Home / Mint-lounge / Mint-on-sunday /  Douglass North and the importance of institutions

On 23 November, iconoclastic American economist Douglass North died at the ripe age of 95. (Two well-written and informative obituaries are in The Economist here and The New York Times here).

North had shared the Nobel Prize in economics in 1993 with Robert Fogel, whom he outlived by two years. North and Fogel were worthy but unlikely Nobel winners at a time when the economics profession was dominated by the increasing use of math and formal modelling.

The emphasis on modelling had been set in train as early as the 1930s within both neoclassical and socialist economics, driven by an aspiration towards a certain kind of scientific rigour. The rapid development of computing technology and the availability of large databases accelerated these trends.

The end result—which is now being partly challenged because of the shock of the global financial crisis and because of challenges from behavioural and experimental economists—was a largely desiccated and arid understanding of what Alfred Marshall had famously called the “study of mankind [sic] in the ordinary business of life". Homo economicus—the calculating, rational human-machine—ruled supreme, and there was little role for history, institutions, culture, or the many other facets of the warp and woof of the lived social fabric.

North and Fogel were outliers, if not renegades, when they nabbed the most coveted prize in economics back in 1993. Both were skilled practitioners of classical economic history, which—along with its sister field of study within economics, the history of economic thought—had been all but relegated to the dustbin by the Anglo-American economic mainstream by the early 1990s. (As a personal note, when I started doctoral studies at Columbia a quarter of a century ago, a course in either economic history or history of thought was mandatory, and even then it was a rarity at major institutions. Most major economics departments have now long since abolished such a requirement.)

Unlike the prevailing fashion then or now, North focused on perennial, grand questions of political economy, similar in spirit to the sorts of questions that Adam Smith or Karl Marx raised: Why do some nations become rich while others remain poor? What accidents of history or of choice of institutions, whether by design or arising organically, explain these divergences? Why are some societies phenomenally successful at one point in time, and then why do some, not others, go into decline? Why do once-moribund societies take off while others remain stagnant?

While it challenged the then (and still prevailing) ruling orthodoxy in economics, it will not come as a surprise to non-economists reading this that North was sceptical that the ahistorical and context-free rational calculating homo economicus could be a terribly useful starting point in answering these grand questions of political economy.

North’s proposition, in a nutshell, was that institutions matter, and you ignore them at your peril in trying to understand the rise and fall of the wealth of nations.

This would seem a statement of the obvious for most social scientists or laypersons, but for many conventional economists who had failed to read and understand either the history of economics or the history of the field and who were wedded to a narrow rational choice paradigm, it came as a surprise, if not necessarily a welcome one.

Because of his insistence on taking history and institutions seriously, and studying them through painstaking case-study analysis, with a judicious use of theoretical and quantitative data analysis as well—very much like fellow Nobel winner, Fogel—North is often called one of the founders of new institutional economics.

The other economist generally credited as co-founder of new institutional economics, also a Nobel winner and particular hero of mine, is Ronald Coase. Readers interested in learning more about new institutional economics, which, it must be said, has now developed its own somewhat cultish following, might read this 2000 survey article by one of its other luminaries, economist Oliver Williamson, himself a Nobel winner from 2009.

The core insight illuminating the work of Coase, North and their many fellow travellers and disciples is that transaction costs—routinely assumed away in textbook, conventional economics—matter. And, if transaction costs matter, they both argued in different ways, the economy might not attain a situation of perfect economic efficiency, which is a situation in which all of the possibilities for mutual gain through production, consumption and voluntary exchange have been exhausted.

By contrast, in a frictionless utopian world, it follows immediately that history, institutions, and indeed, government itself, are irrelevant. Perfect efficiency—Pareto optimality, in the jargon of economics—prevails, and no further surplus or rent (to use the language of David Ricardo and Marx) remains to be extracted; the economy has attained a point of maximum efficiency. History and institutions might determine how the total pie is split, but not the size of the pie, which is as large as it can be.

