Continuing his series of key development readings Asad Abbasi reviews Douglass North’s Institutions, Institutional Change and Economic Performance. Norths’ contributions were of extreme importance and continue to influence developmental discourse today.
The book is about understanding the idea of history, economic growth and institutions. The models of neoclassical economics have underestimated the importance of institutions and therefore these models have been unable to explain divergent patterns of growth between countries. North argues that only by including institutions in the economic models one can understand broad historical patterns of economic growth.
North defines institutions as non-physical constraints designed for human interaction. He differentiates between organizations and institutions. Organizations are those social groups where like-minded people aspire towards a certain target. Institutions are much more complex entity.
In the book he gives example of football to define institutions. In football there are formal rules such as laws of the game, structure and written codes and some informal rules such as sportsman spirit and fair play etc. If a referee or a match official finds any player not abiding by these rules then they could enforce these laws. Like-wise institutions are made up of formal constraints (Laws, constitution), informal constraints (ideas, culture, and ideology) and enforcement (state, judiciary)
North asks two core questions in the book:
1) Why is there a great divergence between third world countries (less developed) and first world countries (developed)?
2) How can one explain the existence of failed countries along with the existence of successful ones?
1) North argues that the divergent patterns between Latin America and United States are due to difference in institutions framework (formal, informal constraints) present in Spain and England at the time of colonization. These institutions provided incentives that shaped policy both in colonial country and in colonies. Therefore the North American rulers understood and supported property rights, individualism and liberty whereas Latin American rulers did not.
2) North suggests that a reason why Latin America, despite its failings, co-exists with North America today is because of imperfect information and transaction cost. In a perfect information model, agents differentiate between efficient markets and inefficient markets without any subjectivity. However these models are not the representation of the real world where information is not perfect and uncertainty is the only certainty. In countries where institutions are not in place investors, entrepreneurs, organizations and firms are not entirely sure about the returns and face uncertainty. Therefore, institutions are important as they try to reduce the degree of uncertainty. Latin America has a weaker institutional infrastructure than North America. Businesses thrive in the latter and suffer in the former.
Criticism of North generally falls within two categories. The first criticism against North is by writers who use the ‘institutional framework’ but only after modifying it. The other criticism is by those who see institutional framework as an extension of neoclassical approach and inadequate to explain divergent paths of development
Kenneth Sokoloff and Stanley Engerman raised the point that North America development due to good institutions in England. And Latin American didn’t develop because of bad institutions in Spain. However, Britain colonized African countries, Caribbean countries and South Asian countries. Why are these countries without ‘good institutions’? This question is a critique of North’s institutional argument. Why Jamaica didn’t have good institutions despite being colonized by Britain. According to Sokoloff and Engerman, type of institutional development depended on the type of factor endowment of each country such as ‘degree in inequality in wealth, human capital and political power’. These factors affected how institutions were shaped. With extreme inequality, elites were able to form institutions that were beneficial to them. Recently, another modification of this argument is presented by Acemoglu and Robinson.
North’s institutional argument is simple and easy to understand but yet historically inaccurate. Institutionalism has been criticized Ha Joon Chang who shows that institutions, laws, regulations, good governance are effects of development and not its cause.
In conclusion, North’s argument is simple, therefore, appealing. Recently, many criticisms have emerged against North’s version of institutions but idea of institutions has not withered away. However with every modification, it is becoming more complex and losing its original appeal: simplicity.
Asad Abbasi has a Master’s degree in Political Economy of Late Development from the London School of Economics.
The views expressed in this article are those of the author and do not necessarily represent the views of Development in Action.
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