(Douglass) North by Northwest (Europe)
The History of Economic History, Part II
Douglass North had one of those stereotypically Berkeley undergraduate experiences: he became a Marxist. Like many who’d follow in his steps, he was more activist than student; although he tripled-majored in philosophy, science, and economics, and though he’d turned down an offer from Harvard, he got “C” grades across the board. “Our family life was certainly not intellectual,” he later reflected. His politics may have been conventional, but he wasn’t. When Hitler invaded Russia in June 1941, North was the only one of his fellow-travelers to remain a pacifist. He’d hoped to attend law school after graduation, but with America’s entry into the war “and because of the strong feeling that I did not want to kill anybody,” he entered the Merchant Marine instead. Having gone to sea, he found three years of “continuous reading” awaiting him in the vast expanses of the Pacific, and it was there that he, like Melville and Darwin, found his calling. He decided to become an economist. North returned to Berkeley after the war, receiving his Ph.D. in 1952.
North’s graduate education was equally unconventional. His teachers—one a Marxist, another Frank Knight’s brother—were more interested in history than theory, and so North learned the basic principles of economics “by rote.” He’d picked up no “real understanding” of economic theory by the time he graduated in 1952. Fortunately, he found work as an assistant professor at the University of Washington in Seattle, where he played chess for two hours a day against Don Gordon, a young colleague, who knew his theory well. While North won game after game, Gordon gave lessons that the historians had neglected. North’s dissertation was uninspiring—a history of life insurance in the United States—but it afforded him the opportunity to visit the East Coast on a fellowship. There, he encountered the intellectual luminaries who’d been absent in his Western upbringing: the sociologist Robert Merton at Columbia and (more importantly) Joseph Schumpeter at Harvard. On another trip out east, he met Simon Kuznets and performed the first empirical work that would lay out his path into economic history. He also attended the famous NBER-EHA conference—of which we spoke last week—that produced Conrad and Meyer’s revolutionary tract on American slavery and inspired a young Robert Fogel. When he came back, he set to work on The Economic Growth of the United States from 1790 to 1860 (1961), where he applied the sort of orthodox neoclassical reasoning—with great effect—that was sweeping the field. As one of the shapers of Washington’s graduate program in the early 1960s, North helped to train and place many of Goldin’s “Young Turks” in top US economics departments.
As we noted last week, North was an apostle of the Cliometric Revolution in economic history. The Economic Growth of the United States, for example, was based on “the proposition that U.S. growth was the evolution of a market economy where the behavior or prices of goods, services, and productive factors was the major element in any explanation of economic change.” Ironically, he explicitly relegated institutions to a subordinate status, writing that “they have modified rather than replaced the underlying forces of a market economy.” As we discussed last week, the book develops a rather conventional (for the time) theory of economic development as a function of geographical specialization—the '“triangular trade” between a food-producing Midwest, manufacturing North, and slave-plantation South. And so long as he continued to work on American economic history, his approach remained stereotypically neoclassical, lining up with Fogel, Lance Davis, and Stanley Engerman in foregrounding technology and production functions.
In 1966-7, however, North decided to “re-tool.” Having moved to Geneva on a one-year grant, he started to read into European economic history. Faced with this broader canvas of economic development—which spanned not just the short, dynamic life of the American republic but long millennia of stagnation—North had something of a revelation. “[T]he tools of neo-classical economic theory,” he later wrote, “were not up to the task of explaining the kind of fundamental societal change that had characterized European economies from medieval times onward.” He began to cast about for something new, the first inklings of which appeared in his 1968 paper “Sources of Productivity Change in Ocean Shipping” in the JPE. In it, he found that organizational rather than technical changes were the greatest contributors to efficiency in oceanic transport prior to 1800. This was exactly the opposite conclusion from the one he’d drawn in an analogous paper a decade before, and a tentative step away from the central model of Economic Growth. By 1971, he was calling for something that seems very familiar to us now: “a body of theory which encompasses the traditional models of the economist and both widens its scope and allows us to include an explanation of the formation, mutation and decay of organizational forms within which man cooperates or competes.” In other words, he’d realized that economics was in need of institutionalism.
Elements of what became the New Institutional Economics (NIE) existed long before North’s volte-face. In 1937, Ronald Coase’s transformative paper “The Nature of the Firm” introduced and developed the concept of transaction costs, which contravened the fundamental assumption of frictionless exchange embodied in early neoclassical models. Asking himself why firms existed when production could be contracted out to individuals, he (later) argued that “the fact that it costs something to enter into these transactions means that firms will emerge to organize what would otherwise be market transactions whenever their costs were less than the costs of carrying out the transactions through the market.” These costs were not only technical (e.g. shipping), but also related to imperfect information and the frequency of exchange between market participants. Coase would later contend that transaction costs could undermine the economy-wide specialization of which North had written in 1961. The centrality of property rights was another innovation of Coase’s; in his 1959 “The Federal Communications Commission,” he contended that people traded rights—rather than physical goods and services—which had to be protected by a legal system. The argument was refined into its most recognizable form by Almen Archian, who defined property rights as “a set of rights to take permissible actions to use, transfer, or otherwise exploit or enjoy property.” Oliver Williamson added the final point of NIE’s “golden triangle” in 1971, when he showed that—by contrast with neoclassical assumptions—individuals defect and violate contracts under certain conditions. North’s contributions in each area would be as if not more significant, but he was fortunate in his intellectual predecessors.
