Steven Medema's history of the idea of self-interest in economics, The Hesitant Hand, starts with the Ancient Greeks and works through to public choice theory and the Coase theorem. So it's not unambitious to start with. It also captured my attention more than I had expected because it's actually about much more than how economics has used the assumption of self-interest. Rather, the theme is the centuries-long debate about how best to govern society, and the extent to which the market does a better job than any other means of organization.

For Plato and Aristotle, and all the way through the Scholastics, good government was that which comported best with the dictates of natural law. Self-interest was to be restrained by rulers – hence, for example, usury prohibitions. Self-interest was sinful. It wasn't really until Adam Smith that the operation of self-interest in the economy was seen to have any positive effects for social welfare – as Medema puts it: “Smith was arguing…that the individual pursuit of self interest serves the best interests of society as a whole, that self-interest and the social interest are partners rather than enemies.” Smith set the scene therefore for the evergreen debate about the extent to which the government can and should intervene in the operation of self-interest through market transactions.

Medema traces this debate through Mill, Marshall, Sidgwick, Pigou and on through the Italian public finance tradition and Wicksell. He depicts a pendulum swing in the centre of gravity in welfare economics, from laissez faire to government regulation and intervention and back again. But he also notes that the views of the principals in this debate have tended to be exaggerated. Those economists painted as the most laissez faire – including Smith – always insisted that the state has an important role in economic life. He quotes Pigou as saying the role of the state is to shape institutions within which markets and self-interest will consequently operate in the general interest. Medema writes:

“Acceptance of this basic idea about the relationship between government and the economy changes the entire character of one's thinking about market and state. 'The real question,' said Pigou, 'is not whether the state should act or not, but in what principles, in what degree and over what departments of economic life its action should be carried on.'” (p65)

However, Pigou's pragmatism has been overlooked, and he is seen instead as the founder of welfare analysis based on interventions in markets by a benevolent dictator, a dispassionate and objective government, to correct market failures. This approach dominated economics for decades, and indeed is still influential.

Yet the other great moment of innovation in this area of economic thought was the appreciation that just as markets could either be perfect or imperfect, so could governments – up until Coase and the public choice theorists, economics assumed that market failures could be corrected by (perfect) government action. As we'd do well to appreciate fully now that markets are in the doghouse, intellectually, due to the financial crisis, government failure is not a minor problem. Coase's challenge to the previously dominant notion that social welfare can be improved if the government steps in to correct an externality – say a tax on pollution – was to note that while pollution imposes harm on others, so does imposing a tax. It raises manufacturers' costs. So the proper debate is one about the distribution of harms and benefits. And of course he went on to show that – absent transactions costs – the allocation of resources will not change but parties with competing rights will negotiate the distribution of income. Coase of course also recognised the importance and prevalence of transactions costs, which went on to form the basis of institutional economics. But he was scathing about what he referred to as the 'blackboard economics' of prescribing a government intervention to transform a market outcome into an idealized 'optimum'. (p120)

Doubts about the efficacy of government intervention were voiced fully by the public choice school, while Coase laid the foundations for the joint discipline of economics and law. As it challenges the objectivity and efficacy of government, public choice theory is often seen as innately right-wing. This is a cop-out – anyone in favour of state intervention has a stronger duty to understand the difficulties of process, of getting good policies implemented in specific circumstances, in ways which take account of legitimate competing interests and are seen to be fair.

But whatever one's political views, it has to be granted that both have contributed to a much richer understanding of the processes of economic policy. You only need to watch what's happening in the climate change debate, from email-gate to Copenhagen, to see the influence of the many personal motivations driving public policy.

I wouldn't describe this as an easy read – it is after all a scholarly book on an aspect of the history of economic thought. But I liked it for illuminating the inanity of thinking in terms of market versus state. The challenge of governing in the public interest is, sadly, more difficult than that.