The Competitiveness of Nations
in a Global Knowledge-Based Economy
June 2002
Douglass C. North
Institutions
The Journal of Economic
Perspectives
Volume 5, Issue
1
Winter, 1991,
97-112.
Index
Institutions to Capture the Gains from
Trade
When Institutions Do Not Evolve
Institutional Evolution in Early Modern
Contrasting Stories of Stability and
Change
Institutions are the humanly devised constraints that
structure political, economic and social interaction. They consist of both informal constraints
(sanctions, taboos, customs, traditions, and codes of conduct), and formal rules
(constitutions, laws, property rights). Throughout history, institutions have
been devised by human beings to create order and reduce uncertainty in exchange.
Together with the standard
constraints of economics they define the choice set and therefore determine
transaction and production costs and hence the profitability and feasibility of
engaging in economic activity. They
evolve incrementally, connecting the past with the present and the future;
history in consequence is largely a story of institutional evolution in which
the historical performance of economies can only be understood as a part of a
sequential story. Institutions
provide the incentive structure of an economy; as that structure evolves, it
shapes the direction of economic change towards growth, stagnation, or decline.
In this essay I intend to elaborate
on the role of institutions in the performance of economies and illustrate my
analysis from economic history.
What makes it necessary to constrain human interaction
with institutions? The issue can be
most succinctly summarized in a game theoretic context. Wealth-maximizing individuals will
usually find it worthwhile to cooperate with other players when the play is
repeated, when they possess complete information about the other player’s past
performance, and when there are small numbers of players. But turn the game upside down. Cooperation is difficult to sustain when
the game is not repeated (or there is an endgame), when information on the other
players is lacking, and when there are large numbers of
players.
Douglass C. North is Lace Professor of Law and Liberty
and Director of the Center in Political Economy, Washington University, St.
Louis, Missouri.
97
These polar extremes reflect contrasting economic
settings in real life. There are
many examples of simple exchange institutions that permit low cost transacting
under the former conditions. But
institutions that permit low cost transacting and producing in a world of
specialization and division of labor require solving the problems of human
cooperation under the latter conditions.
It takes resources to define and enforce exchange
agreements. Even if everyone had
the same objective function (like maximizing the firm’s profits), transacting
would take substantial resources; but in the context of individual
wealth-maximizing behavior and asymmetric information about the valuable
attributes of what is being exchanged (or the performance of agents),
transaction costs are a critical determinant of economic performance. Institutions and the effectiveness of
enforcement (together with the technology employed) determine the cost of
transacting. Effective institutions
raise the benefits of cooperative solutions or the costs of defection, to use
game theoretic terms. In
transaction cost terms, institutions reduce transaction and production costs per
exchange so that the potential gains from trade are realizeable. Both political and economic institutions
are essential parts of an effective institutional matrix.
The major focus of the literature on institutions and
transaction costs has been on institutions as efficient solutions to problems of
organization in a competitive framework (Williamson, 1975; 1985). Thus market exchange, franchising, or
vertical integration are conceived in this literature as efficient solutions to
the complex problems confronting entrepreneurs under various competitive
conditions. Valuable as this work
has been, such an approach assumes away the central concern of this essay: to
explain the varied performance of economies both over time and in the current
world.
How does an economy achieve the efficient, competitive
markets assumed in the foregoing approach? The formal economic constraints or
property rights are specified and enforced by political institutions, and the
literature simply takes those as a given. But economic history is overwhelmingly a
story of economies that failed to produce a set of economic rules of the game
(with enforcement) that induce sustained economic growth. The central issue of economic history and
of economic development is to account for the evolution of political and
economic institutions that create an economic environment that induces
increasing productivity.