What is more, government intervention—say through taxes and transfers—can only redistribute slices of the pie, and, if done poorly, may actually cause the pie to shrink. Hence, such intervention cannot be asserted to be unambiguously beneficial to a liberal society that cherishes individual liberty.

The work of North and Coase undercut this libertarian Garden of Eden situation prevailing in neoclassical economics, and they did so in different ways.

Coase began with a conceptual experiment in which transactions costs were zero or so small as to be irrelevant, and proceeded to show that in this world, history, institutions and government would be irrelevant to our understanding of economic efficiency—something self-evidently different from what prevails in the actual world we live in.

He then went on to argue that, in the real world in which transactions costs are important, all of these non-economic elements, relegated to the background by economists, all come into play with a vengeance in determining the shape of economic outcomes.

Less conceptually fundamental than Coase, North, a historian by inclination if an economist by training, took it as given that transaction costs are important, and he proceeded to study exactly how the intricate interaction of history and institutions shaped economic outcomes, which could be widely divergent across times and places whose fundamental economic conditions superficially appeared similar.

As an example of his style of work, a classic 1990 research paper, co-authored with economist Paul Milgrom and political scientist Barry Weingast, investigated the success of a specific institution—merchant law in late medieval Europe—in ensuring that merchants would honour their promises rather than reneging, weaving together narrative and a clever application of game theory to buttress their argument.

This blog post by economist Kevin Bryan offers useful insights into North’s method of work and contribution by analysing the same research paper on merchant law in medieval Europe.

Going against the grain of mainstream economics of his time, North refused to see the state primarily as a rent-seeking extortionist. Rather, he considered the state as a pivotal coordinating body, which, if it functioned well, could lower transaction costs meaningfully and raise economy-wide efficiency levels.

North emphasized that free markets in themselves do not mean efficient markets, and that for a market to be efficient, well-functioning state and legal systems are sine qua non.

“Efficient markets imply a well-specified legal system, a well-specified and impartial third party of government to enforce them, and a set of attitudes toward contracting and trading that encourages people to engage in them at low cost," wrote North in a succinct 1986 paper outlining the rationale and scope of new institutional economics. “We are a long way from a body of theory that will unravel all these problems, but the new institutional economics can be a major step forward in confronting these issues."

The upshot of both men’s work, and of their followers’, was to implant the idea that successful institutions are those that minimize, or at any rate mitigate, transaction costs, and these may allow real-world economies to approach, if not attain, the nirvana of perfect efficiency imagined in the world of blackboard economics.

By contrast, poor institutions, or otherwise good institutions that are fragile and unsustainable—due, for example, to the fact that they are incompatible with individual incentives—may lock in inefficiency and poor economic outcomes and trap nations in poverty rather than put them on the path to prosperity.

Far from being irrelevant or a second order nuisance that may be ignored, transactions costs—and the institutions they spawn, in specific historical circumstances—are absolutely central to this conception of the grand political economy questions of the wealth and poverty of nations. For this understanding, and the implications which flow from it, we owe the late Douglass North a great intellectual debt.

What’s more, the insights of Coase, North and others live on, and are seminal to the work of influential scholars today, as different as Harvard historian Niall Ferguson, on the one hand, and the team of MIT economist Daron Acemoglu and Harvard political scientist James Robinson, on the other. For the consummate scholar that North was, perhaps that is the greatest tribute of all.

Ironically, while North is hailed as a maverick who challenged this conventional view, Coase, somewhat to his chagrin, was hailed as upholding it, through a narrow reading of his work, which was, perhaps misleadingly, dubbed the Coase theorem by George Stigler, his Chicago colleague and also a Nobel winner.

The force of Stigler’s interpretation of Coase supported the classic Chicago school view that the possibility of market failure must be weighed against the equally likely possibility of government failure, so that government intervention to correct market failure is not prima facie warranted. But that is a tale for another time.

Economics Express runs weekly, and features interesting reads from the world of economics and finance.

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