Joseph Schumpeter Lecture Ideology

I develop a model of ideologies as collectively sustained (yet individually rational) distortions in beliefs concerning the proper scope of governments versus markets. In processing and interpreting signals of the efficacy of public and market provision of education, health insurance, pensions, etc., individuals optimally trade off the value of remaining hopeful about their future prospects (or their children’s) versus the costs of misinformed decisions. Because these future outcomes also depend on whether other citizens respond to unpleasant facts with realism or denial, endogenous social cognitions emerge. Thus, an equilibrium in which people acknowledge the limitations of interventionism coexists with one in which they remain obstinately blind to them, embracing a statist ideology and voting for an excessively large government. Conversely, an equilibrium associated with appropriate public responses to market failures coexists with one dominated by a laissez-faire ideology and blind faith in the invisible hand. With public-sector capital, this interplay of beliefs and institutions leads to history-dependent dynamics. The model also explains why societies find it desirable to set up constitutional protections for dissenting views, even when ex-post everyone would prefer to ignore unwelcome news. (JEL: H11, D72, D83, P16, Z1) Social scientists have incorporated the costliness of information in their models, but have not come to grips with the subjective mental constructs by which individuals process information and arrive at conclusions that shape their choices. . . . The subjective mental constructs of the participants will evolve an ideology that not only rationalizes the society’s structure but accounts for its poor performance. As a result, the economy will evolve policies that reinforce the existing incentives and organizations. —Douglass North (1990). Institutions, Institutional Change and Economic Performance Acknowledgments: The 2007 Joseph Schumpeter lecture was given at the 22nd Annual Congress of the European Economic Association in Budapest, August 2007. I am particularly grateful to Jean Tirole, as the paper builds on much of our earlier collaborative work. I am also grateful for helpful comments from Daron Acemoglu, Rafael Di Tella, Xavier Gabaix, Mohammad Yildiz, JeanCharles Rochet, TomRomer, Karl Schlag, and GlenWeyl. Rainer Schwabe provided superb research assistance. Support from the Canadian Institute for Advanced Research is gratefully acknowledged. E-mail addresses: [email protected] Journal of the European Economic Association April-May 2008 6(2–3):321–352 © 2008 by the European Economic Association 322 Journal of the European Economic Association