Institutions to Capture the Gains from
Trade
Many readers will be at least somewhat familiar with the
idea of economic history over time as a series of staged stories. The earliest economies are thought of as
local exchange within a village (or even within a simple hunting and gathering
society). Gradually, trade expands
beyond the village: first to the region, perhaps as a bazaar-like economy; then
to longer distances, through particular caravan or shipping routes; and
eventually to much of the world. At
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each stage, the economy involves increasing
specialization and division of labor and continuously more productive
technology. This story of gradual
evolution from local autarky to specialization and division of labor was derived
from the German historical school. However, there is no implication in this
paper that the real historical evolution of economies necessarily paralleled the
sequence of stages of exchange described here. 1
I begin with local exchange within the village or even
the simple exchange of hunting and gathering societies (in which women gathered
and men hunted). Specialization in
this world is rudimentary and self-sufficiency characterizes most individual
households. Small-scale village
trade exists within a “dense” social network of informal constraints that
facilitates local exchange, and the costs of transacting in this context are
low. (Although the basic societal
costs of tribal and village organization may be high, they will not be reflected
in additional costs in the process of transacting.) People have an intimate understanding of
each other, and the threat of violence is a continuous force for preserving
order because of its implications for other members of society.
2
As trade expands beyond a single village, however, the
possibilities for conflict over the exchange grow. The size of the market grows and
transaction costs increase sharply because the dense social network is replaced;
hence, more resources must be devoted to measurement and enforcement. In the absence of a state that enforced
contracts, religious precepts usually imposed standards of conduct on the
players. Needless to say, their
effectiveness in lowering the costs of transacting varied widely, depending on
the degree to which these precepts were held to be
binding.
The development of long-distance trade, perhaps through
caravans or lengthy ship voyages, requires a sharp break in the characteristics
of an economic structure. It
entails substantial specialization in exchange by individuals whose livelihood
is confined to trading and the development of trading centers, which may be
temporary gathering places (as were the early fairs in
The growth of long distance trade poses two distinct
transaction cost problems. One is a
classical problem of agency, which historically was met by
1. In an article written many years ago (North, 1955), I
pointed out that many regional economies evolved from the very beginning as
export economies and built their development around the export sector. This is in comparison and in contrast to
the old stage theory of history derived from the German historical school, in
which the evolution was always from local autarky to gradual evolution of
specialization arid division of labor. It is this last pattern that is described
here, even though it may not characterize the particular evolution that
in fact has occurred.
2. For an excellent summary of the anthropological
literature dealing with trade in tribal societies, see Elizabeth Colson
(1974).
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use of kin in long-distance trade. That is, a sedentary merchant would send
a relative with the cargo to negotiate sale and to obtain a return cargo. The costliness of measuring performance,
the strength of kinship ties, and the price of “defection” all determined the
outcome of such agreements. As the
size and volume of trade grew, agency problems became an increasingly major
dilemma. 3 A second
problem consisted of contract negotiation and enforcement in alien parts of the
world, where there is no easily available way to achieve agreement and enforce
contracts. Enforcement means not
only such enforcement of agreements but also protection of the goods and
services en route from pirates, brigands, and so on.
The problems of enforcement en route were met by armed
forces protecting the ship or caravan or by the payment of tolls or protection
money to local coercive groups. Negotiation and enforcement in alien
parts of the world entailed typically the development of standardized weights
and measures, units of account, a medium of exchange, notaries, consuls,
merchant law courts, and enclaves of foreign merchants protected by foreign
princes in return for revenue. By
lowering information costs and providing incentives for contract fulfillment
this complex of institutions, organizations, and instruments made possible
transacting and engaging in long-distance trade. A mixture of voluntary and semi-coercive
bodies, or at least bodies that effectively could cause ostracism of merchants
that didn’t live up to agreements, enabled long-distance trade to occur.
4
This expansion of the market entails more specialized
producers. Economies of scale
result in the beginnings of hierarchical producing organizations, with full-time
workers working either in a central place or in a sequential production process.
Towns and some central cities are
emerging, and occupational distribution of the population now shows, in
addition, a substantial increase in the proportion of the labor force engaged in
manufacturing and in services, although the traditional preponderance in
agriculture continues. These
evolving stages also reflect a significant shift towards urbanization of the
society.
Such societies need effective, impersonal contract
enforcement, because personal ties, voluntaristic constraints, and ostracism are
no longer effective as more complex and impersonal forms of exchange emerge.
It is not that these personal and
social alternatives are unimportant; they are still significant even in today’s
interdependent world. But in the
absence of effective impersonal contracting, the gains from “defection” are
great enough to forestall the development of complex exchange. Two illustrations deal with the creation
of a
1. Jewish traders in the Mediterranean in the 11th
century “solved” the agency problem as a result of close community relationships
amongst themselves that lowered information costs and enabled them to act as a
group to ostracize arid retaliate against agents who violated their commercial
code. See Avner Gieif
(1989).