North set out on the road to Damascus in the early 1970s, when he published two books that straddled the divide between the neoclassical and institutionalist paradigms. Institutional Change and American Economic Growth (1971) and The Rise of the Western World (1973), co-authored with Lance Davis and Robert Paul Thomas respectively, both sought to rationalize the evolution of long-run institutions as a process of maximizing net benefits. In the latter book, he wrote that “the key to growth” was “the establishment of institutional arrangements and property rights that create an incentive to channel individual economic effort into activities that bring the private rate of return close to the social rate of return.” The classic example of the new reasoning was North and Thomas’s explanation of how increased labor costs after the Black Death led to two different institutions: wage work in Western Europe and retrenched serfdom in the East. In the former case, landlords signed away life leases to retain tenants, and the inflations of subsequent years wiped out the value of fixed money rents until they became all but nominal. In the East, by contrast, lords were able to collude and avoid competition for labor, which permitted a consolidation rather than a collapse of rentier hegemony. Institutions, contracting, and transaction costs played a key role in the analysis, but the logic remained fundamentally neoclassical: organizations are altered when the net benefits outweigh the costs.
The theory of “neoclassical institutions” resulted in two key insights. First, changes in relative prices create incentives for alterations in human organization. But these shifts are sticky, transcending the short-term economic conditions that brought them about. North thought that path dependence and transaction costs were part of the explanation. Once institutions were in place, transaction costs created frictions that led them to persist beyond the context for which they initially evolved. More importantly, North was slowly realizing that neoclassical theory was inadequate for explaining the kind of long-term dynamics that he believed at the center of the wealth and poverty of nations.
From my quite subjective perspective, the new economic history has made a significant contribution to revitalizing the field and advancing the frontiers of knowledge. Yet I think it stops short – far short of what we should be accomplishing in the field. Our objective surely remains that of shedding light on man’s economic past, conceived in the broadest sense of those words; and I submit to you that the new economic history as it has developed has imposed strictures on enquiry that narrowly limit its horizons-and that some of my former revolutionary compatriots show distressing signs of complacency with the new orthodoxy (North 1974, p. 1).
North’s “breakthrough” work began to resolve these dilemmas. Structure and Change in Economic History (1981) offered a radical new explanation of persistence that superseded the transaction cost compromise: culture. The “cumulative experience” handed down across generations coalesces over time into beliefs and ideologies, and the accretive nature of this process makes the outputs persist even if economic efficiency arguments dictate change. Bad institutions that clearly retard development can be locked into place by the cultural framework of a society merely because of the path-dependent construction of the underlying norms and assumptions—hardened by thousands of discrete interactions between anonymous actors. Change, therefore, occurred on two levels: the discontinuous and abrupt, as in the Black Death case, and continuous evolutions in the longue duree. Neither type need necessarily persist; Structure and Change offers framework for thinking about why they do and don’t. The assumption that existing arrangements were efficient had been abandoned for good.
In 1989, North (along with Barry Weingast) published the work for which he’s perhaps best known: “Constitutions and Commitment,” which explored the role of the Glorious Revolution in creating institutions favorable for the emergence of economic growth in Britain. The overthrow of the arbitrary and domineering Stuart monarchy, in the now-familiar parable, led to the rise of “Parliamentary supremacy” and constraints on the executive, both of which secured private property—in turn increasing investment incentives and greasing the wheels of exchange. This argument would be enormously influential, both in its own right, and in setting out a precursor to the Acemoglu-and-Robinson paradigm of Why Nations Fail and “Atlantic Traders.” Indeed, North and Weingast offered a straightforward explanation of how most nations failed, and why Britain—despite a “nearly” moment—didn’t.
Rules the sovereign can readily revise differ significantly in their implications for performance from exactly the same rules when not subject to revision. The more likely it is that the sovereign will alter property rights for his or her own benefit, the lower the expected returns from investment and the lower in turn the incentive to invest. For economic growth to occur the sovereign or government must not merely establish the relevant set of rights, but must make a credible commitment to them (North and Weingast 1989, p. 803).
At the same time, North was writing Institutions, Institutional Change, and Economic Performance, where he further refined these ideas into a solid definition. According to his “sports analogy,” institutions were the “rules of the game” and the referees, and organizations were the players. Players had three moves: to maximize within the rules, expend resources in changing them, or cheat. The payoffs from these non-exclusive strategies determined how what happened to the institutions—whether they remained static, evolved gradually, or made revolutionary leaps. This distinction between institutions and organizations was novel; in earlier treatments, organizations were treated as appendages to institutions, which interacted directly with the representative individuals of neoclassical theory. Institutions was ultimately a claim, according to John Wallis, that “the function of institutions [w]as providing stability and predictability... and that the persistence of institutions was not a matter of real-time economic and political forces, but an outcome of the natural limits of human capacities for cognition and culture.”
