Monday, December 5, 2011

Douglass North's Understanding Economic Change

I warned in the last post another serious book was coming up, and this is a major one. Douglass North is a Nobel-Prize-winning economist, or more specifically, an economic historian. I mentioned him before here. He thinks about the nature of economic change and the factors which make some societies more successful than others. 

He won the Nobel in 1993 for work done in 1982. But in 2005 he published a new book, Understanding the Process of Economic Change. I found it extremely valuable, partly because it organizes and reinforces some of the intuitions I have been gradually developing in this blog. It provides more of a conceptual vocabulary to discuss them. 

Here's the core of the book: You have to think about institutions and incentives.

The ideal economic model comprises a set of economic institutions that provide incentives for individuals and organizations to engage in productive activity. 

That would be tricky enough if society was static. But the nature of those institutions and incentives is always changing in response to growth in knowledge, changing beliefs  and other factors. 

So the success of an economy also depends on how well it adapts to those changes.

And some of these changes can be very broad-ranging. One of the most profound of all changes, he says  - which some societies have still not successfully managed - is when the physical environment is no longer the primary challenge for society. 

 The contrast between the institutions and beliefs geared to confronting the uncertainties of the physical environment and those constructed to confront the human environment is the key to understanding the process of change. 

So that is the outline. Let's look at it in more detail.


We develop economic and political institutions to try to reduce pervasive uncertainty.   

Standard economics has not properly come to grips with uncertainty, he says. 

Economists have themselves displayed a good deal of ambiguity on the subject, largely proceeding as though uncertainty was an unusual condition and therefore the usual condition, certainty, could warrant the elegant mathematical modeling that characterizes formal economics. But uncertainty is not an unusual condition; it has been the underlying condition responsible for the evolving structure of human organization thioughout history and pre-history. 

We simply do not live in a world which is constant and easily predictable, he says. It is a non-ergodic world. 

 An ergodic economy is one in which the fundamental underlying structure of the economy is constant and therefore timeless. But the world we live in is non-ergodic—a world of continuous novel change; and comprehending the world that is evolving entails new theory, or at least modification of that which we possess. In consequence, there is no implication that we “have it right” despite the awesome advances in science which have enormously reduced uncertainty about the physical environment. 

He notes that Paul Samuelson once said an assumption of an ergodic world was necessary for economics to be a science. Too bad for that hope.


People set up rules of the game to try to limit the uncertainty they face. Those rules of the game are institutions.

ALL ORGANIZED ACTIVITY by humans entails a structure to define the “way the game is played,” whether it is a sporting activity or the working of an economy. That structure is made up of institutions—formal rules, informal norms, and their enforcement characteristics.

Note those three components, which I think are very important. Where do the rules, informal norms, and for that matter the effectiveness of enforcement, come from? They are derived, he says, from the beliefs humans have. This not physics or mathematics, with unchanging natural laws. 

An institutional framework develops over time.

That institutional framework consists of the political structure that specifies the way we develop and aggregate political choices, the property rights structure that defines the formal economic incentives, and the social structure—norms and conventions—that defines the informal incentives in the economy. 

Zeroing on on the economic rules of the game:

 The formal economic rules are broadly speaking property rights defining ownership, use, rights to income, and alienability of resources and assets as expressed in laws and regulations. There is an immense literature on this subject; there is less on the way informal constraints influence economic performance. 

Institutions are not static, either. They are always changing, partly because the players change their behavior in response to incentives.

Institutions are the rules of the game, organizations are the players; it is the interaction between the two that shapes institutional change 

And here is one of the deepest themes - the more incentives provide for cooperation and productive activity, the better off a society will be. Altering our institutions, our rules of the game, is the main way people change their society.

How does this happen?

 Historically, institutional change has altered the pay-off to cooperative activity (the legal enforcement of contracts, for example), increased the incentive to invent and innovate (patent laws), altered the pay-off to investing in human capital (the development of institutions to integrate the distributed knowledge of complex economies), and lowered transaction costs in markets (the creation of a judicial system that lowers the costs of contract enforcement).

It is easier to change formal rules than informal norms and constraints, however.

History and Change

Institutional change is not easy.  You cannot simply write down an institutional framework on a sheet of paper and hope to enact it easily. Even if economic rules are ultimately a matter of belief and intentionality, they are still not easy to change.

Institutional change is typically incremental and is path dependent. It is incremental because large-scale change will create too many opponents among existing organizations that will be harmed and therefore oppose such change. Revolutionary change will only occur in the case of gridlock among competing organizations which thwarts the ability of organizations to capture gains from trade. 

The importance of informal norms about trust and cooperation means history profoundly matters. Culture matters. Economic change is path dependent. It depends on the existing institutional matrix, he says, as well as the kind of skills and knowledge people have already invested in.

Institutional constraints cumulate through time, and the culture of a society is the cumulative structure of rules and norms (and beliefs) that we inherit from the past that shape our present and influence our future. Institutions change, usually incrementally, as political and economic entrepreneurs perceive new opportunities or react to new threats affecting their well-being. Institutional change can result from change in the formal rules, the informal norms, or the enforcement of either of these. 

Adaptive Efficiency

So we are constrained by the past, by our existing institutions and skills and beliefs. But we must also constantly adapt to the future. So the other main  theme in the book is  the importance of adaptive efficiency. Our institutions and environment are always changing, and incentive systems must change too. 