2. Philip Curtin’s Cross Cultural Trade in World
History (1984) summarizes a good deal of the literature, but is short on
analysis and examination of the mechanisms essential to the structure of such
trade. The Cambridge Economic
History, Volume III (1966), has more useful details on the organization of such
trade.
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capital market and with the interplay between
institutions and the technology employed.
A capital market entails security of property rights
over time and will simply not evolve where political rulers can arbitrarily
seize assets or radically alter their value. Establishing a credible commitment to
secure property rights over time requires either a ruler who exercises
forebearance and restraint in using coercive force, or the shackling of the
ruler’s power to prevent arbitrary seizure of assets. The first alternative was seldom
successful for very long in the face of the ubiquitous fiscal crises of rulers
(largely as a consequence of repeated warfare). The latter entailed a fundamental
restructuring of the polity such as occurred in England as a result of the
Glorious Revolution of 1688, which resulted in parliamentary supremacy over the
crown. 5
The technology associated with the growth of
manufacturing entailed increased fixed capital in plant and equipment,
uninterrupted production, a disciplined labor force, and a developed transport
network; in short, it required effective factor and product markets. Undergirding such markets are secure
property rights, which entail a polity and judicial system to permit low costs
contracting, flexible laws permitting a wide latitude of organizational
structures, and the creation of complex governance structures to limit the
problems of agency in hierarchical organizations. 6
In the last stage, the one we observe in modern western
societies, specialization has increased, agriculture requires a small percentage
of the labor force, and markets have become nationwide and worldwide. Economies of scale imply large-scale
organization, not only in manufacturing but also in agriculture. Everyone lives by undertaking a
specialized function and relying on the vast network of interconnected parts to
provide the multitude of goods and services necessary to them. The occupational distribution of the
labor force shifts gradually from dominance by manufacturing to dominance,
eventually, by what are characterized as services. Society is overwhelmingly
urban.
In this final stage, specialization requires increasing
percentages of the resources of the society to be engaged in transacting, so
that the transaction sector rises to be a large percentage of gross national
product. This is so because
specialization in trade, finance, banking, insurance, as well as the simple
coordination of economic activity, involves an increasing proportion of the
labor force. 7 Of necessity, therefore, highly specialized forms of
transaction organizations emerge. International specialization and division
of labor requires institutions and organizations to safeguard property rights
across inter-
5. North and Weingasm (1989) provide a history and
analysis of the political institutions of 17th century England leading up to the
Revolution of 1688 and of the consequences for the development of the English
capital market.
6. See North (1981), particularly chapter 13, and
Chandler (1977). Joseph Stiglitz’s
(1989) essay, “Markets, Market Failures, and Development,” details some of the
theoretical issues.
7. The transaction sector (that proportion of transaction
costs going through the market and therefore measureable) of the U.S.
economy was 25 percent of GNP in 1870 and 45 percent of GNP in 1970
(Wallis and North, 1986).
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national boundaries so that capital markets (as well as
other kinds of exchange) can take place with credible commitment on the part of
the players.
These very schematic stages appear to merge one into
another in a smooth story of evolving cooperation. But do they? Does any necessary connection move the
players from less complicated to more complicated forms of exchange? At stake in this evolution is not only
whether information costs and economies of scale together with the development
of improved enforcement of contracts will permit and indeed encourage more
complicated forms of exchange, but also whether organizations have the incentive
to acquire knowledge and information that will induce them to evolve in more
socially productive directions.
In fact, throughout history, there is no necessary
reason for this development to occur. Indeed, most of the early forms of
organization that I have mentioned in these sections still exist today in parts
of the world. There still exist
primitive tribal societies; the Suq (bazaar economies engaged in regional trade)
still flourishes in many parts of the world; and while the caravan trade has
disappeared, its demise (as well as the gradual undermining of the other two
forms of “primitive” exchange) has reflected external forces rather than
internal evolution. In contrast,
the development of European long-distance trade initiated a sequential
development of more complex forms of organization.
The remainder of this paper will examine first some
seemingly primitive forms of exchange that failed to evolve and then the
institutional evolution that occurred in early modern Europe. The concluding section of the paper will
attempt to enunciate why some societies and exchange institutions evolve and
others do not, and to apply that framework in the context of economic
development in the western hemisphere during the 18th and 19th
centuries.
