We have to add social capital to the free market equation

There is a real epidemic of morality in economics at the moment. It is not that members of the dismal profession have started behaving better - most, of course, are models of virtue to start with. Rather, it is that an increasing amount of interesting analysis has started to focus on the impact of values on economic outcomes.

This is the kind of thing that sounds pretty obvious to most non-economists - for example, it is pretty obvious that people with a stronger work ethic work harder. However, the modern discipline of economics has always shrunk from anything that involves making overt value judgments.

Even welfare economics - the sub-branch that looks specifically at the well-being of particular groups or individuals - restricts itself to saying that there is only an improvement in welfare if somebody is better off and nobody is worse off. No room here for judgments between competing interests, the fabric of real life.

This fear of making a judgment, of applying the labels "better" or "worse" is in retreat - and not a moment too soon, according to the many critics of the subject as it is practised in universities and official organisations. Even better, the muscular intellectual rigor of the discipline, its fondness for equations and evidence and formal proofs, means that this new thinking about values is incredibly fruitful. There is nothing wishy-washy about it.

At least three examples of the new value-ridden economics leap to mind. They crop up in writing about economic development, about national competitive advantage, and about unemployment. All introduce the idea that values, culture and history make a difference to hard economic outcomes, to the number of jobs and the level of prosperity.

The first piece of evidence is the World Bank's recent annual World Development Report, called this year, The State in a Changing World. The World Bank has long been criticised by non-governmental aid organisations for its ultra-orthodox free-market approach to the poor countries it lends to. It has made the adoption of Anglo-Saxon style capitalism, in theory at least, a condition of its loans - removing tariffs, deregulating prices, shrinking government spending and so on.

The bank has not abandoned free-market philosophy by any means, but the new report puts at centre stage questions about other dimensions of policy in poor countries. Is the government corrupt? Does the rule of law hold? How unequal is the society? Do girls have access to primary education? For the answers to these questions, on the face of it irrelevant to the macro-economic outcomes, make all the difference to whether or not aid policies work.

The report concludes that it is not necessary to have a minimalist state, as ultra-free market thinkers would conclude, but an effective state. Politics, history, institutions and laws will determine how well the economy works, and there is no one-size-fits-all development strategy.

A second example of value-laden economics was provided in a presentation at a conference in London by Professor John Kay, head of Oxford University's new management school. An expert on competitive advantage, he argued that there is a role for the Government in boosting British business. This role is nothing so crude as trying to pick winners, 1960s style.

Rather, it is shaping the general cultural and legal framework in which all companies operate to ensure that business can take best advantage of the things the nation excels at. What governments do is shape the nation's history, and history plays a crucial role in determining competitive advantage. It is just like the old joke about asking for directions to Oswaldtwistle (in my part of the world): "Ee, I can tell you 'ow to get there, but not from 'ere."

My third illustration is recent research about unemployment and job creation. A report published this week by the Council of Churches, Unemployment and the Future of Work, not surprisingly takes a strong moral stance on the need to create jobs offering decent pay and conditions for all who want them. It attacks the prevalence of poverty and growth of inequality.

Interestingly, much of its detailed analysis bears a strong resemblance to the conclusions of the latest annual Employment Outlook from the Organisation for Economic Co-operation and Development. Another bastion of conventional economic analysis, its report this year focuses on earnings inequality and low pay.

The focus is the result of the reluctance of some high-unemployment member countries, notably France, to adopt its job-creation prescriptions.

The OECD sticks by these - broadly, the kind of deregulation that Conservative governments introduced in the UK. However, it accepts that inequality and social exclusion extract a price in terms of economic growth. They reduce the economy's productive potential. "Many workers are trapped in a cycle of low pay and no pay, with potential negative consequences for poverty and their productive capacity, as well as that of the economy as a whole," the report says. It stresses the role education and training play in reducing social and economic exclusion, and it recommends further research on policies to combat low pay and inequality.

You could describe this as an admission that the New Labour approach is a necessary successor to the Tory approach to jobs policies.

A unifying theme in all three areas is the importance of social capital to the economy. The phrase comes from sociology, but appeals to economists because it fits in with the way the profession thinks about economic growth.

The importance of physical capital, the history of investment in machinery, equipment and buildings, has always been recognised as having a central role in growth. For the past quarter century or so, economists' recognition of the importance of human capital has strengthened. This refers to the skills, attributes and educational attainments of the workers using the physical capital. It highlights the importance of investment in education and training.

Social capital encompasses an even broader concept of investment - history per se. It covers the detail of the society in which markets are embedded, its culture, regulations, informal understandings and so on. It is a concept which, rightly, injects history and politics into the heart of the study of economics. Which is, after all, how it started out, as the study of political economy in 18th century Scotland.