 Adaptive efficiency—the kind of efficiency that has characterized the United States and western Europe—entails a set of institutions that readily adapt to the shocks, disturbances, and ubiquitous uncertainty that characterize every society over time. Conformity can be costly in a world of uncertainty. In the long run it produces stagnation and decay as humans confront ever new challenges in a non-ergodic world that requires innovative institutional creation because no one can know the right path to survival. Therefore, institutional diversity that allows for a range of choices is a superior survival trait, as Hayek has reminded us.

Indeed, one of the most important transitions in economic history required a fundamental change in belief and incentive systems. 

 Problems posed by the transition of a belief system from one constructed to deal with the physical environment to one constructed to confront the complex problems of the human environment are at the core of the problems of economic development. There is nothing automatic about such a transition being successful. 

This is particularly interesting to me, of course, because I think we are confronting another huge change in the underlying nature of our environment, one which needs significant adaptation in our institutions. 

The previous shift required a change from personal exchange to impersonal exchange, with less reliance on personal and family ties and more on a "formal structure of rules and enforcement mechanisms." Each structure, he says, fostered a set of beliefs, which in turn shaped politics, economics and society as a whole.  Such institutional changes are often difficult stumbling blocks.

 The shift from personal to impersonal exchange has produced just such a stumbling block both historically and in the contemporary world. Personal exchange relies on reciprocity, repeat dealings, and the kind of informal norms that tend to evolve from strong reciprocity relationships. Impersonal exchange requires the development of economic and political institutions that alter the pay-offs in exchange to reward cooperative behavior. 

How does on adapt to large-scale change? The important thing is to experiment and try alternatives, he says. 

 Adaptive efficiency entails an institutional structure that in the face of the ubiquitous uncertainties of a non-ergodic world will flexibly try various alternatives to deal with novel problems that continue to emerge over time. In turn this institutional structure entails a belief structure that will encourage and permit experimentation and equally will wipe out failures. The Soviet Union represented the very antithesis of such an approach. 

This helps explain the failure of the Soviet Union. it may have been statically efficient. But its centrally planned economy found it difficult to experiment and adapt. And that is the secret, he says, of US success.

 The best recipe for confronting such novel situations is the one that Hayek put forth many years ago and that has been the source of U.S. material success, which is the maintenance of institutions that permit trial and error experiments to occur. Such a structure entails not only a variety of institutions and organizations so that alternative policies can be tried but also effective means of eliminating unsuccessful solutions.

Competition helps spur organizations to adapt:

Competition forces organizations to continually invest in skills and knowledge to survive. The kinds of skills and knowledge individuals and their organizations acquire will shape evolving perceptions about opportunities and hence choices that will incrementally alter institutions. 

There is a clear link here to two books I talked about near the beginning of this blog,   Adapt: Why Success Always Starts with Failure by Tim Harford and Origin of Wealth by Eric Beinhocker. They both talk about the fact that the economy is an evolutionary system. You need a mechanism to generate diversity, as well as a selection mechanism. Together those can produce dazzling complexity and beauty over time. 


Politics and Transaction Costs

Much depends on how easy it is to make agreements, monitor adherence and enforce them. This is particularly important in politics. 

Transaction costs - the costs entailed in the measurement and enforcement of agreements, in this case - are a basic economic concept. They can often be very high in the political sphere, because, among other things, 

Imperfect models of the complex environment that the politician (and constituent) is attempting to order, institutional inability to get credible commitment between principal and agent (voter and legislator, legislator and policy implementer), the high cost of information, and the negligible payoff to the individual constituent of acquiring information all conspire to make political markets inherently imperfect.

The political sphere is naturally different to the economic sphere,

 Bargaining strength and the incidence of transaction costs are not the same in the polity as in the economy, otherwise it would not be worthwhile for groups to shift the issues to the political arena. Thus the selection process is one in which the high transaction cost items gravitate to the polity. Madison’s insightful views about the inherent nature of the political process as described in Federalist Paper no. 10—in effect he maintained that polities tend to be captured by special interests and used by them for their own advantage at the expense of the general public and that this was a universal dilemma of polities throughout history—are as pertinent today as they were two centuries ago. 

This means it is critical to have limits on political power.

Well-functioning markets require government, but not just any government will do. There must be institutions that limit the government from preying on the market. 

Order and Disorder

Change does not necessarily produce positive outcomes, however. It can produce much more uncertainty and disorder than before. People want to feel the basic rules are predictable.

Disorder increases uncertainty because rights and privileges of individuals and organizations are up for grabs, implying disruption of existing exchange relationships in both political and economic markets; and conformity disappears as a result of disintegration of norms and/ or change in enforcement. Disorder can result from changes which lead to a reduction of coercive enforcement of rules or from the weakening of norms of cooperation, which induces organizations to attempt radical changes in the rules of the game. One kind of change is an event that dislodges the old mechanisms that provided credible commitment in society without providing adequate substitutes.
This is a serious warning about how weakening old mechanisms can undermine a society. Radical changes in the rules of the game can be destabilizing, and so will therefore bring forward equally fervent opposition.

I think some radical evolution is necessary, simply because economic institutions have not kept up with the extraordinary changes in knowledge and productivity that we have experienced in recent decades. But this underlines how hard it can be to change without undermining the system as well.

 I'll talk more about knowledge and the limits of change in the next post.

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