When Institutions Do Not
Evolve
In every system of exchange, economic actors have an
incentive to invest their time, resources, and energy in knowledge and skills
that will improve their material status. But in some primitive institutional
settings, the kind of knowledge and skills that will pay off will not result in
institutional evolution towards more productive economies. To illustrate this argument, I consider
three primitive types of exchange - tribal society, a regional economy with
bazaar trading, and the long-distance caravan trade - that are unlikely to
evolve from within.
As noted earlier, exchange in a tribal society relies on
a dense social network. Elizabeth
Colson (1974, p. 59) describes the network this way:
The communities in which all these people live were
governed by a delicate balance of power, always endangered and never to be taken
for
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granted: each person was constantly involved in securing
his own position in situations where he had to show his good intentions. Usages and customs appear to be flexible
and fluid given that judgement on whether or not someone has done rightly varies
from case to case... But this is because it is the individual who is being
judged and not the crime. Under
these conditions, a flouting of generally accepted standards is tantamount to a
claim to illegitimate power and becomes part of the evidence against
one.
The implication of Colson’s analysis as well as that of
Richard Posner in his account of primitive institutions (1980) is that deviance
and innovation are viewed as threats to group survival.
A second form of exchange that has existed for thousands
of years, and still exists today in North Africa and the Middle East is that of
the Suq, where widespread and relatively impersonal exchange and relatively high
costs of transacting exist. 5 The basic characteristics are a multiplicity of
small-scale enterprises with as much as 40 to 50 percent of the town’s labor
force engaged in this exchange process; low fixed costs in terms of rent and
machinery; a very finely drawn division of labor; an enormous number of small
transactions, each more or less independent of the next; face to face contacts;
and goods and services that are not homogeneous.
There are no institutions devoted to assembling and
distributing market information; that is, no price quotations, production
reports, employment agencies, consumer guides, and so on. Systems of weights and measures are
intricate and incompletely standardized. Exchange skills are very elaborately
developed, and are the primary determinant of who prospers in the bazaar and who
does not. Haggling over terms with
respect to any aspect or condition of exchange is pervasive, strenuous, and
unremitting. Buying and selling are
virtually undifferentiated, essentially a single activity; trading involves a
continual search for specific partners, not the mere offers of goods to the
general public. Regulation of
disputes involves testimony by reliable witnesses to factual matters, not the
weighting of competing, juridical principles. Governmental controls over marketplace
activity are marginal, decentralized, and mostly
rhetorical.
To summarize, the central features of the Suq are (1)
high measurement costs; (2) continuous effort at clientization (the development
of repeat-exchange relationships with other partners, however imperfect); and
(3) intensive bargaining at every margin. In essence, the name of the game is to
raise the costs of transacting to the other party to exchange. One makes money by having better
information than one’s adversary.
5. There is an extensive literature on the Suq. A sophisticated analysis (on which I have
relied) focused on the Suq in Sefrou, Morocco is contained in (Geertz, Geertz,
and Rosen (1979).
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It is easy to understand why innovation would be seen to
threaten survival in a tribal society but harder to understand why these
“inefficient” forms of bargaining would continue in the Suq. One would anticipate, in the societies
with which we are familiar, that voluntary organizations would evolve to insure
against the hazards and uncertainties of such information asymmetries. But that is precisely the issue. What is missing in the Suq are the
fundamental underpinnings of institutions that would make such voluntary
organizations viable and profitable. These include an effective legal
structure and court system to enforce contracts which in turn depend on the
development of political institutions that will create such a framework. In their absence there is no incentive to
alter the system.
The third form of exchange, caravan trade, illustrates
the informal constraints that made trade possible in a world where protection
was essential and no organized state existed. Clifford Geertz (1979, p. 137) provides
a description of the caravan trades in Morocco at the turn of the
century:
In the narrow sense, a zettata (from the Berber
TAZETTAT, ‘a small piece of cloth’) is a passage toll, a sum paid to a local
power… for protection when crossing localities where he is such a power. But in fact it is, or more properly was,
rather more than a mere payment. It
was part of a whole complex of moral rituals, customs with the force of law and
the weight of sanctity - centering around the guest-host, client-patron,
petitioner-petitioned, exile-protector, suppliant-divinity relations - all of
which are somehow of a package in rural Morocco. Entering the tribal world physically, the
outreaching trader (or at least his agents) had also to enter it
culturally.