One of my favorite of North’s papers, simply titled “Institutions” (1991), tries to extend this concept to a theory of state formation. Initially, exchange takes place within the context of a single village, where “dense social networks” permit transactions to occur at low cost, but limit the amount of productive specialization that can feasibly take place. Population and economic growth eventually extend the market beyond immediate personal relations, necessitating the development of institutions to prevent defection. Long-distance trade generates further problems: agency problems for merchants hiring operatives at a distance and contract enforcement in faraway markets. Successfully resolution of these issues required 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.” Such innovations lowered information costs and ensured contract fulfillment, encouraging greater participation in long-distance trade. “A mixture of voluntary and semi-coercive bodies” ostracized merchants who failed to live up to expectations. Long-distance trade, in turn, fostered a broader division of labor and specialization, which lowers production costs through economies of scale, offsetting the transaction costs imposed by distance and anonymity. Towns and cities spring up, labor shifts out of agriculture into manufacturing and services, and eventually specific institutions—an effective judiciary, constrained executive, and private property rights—are required to keep the development process moving: into fixed plants and continuous-process technology run by specialized wage labor. In the “final stage,” the financial sector itself becomes a large fraction of national product and international institutions emerge to regulate a cross-country division of labor.
By the late 1980s, the New Institutional Economics was gaining significant ground. The proliferation of cross-country data on national income and institutional quality spurred a massive literature on the institutions-growth relationship during the following decade. Problems generated by the first generation of studies—namely, that institutional quality might well be endogenous to rather than formative for economic performance—inspired a famous set of studies: the AJR research agenda of “Colonial Origins,” “Reversal of Fortune,” and “Atlantic Traders”; Rodrik, Subramanian, and Trebbi’s “Institutions Rule”; and the “Legal Origins” work of La Porta, Lopez-de-Silanes, and Shleifer. Stanley Engerman and Kenneth Sokoloff’s classic “Factor Endowments, Inequality, and Paths of Development Among New World Economies” foregrounded the interaction between initial levels of social stratification—determined by geography—and the evolution of institutions in explaining economic performance in the Americas. Avner Greif’s studies of the European guilds and the Maghribi traders picked up where North left off in studying beliefs and norms (not just rules) in demonstrating how informal coalitions used reputational mechanisms to create secure conditions for exchange. And Joel Mokyr, one of the doyens of recent economic history, has been developing a theory, spanning multiple books, of how cultural evolution influences the formation of innovation-friendly values and institutions. With the “Culture of Growth,” combining gentlemanly capitalism with a Baconian obsession with useful knowledge, he seeks to explain the immediate origins of the Industrial Revolution in Western Europe.
North’s final act was, along with Wallis and Weingast, to apply his institutional theory to the entirety of human history, via “Violence and the Rise of Open-Access Orders” (2009). Ten thousand years ago, warring tribes were the were the prevailing mode of “organization.” In some of these bands, elite coalitions arose between specialized warrior, economic, and priestly castes who exchanged protection, resources, and legitimation and excluded outsiders. This upper tier controlled the productive base of society and extracted rents, which encouraged their cooperation; this alliance—the “natural state” was extraordinarily stable, forming the basis for thousands of years of “limited-access” political regimes. Property rights and law are written by elites, for elites, and admission to trade and business was limited by a range of exclusive corporations, clubs, and associations. Elites can outcompete commoners through easier access to credit and the manipulation of state patronage, removing the incentives for many potentially profitable business enterprises. “Open-access” orders, by contrast, put violence under the control of civilian politicians, passed impartial laws, and ensured that ordinary citizens could compete at relatively low cost in markets and political activity. Free entry loosed a process of Schumpeterian creative descruction. Economic development was synonymous with credibly enforced property rights and contracts, the rule of law, and the egalitarian recognition of political and human rights. This, needless to say, was the apotheosis of the new institutionalism as applied to history.
What was North’s great intellectual contribution, in the end? To the Nobel Committee, which awarded him the Prize in 1993, North “[s]hed new light on the economic development in Europe and the United States before and in connection with the industrial revolution” and “emphasized the role of property rights and institutions.” As we’ve seen, though, his research program was far more ambitious. To Claudia Goldin, North sought nothing less than to return economic history—led astray by the Cliometric Revolution—to the study of the “humanly devised constraints that shape human interactions,” as he put it in a 1991 paper in the JEP. Neoclassical theory explained capital accumulation and technical change assuming a given set of institutions, but not why or how a particular institutional configuration came to exist in the first place. Accumulation of the conventional factors of production set out the capacity, but not the impetus, for sustained economic growth. To me, North did something even more profound. His efforts to develop a theory of institutions led him, with economic history itself in tow, to study the truly fascinating questions in history: why and how complex societies emerge, change over time, and differ in wealth and power today.