Politics, the `real world' of administrative feasibility and complex social structures, pervasive bargaining led by interest groups - all these are supposedly ignored when economists propose `optimal' policies. But economists from Adam Smith onwards have seldom operated in an institutional void. We are only too conscious of the abstractions in our models and the constraints that make all economic policy into the `economics of the second best'.

Symbolizing this is the 1993 Nobel Prize in Economic Sciences, which honoured work on the economics of institutions and the institutional framework of economics. And that is the theme of this issue of European Economic Perspectives. The economics of subsidiarity deals with the allocation of economic decision-making rather than of resources themselves. Balancing market failure against government failure can give some guidance to the political decisions that must determine how much centralization there will be in European economic policies. One example is the regulation of mergers in Europe, where the Community has had to decide explicitly at what governmental levels mergers will be evaluated and what institutional structures will implement policy.

Deciding where to put the European Monetary Institute may in retrospect seem a minor issue in comparison with how this new institution will act out the roles written very broadly for it in the Maastricht script. Its choices as well as its independence and credibility could have considerable economic implications. At a national level, central bank independence does not offer a painless `institutional fix' for deep-seated inflationary pressures, but institutional changes judiciously adapted to national circumstances can significantly improve the framework for monetary policy.

Some of the research underlying these analyses of economic institutions is the `new political economy' to which several CEPR Research Fellows have made important contributions; but work on topics so diverse as public choice, `rent-seeking', spillovers and credibility is all directly relevant. Economic change can provide the impetus for institutional change, and new institutions can powerfully shape economic events. Economics can illuminate these relationships, even if politics will ultimately strike the balance between markets and institutions.

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