Despite the vast variety of particular forms through
which they manifest themselves, the characteristics of protection in the Berber
societies of the High and Middle Atlas are clear and constant. Protection is personal, unqualified,
explicit, and conceived of as the dressing of one man in the reputation of
another. The reputation may be
political, moral, spiritual, or even idiosyncratic, or, often enough, all four
at once. But the essential
transaction is that a man who counts ‘stands up and says’ (quam wa qal,
as the classical tag has it) to those to whom he counts: ‘this man is
mine; harm him and you insult me; insult me and you will answer for it.’ Benediction (the famous baraka),
hospitality, sanctuary, and safe passage are alike in this: they rest on the
perhaps somewhat paradoxical notion that though personal identity is radically
individual in both its roots and its expressions, it is not incapable of being
stamped onto the self of someone else.
While tribal chieftains found it profitable to protect
merchant caravans they had neither the military muscle nor the political
structure to extend, develop, and enforce more permanent property
rights.
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Institutional Evolution in Early Modern
Europe
In contrast to many primitive systems of exchange, long
distance trade in early modern Europe from the 11th to the 16th centuries was a
story of sequentially more complex organization that eventually led to the rise
of the western world. Let me first
briefly describe the innovations and then explore some of their underlying
sources. 9
Innovations that lowered transaction costs consisted of
organizational changes, instruments, and specific techniques and enforcement
characteristics that lowered the costs of engaging in exchange over long
distances. These innovations
occurred at three cost margins: (1) those that increased the mobility of
capital, (2) those that lowered information costs, and (3) those that spread
risk. Obviously, the categories are
overlapping, but they provide a useful way to distinguish cost-reducing features
of transacting. All of these
innovations had their origins in earlier times; most of them were borrowed from
medieval Italian city states or Islam or Byzantium and then elaborated
upon.
Among the innovations that enhanced the mobility of
capital were the techniques and methods evolved to evade usury laws. The variety of ingenious ways by which
interest was disguised in loan contracts ranged from “penalties for late
payment,” to exchange rate manipulation (Lopez and Raymond, 1955, p.163), to the
early form of the mortgage; but all increased the costs of contracting. The costliness of usury laws was not only
that they made the writing of contracts to disguise interests complex and
cumbersome, but also that enforceability of such contracts became more
problematic. As the demand for
capital increased and evasion became more general, usury laws gradually broke
down and rates of interest were permitted. In consequence, the costs of writing
contracts and the costs of enforcing them declined.
A second innovation that improved the mobility of
capital, and the one that has received the most attention, was the evolution of
the bill of exchange (a dated order to pay, say 120 days after issuance,
conventionally drawn by a seller against a purchaser of goods delivered) and
particularly the development of techniques and instruments that allowed for its
negotiability as well as for the development of discounting methods. Negotiability and discounting in turn
depended on the creation of institutions that would permit their use and the
development of centers where such events could occur: first in fairs, such as
the Champagne fairs that played such a prominent part in economic exchange in
12th and 13th century Europe; then through banks; and finally through financial
houses that could specialize in discounting. These developments were a function not
only of specific institutions but also of the scale of economic activity. Increasing volume obviously made such
institutional developments
9. For a much more detailed description and analysis of
the evolution of European trade see Tracy (forthcoming), particularly Volume II.
For a game theoretic analysis of
one aspect of this trade revival see Milgrom, North and Weingast
(1990).
105
possible. In addition to the economies of scale
necessary for the development of the bills of exchange, improved enforceability
of contracts was critical, and the interrelationship between the development of
accounting and auditing methods and their use as evidence in the collection of
debts and in the enforcement of contracts was an important part of this process
(Yamey, 1949; Watts and Zimmerman, 1983).
Still a third innovation affecting the mobility of
capital arose from the problems associated with maintaining control of agents
involved in long distance trade. The traditional resolution of this
problem in medieval and early modern times was the use of kinship and family
ties to bind agents to principals. However, as the size and scope of
merchant trading empires grew, the extension of discretionary behavior to others
than kin of the principal required the development of more elaborate accounting
procedures for monitoring the behavior of agents.
