) remarks on this point:

I believe that these traditional behavioural assumptions [of the rational choice approach] have prevented economists from coming to grips with some very fundamental issues and that a modification of these assumptions is essential to further progress in the social sciences. The motivation of the actors is more complicated (and their preferences less stable) than assumed in received theory.

North continues:

[Various empirical studies show] that issues of free-riding, fairness, and justice enter the utility function and do not necessarily fit neatly with the maximizing postulates in the narrow sense (North 1990, p. 21).

Both schools consider with disbelieve the classical doctrine that competition (or natural selection) will lead to social optima.

Not all human progress is the result of natural selection. Darwin himself had to concede that the moral properties on which society is based were furthered more by habit, reason, education and religion. The conditions of human social life cannot, after all, be directly paralleled with those of animals and plants,… (Schmoller 1900, p. 66).

Competition may be so muted and the signals so confused that adjustment may be slow or misguided and the classic evolutionary consequences may not obtain for very long periods of time (North 1990, p. 24).

These are not contradictory terms; the old contrast between individualism and collectivism misses the point. Individuals deal with each other and the theory of exchange between individuals is an important part of economics. The institution of the market (or the firm) is a social undertaking, which is not explained by neoclassical theory.

Schmoller as well as modern institutionalists deal explicitly with the formation and execution of social relationships between individuals or groups of individuals. Here a quote from Schmoller:

[Classical Economics] … was a theory which taught the ideals of individualism and liberalism and considered the state to be almost unnecessary and politicians to be scoundrels—Today’s general economics [instead] is of a philosophical-sociological character. It is based on the nature of society and the general causes of economic life and behavior—it describes its typical organizations and their developments, its most important institutions [Einrichtungen] statically and dynamically (Schmoller 1894, pp. 537, 531).¹⁹

Similarly Commons (1934) argued that the classical and neoclassical doctrine was misleading because

it failed to recognize that it is not harmony but “conflict of interest” among individuals that is predominant in transactions (Commons 1934, p. 69).

Unlike Marx, however, Commons did not believe that conflict of interests represented the only relevant principle to consider. Also important are mutual dependence of people, and maintenance of order by collective action. Modern institutional economics deals sui generis with arrangements of social relationships, i.e., their “governance structures” (Williamson 1985). Since this is evident, I will quote an author who is not necessarily a ‘neoinstitutionalist’, viz., Kenneth Arrow. He argues:

It seems commonly to be assumed that the individual decisions…form a complete set of explanatory variables. A name is even given to this point of view, that of methodological individualism, that it is necessary to base all accounts of economic interaction on individual behaviour. (Arrow 1994, p. 1).—The current formulation of methodological individualism is game theory (op.cit., 4).

Arrow continues, in order to show that the rules of the game are of a social character:

The theory of games gets its name and much of its force from an analogy with social games. But these have definite rules, which are constructed, indeed, by a partly social process. Who sets rules for real-life games? (op.cit.,5)

This leads us to one of the central definitorial questions of institutional economics:

Schmoller (1900, p. 61) understands an institution

to be a partial order for community life which serves specific purposes and which has the capacity to undergo a further development on its own. It offers a firm basis for shaping social actions, frequently for centuries or millennia, as for example property, slavery, serf hood, marriage, guardianship, market system, freedom of trade.

North (1990, 3f.) writes:

Institutions reduce uncertainty by providing a structure to everyday life. They are a guide to human interaction, … In the jargon of the economist, institutions define and limit the set of choices of individuals. Institutional constraints include both what individuals are prohibited from doing and, sometimes, under what conditions some individuals are permitted to undertake certain activities. As defined here, they therefore are the frameworks within which human interaction takes place. They are perfectly analogous to the rules of the game in a competitive team sport.²⁰

How institutions come to be established is another question of interest, and the literature suggests at least two basic explanations. At one extreme, institutions are said to arise “spontaneously” on the basis of self-interest of individuals [which works only for conventions in the sense of Lewis (1969)], at the other, institutions may be the product of deliberate design. Hayek (1973) speaks of the respective situations as of “evolutionary” and “constructivist” rationalism, Williamson (1991, p. 3) of spontaneous and intentional governance. Schmoller (1900, pp. 58, 74) expresses strong scepticism with respect to the liberal creed.