The major developments in the area of information costs
were the printing of prices of various commodities, as well as the printing of
manuals that provided information on weights, measures, customs, brokerage fees,
postal systems, and, particularly, the complex exchange rates between monies in
Europe and the trading world. Obviously these developments were
primarily a function of the volume of international trade and therefore a
consequence of economies of scale.
The final innovation was the transformation of
uncertainty into risk. By
uncertainty, I mean here a condition wherein one cannot ascertain the
probability of an event and therefore cannot arrive at a way of insuring against
such an occurrence. Risk, on the
other hand, implies the ability to make an actuarial determination of the
likelihood of an event and hence insure against such an outcome. In the modern world, insurance and
portfolio diversification are methods for converting uncertainty into risks and
thereby reducing, through the provision of a hedge against variability, the
costs of transacting. In the
medieval and early modern world, precisely the same conversion occurred. For example, marine insurance evolved
from sporadic individual contracts covering partial payments for losses to
contracts issued by specialized firms. As De Roover (1945, p. 198)
described:
By the fifteenth century marine insurance was
established on a secure basis. The
wording of the policies had already become stereotyped and changed very little
during the next three or four hundred years... In the sixteenth century it was
already current practice to use printed forms provided with a few blank spaces
for the name of the ship, the name of the master, the amount of the insurance,
the premium, and a few other items that were apt to change from one contract to
another.
Another example of the development of actuarial,
ascertainable risk was the business organization that spread risk through either
portfolio diversifica-
106
tion or institutions that permitted a large number of
investors to engage in risky activities. For example, the commenda was a contract
employed in long distance trade between a sedentary partner and an active
partner who accompanied the goods. It evolved from its Jewish, Byzantine,
and Muslim origins (Udovitch, 1962) through its use at the hands of Italians to
the English Regulated Company and finally the Joint Stock Company, thus
providing an evolutionary story of the institutionalization of
risk.
These specific innovations and particular institutional
instruments evolved from interplay between two fundamental economic forces: the
economies of scale associated with a growing volume of trade, and the
development of improved mechanisms to enforce contracts at lower costs. The causation ran both ways. That is, the increasing volume of long
distance trade raised the rate of return to merchants of devising effective
mechanisms for enforcing contracts. In turn, the development of such
mechanisms lowered the costs of contracting and made trade more profitable,
thereby increasing its volume.
The process of developing new enforcement mechanisms was
a long one. While a variety of
courts handled commercial disputes, it is the development of enforcement
mechanisms by merchants themselves that is significant. Enforceability appears to have had its
beginnings in the development of internal codes of conduct in fraternal orders
of guild merchants; those who did not live up to them were threatened with
ostracism. A further step was the
evolution of mercantile law. Merchants carried with them in long
distance trade mercantile codes of conduct, so that Pisan laws passed into the
sea codes of Marseilles; Oleron and Lubeck gave laws to the north of Europe,
Barcelona to the south of Europe; and from Italy came the legal principle of
insurance and bills of exchange (Mitchell, 1969, p. 156).
The development of more sophisticated accounting methods
and of notarial records provided evidence for ascertaining facts in disputes.
The gradual blending of the
voluntaristic structure of enforcement of contracts via internal merchant
organizations with enforcement by the state is an important part of the story of
increasing the enforceability of contracts. The long evolution of merchant law from
its voluntary beginnings and the differences in resolutions that it had with
both the common and Roman law are a part of the story.
The state was a major player in this whole process, and
there was continuous interplay between the state’s fiscal needs and its
credibility in its relationships with merchants and the citizenry in general.
In particular, the evolution of
capital markets was critically influenced by the policies of the state, since to
the extent the state was bound by commitments that it would not confiscate
assets or use its coercive power to increase uncertainty in exchange, it made
possible the evolution of financial institutions and the creation of more
efficient capital markets. The
shackling of arbitrary behavior of rulers and the development of impersonal
rules that successfully bound both the state and voluntary organizations were a
key part of this whole process. The
development of an institutional process by which government debt could be
circulated, become a
107
part of a regular capital market, and be funded by
regular sources of taxation was also a key part (Tracy, 1985; North and
Weingast, 1989).
It was in the Netherlands, Amsterdam specifically, that
these diverse innovations and institutions were combined to create the
predecessor of the efficient modern set of markets that make possible the growth
of exchange and commerce. An open
immigration policy attracted businessmen. Efficient methods of financing long
distance trade were developed, as were capital markets and discounting methods
in financial houses that lowered the costs of underwriting this trade. The development of techniques for
spreading risk and transforming uncertainty into actuarial, ascertainable risks
as well as the creation of large scale markets that allowed for lowering the
costs of information, and the development of negotiable government indebtedness
all were a part of this story (Barbour, 1949).
Contrasting Stories of Stability and
Change
These contrasting stories of stability and change go to
the heart of the puzzle of accounting for changes in the human economic
condition. In the former cases,
maximizing activity by the actors will not induce increments to knowledge and
skills which will modify the institutional framework to induce greater
productivity; in the latter case, evolution is a consistent story of incremental
change induced by the private gains to be realized by productivity-raising
organizational and institutional changes.
What distinguished the institutional context of western
Europe from the other illustrations? The traditional answer of economic
historians has been competition among the fragmented European political units
accentuated by changing military technology which forced rulers to seek more
revenue (by making bargains with constituents) in order to survive (North and
Thomas, 1973; Jones, 1981; Rosenberg and Birdzell, 1986). That is surely part of the answer;
political competition for survival in early modern Europe was certainly more
acute than in other parts of the world. But it is only a partial answer. Why the contrasting results within
western Europe? Why did Spain, the
great power of 16th century Europe, decline while the Netherlands and England
developed?
To begin to get an answer (and it is only a beginning),
we need to dig deeper into two key (and related) parts of the puzzle: the
relationship between the basic institutional framework, the consequent
organizational structure, and institutional change; and the path dependent
nature of economic change that is a consequence of the increasing returns
characteristic of an institutional framework.
In the institutional accounts given earlier, the
direction and form of economic activity by individuals and organizations
reflected the opportunities thrown up by the basic institutional framework of
customs, religious precepts,
108
and formal rules (and the effectiveness of enforcement).
Whether we examine the organization
of trade in the Suq or that in the Champagne Fairs, in each case the trader was
constrained by the institutional framework, as well as the traditional
constraints common to economic theory.
In each case the trader would invest in acquiring
knowledge and skills to increase his wealth. But in the former case, improved
knowledge and skills meant getting better information on opportunities and
having greater bargaining skills than other traders, since profitable
opportunities came from being better informed and being a more skilled bargainer
than other traders. Neither
activity induced alteration in the basic institutional framework. On the other hand, while a merchant at a
medieval European Fair would certainly gain from acquiring such information and
skills, he would gain also from devising ways to bond fellow merchants, to
establish merchant courts, to induce princes to protect goods from brigandage in
return for revenue, to devise ways to discount bills of exchange. His investment in knowledge and skills
would gradually and incrementally alter the basic institutional
framework.
Note that the institutional evolution entailed not only
voluntary organizations that expanded trade and made exchange more productive,
but also the development of the state to take over protection and enforcement of
property rights as impersonal exchange made contract enforcement increasingly
costly for voluntary organizations which lacked effective coercive power. Another essential part of the
institutional evolution entails a shackling of the arbitrary behavior of the
state over economic activity.
Path dependence is more than the incremental process of
institutional evolution in which yesterday’s institutional framework provides
the opportunity set for today’s organizations and individual entrepreneurs
(political or economic). The
institutional matrix consists of an interdependent web of institutions and
consequent political and economic organizations that are characterized by
massive increasing returns. 10
That is, the organizations owe their existence to the
opportunities provided by the institutional framework. Network externalities arise because of
the initial setup costs (like the de novo creation of the U.S. Constitution in
1787), the learning effects described above, coordination effects via contracts
with other organizations, and adaptive expectations arising from the prevalence
of contracting based on the existing institutions.
When economies do evolve, therefore, nothing about that
process assures economic growth. It
has commonly been the case that the incentive structure provided by the basic
institutional framework creates opportunities for the consequent organizations
to evolve, but the direction of their development has
10. The concept of path dependence was developed by Brian
Arthur (1988, 1989) and Paul David (1985) to explore the path of technological
change. I believe the concept has
equal explanatory power in helping us understand institutional change. In both cases increasing returns are the
key to path dependence, but in the case of institutional change the process is
more complex because of the key role of political organizations in the
process.