Not only history matters; terminology matters as well. Thus, the terms “institution” and “organization” are not always kept well apart in economic writings. But not so by Schmoller and North:

Schmoller (1900, p. 61) defines:

We view the formation of an organization [Organbildung] as the personal side of the institution; marriage is the institution, the family is the organization [Organ]. The social organizations are the lasting forms of the relationship between persons and goods for specific purposes: the gens, the family, the clubs, the associations, the cooperatives, the communities, the firms, the state—these are the essential organizations of social life.

North (1990, 4f.) writes:

A crucial distinction in this study is made between institutions and organizations. Like institutions, organizations provide a structure to human interaction…[But]…Conceptually, what must be clearly differentiated are the rules from the players. The purpose of the rules is to define the way the game is played. But the objective of the team within that set of rules is to win the game—by a combination of skills, strategy, and coordination; by fair means and sometimes by foul means. …. Organizations include political bodies (firms, trade unions, family farms, cooperatives), social bodies (churches, clubs, athletic associations), and educational bodies (schools, universities, vocational training centres). They are groups of individuals bound by some common purpose to achieve objectives.²¹—Organizations are created with purposive intent…

Organizations may be formal or informal ones. A formal organization is, e.g., the New York Stock Exchange, an informal organization the international copper market. The same can be said of institutions: conventional marriage is a formal institution, friendship an informal. Correspondingly we find formal and informal constraints both in institutions and in organizations.

Custom, tradition, habit, usage, practice—these are all terms describing what North (1990, p. 36) calls “informal constraints” of social life. Schmoller (1900) uses the less technical language of his time. He speaks simply of “custom” (Sitte) and devotes some 35 densely printed pages of his Grundriss to the topic of Sitte: its nature, its relationship to law and morality, its relationship to economic life (1900, pp. 41–74). We will give only a few quotes from these pages to compare afterwards Schmoller’s position with that of North (1990), as a prominent exponent of modern institutional economics.

Schmoller (1900) writes, i.a.,:

Each custom gives a recurrent action a certain, ever-recognizable character. (p. 49).—The individual realization of custom is … difficult to explain; it is a complicated result of various strands of conceptions and causes. (p. 50)—Die Sitte is the fundamental external [äussere] order of life of human society, it relates to all external spheres of life, in particular also to economic life. (p.51)—The great questions of social and economic reform depend on the possibility and difficulty of restructuring customs.

After a remark on the “tenacity” [Zähigkeit] of customs Schmoller continues:

Those who wish to understand economic life without social custom,[…], will always easily err,…(p. 51).

North (1990, p. 36) writes:

In all societies from the most primitive to the most advanced, people impose constraints upon themselves to give a structure to their relations with others….Yet formal rules, …, make up a small…part of the sum of constraints that shape choices;… the governing structure is overwhelmingly defined by codes of conduct, norms of behaviour, and conventions. …what is most striking is the persistence of so many aspects of a society in spite of a total change in the rules.

North (1994, p. 10), speaking of the “second economic revolution” (the wedding of science and technology), stresses

that the tension arising between the new technology and organization are a fundamental dilemma [a problem first pointed out by Marx]—Uprooted are all the old informal constraints built around the family, personal relationships, and repetitive individual exchanges. (p. 9)

To show that was one of the main purposes of Schmoller’s (1879) study of the Strassburger Tucher- und Weberzunft that, according to his foreword, was

the first attempt to show the history of the German guilds regarding their various epochs and the concomitant psychological, legal, economic and technical causes, to understand these “from the inside” [von innen heraus],… [and thus to demonstrate] how large economic institutions …slowly develop through the centuries … (etc., see above quote from this book).

Where do informal constraints come from? Schmoller (1900, p. 61) answers:

Each generation rests on the intellectual—moral treasure [geistig-sittlichem Schatz] of its past. The transmission of this property, as the education of each young generation and its training in the customs and usages of society form an important function of its moral forces [sittlichen Kräfte]. Indeed, a national economy cannot be imagined without this process of education and training.²²

North (1990, p. 37), quoting Boyd and Richardson, answers the same question as follows:

[The informal constraints…] …come from socially transmitted information and are part of the heritage that we call culture…Culture can be defined as the “transmission from one generation to the next, via teaching and imitation, of knowledge, values, and other factors that influence behaviour.” (Boyd and Richardson 1985, p. 2).