109
not been to promote productivity-raising activities.
Rather, private profitability has
been enhanced by creating monopolies, by restricting entry and factor mobility,
and by political organizations that established property rights that
redistributed rather than increased income.
The contrasting histories of the Netherlands and England
on the one hand and Spain on the other hand reflected the differing opportunity
sets of the actors in each case. To
appreciate the pervasive influence of path dependence, let us extend the
historical account of Spain and England to the economic history of the New World
and the striking contrast in the history of the areas north and south of the Rio
Grande River.
In the case of North America, the English colonies were
formed in the century when the struggle between Parliament and the Crown was
coming to a head. Religious and
political diversity in the mother country was paralleled in the colonies. The general development in the direction
of local political control and the growth of assemblies was unambiguous. Similarly, the colonist carried over free
and common socage tenure of land (fee simple ownership rights) and secure
property rights in other factor and product markets.
The French and Indian War from 1755-63 is a familiar
breaking point in American history. British efforts to impose a very modest
tax on colonial subjects, as well as curb westward migration, produced a violent
reaction that led via a series of steps, by individuals and organizations, to
the Revolution, the Declaration of Independence, the Articles of Confederation,
the Northwest Ordinance, and the Constitution, a sequence of institutional
expressions that formed a consistent evolutionary pattern despite the
precariousness of the process. While the American Revolution created the
United States, post-revolutionary history is only intelligible in terms of the
continuity of informal and formal institutional constraints carried over from
before the Revolution and incrementally modified (Hughes,
1989).
Now turn to the Spanish (and Portuguese) case in Latin
America. In the case of the Spanish
Indies, conquest came at the precise time that the influence of the Castilian
Cortes (parliament) was declining and the monarchy of Castile, which was the
seat of power of Spain, was firmly establishing centralized bureaucratic control
over Spain and the Spanish Indies. 11 The conquerors imposed a uniform religion
and a uniform bureaucratic administration on an already existing agricultural
society. The bureaucracy detailed
every aspect of political and economic policy. There were recurrent crises over the
problem of agency. Wealth-maximizing behavior by
organizations and entrepreneurs (political and economic) entailed getting
control of, or influence over, the bureaucratic machinery. While the nineteenth century Wars of
Independence in Latin America turned out to be a struggle for control of the
bureaucracy and consequent policy as between local colonial control and imperial
control, nevertheless the struggle was imbued with the ideological overtones
that
11. The subsequent history of Spanish rise and decline is
summarized in North and Thomas (1973).
110
stemmed from the American and French revolutions. Independence brought U.S.-inspired
constitutions, but the results were radically different. In contrast to those of the United
States, Latin American federal schemes and efforts at decentralization had one
thing in common after the Revolutions. None worked. The gradual country-by-country reversion
to centralized bureaucratic control characterized Latin America in the 19th
century. 12
The divergent paths established by England and Spain in
the New World have not converged despite the mediating factors of common
ideological influences. In the
former, an institutional framework has evolved that permits complex impersonal
exchange necessary to political stability as well as to capture the potential
economic benefits of modern technology. In the latter, “personalistic”
relationships are still the key to much of the political and economic exchange.
They are the consequence of an
evolving institutional framework that has produced erratic economic growth in
Latin America, but neither political nor economic stability, nor realization of
the potential of modern technology.
The foregoing comparative sketch probably raises more
questions than it answers about institutions and the role that they play in the
performance of economies. Under
what conditions does a path get reversed, like the revival of Spain in modern
times? What is it about informal
constraints that gives them such a pervasive influence upon the long-run
character of economies? What is the
relationship between formal and informal constraints? How does an economy develop the informal
constraints that make individuals constrain their behavior so that they make
political and judicial systems effective forces for third party enforcement?
Clearly we have a long way to go
for complete answers, but the modern study of institutions offers the promise of
dramatic new understanding of economic performance and economic
change.
I would like to thank the editors of this journal for
their comments on an earlier draft, which has resulted in substantial
improvements in this essay, and Elisabeth Case for editorial improvements. This essay is based in part on a
forthcoming book by the author entitled Institutions, Institutional Change, and Economic
Performance.
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The Competitiveness of Nations
in a Global Knowledge-Based Economy
June 2002