Understanding Economic Change
Douglass C. North
There are some fundamental characteristics of successful economic development that are common to economies everywhere. There is, however, no universal pattern for achieving these results. While we do have some idea of what has led to successful development in the past, we have very imperfect knowledge about how to achieve such results in the present. Awareness of the current limits to our knowledge is a prerequisite to understanding the problems involved in improving the performance of economies in transition from state socialism.
Economic growth results when the output of an economy grows because more land, labor, capital, and entrepreneurial talent are devoted to the production process and/or because the productivity of these factors of production rises. Growing markets, technological improvements, and additional investment in human beings (human capital) all have played a part in increasing productivity. While the new literature on growth economics has formalized some of these findings, they have been broadly understood for some time by economic historians, development economists, and specialists in growth accounting. But how do we explain the continuation of poverty in much of the world if the sources of growth are known? The answer is to be found in the failure of humans to organize themselves to undertake the improvements that would result in increasing output. The institutional framework of a society provides the incentive structure that directs economic (and political) activity. We do know a good deal about the institutional foundations of successful economic growth. A number of recent empirical studies have made clear the importance of the institutional matrix. Stable political structures, well-speci-
fied and enforced property rights, and low-cost enforcement of contracts (typically through the rule of law) have resulted in the low transaction costs underlying the success of the developed economies. Throughout history, humans have all too often failed to provide the institutional framework necessary for productive activity.
Until we understand more than we currently do about the process of economic change, we are fundamentally hampered in improving economic performance. The theory from which we start is static and frictionless—critical limitations to our understanding of the process. Moreover, path dependence matters, and we are still unclear about exactly what it is that makes the path we have trod such a critical factor in constraining present and future choices. However, the discussion that follows provides a loose structure designed to be an aid in thinking about the issues involved in this process.
An economy can be characterized by innumerable statistics on its demographic, economic, technological, and institutional features, but what we really need to know is the interplay among all these features that makes it work. The foundations of that interplay are three: the demography, which describes the quantity and quality of human beings; the stock of knowledge the society possesses, which determines the human command over nature; and the institutional framework, which determines the rules of the game. The demographic characteristics include not only fertility, mortality, and migration characteristics and labor force composition, but also the stock of human capital (derived from the stock of knowledge). The stock of knowledge includes not only the scientific knowledge a society possesses, its distribution in the society, and its application to solving problems of scarcity, but also the beliefs the society holds that influence the choices made. That stock of knowledge determines the potential upper bound of the well-being of the society. The institutional framework determines the incentive structure of the society. It is the interplay among these three that shapes the features of the economy. We know very little about this interaction, although we do have some limited hypotheses about certain of its aspects. But self-conscious modeling of this interaction at a moment in time, much less over time, has not been part of the agenda of economists, development economists, or economic historians.
Yet we do construct in our minds a synthetic framework designed to explain how the economy works. This framework is derived from the culturally determined belief systems we possess and in part from the available evidence. The structure is both a positive model of the way we perceive the economy and a normative model of the way the economy really works. In some cases the defects are fatal, as in the case of the communist models that disintegrated in 1989. From this (typically implicit) model, we, or those political and economic entrepreneurs who are in the position to make choices that shape micro- and macroeconomic performance, erect an elaborate struc-
ture of rules, norms, conventions, and beliefs embodied in constitutions, property rights, and informal constraints that in turn shape economic performance. This ''scaffolding" not only constrains the choice set at a moment of time, but also is the source of path dependence. When political or economic entrepreneurs seek to alter some aspect of economic performance, they make choices that are limited not only by the standard constraints of technology and income, but also by this scaffolding. The intention is to alter economic performance in a particular direction. The aggregate of such policies is continually altering the way the economy works. In turn that leads to gradual alterations of the models we devise in a never-ending process of economic change. I should complicate this all too brief account by pointing out that nonhuman forces, such as climate change in history, also influence the performance.
Throughout history, humans have typically gotten it (at least partly) wrong in (1) their understanding of the way the economy works, (2) the synthetic frameworks they construct, or (3) the policies they enact (at best blunt instruments to serve their purposes), producing unanticipated consequences. We may write economic history as a great success story of an enormous increase in material well-being, which has reflected the secular growth in the stock of knowledge. But it is also a vast panorama of decisions that have produced death, famine, starvation, defeat in warfare, economic decline and stagnation, and indeed the total disappearance of civilizations. And even the decisions made in the success stories have typically been an admixture of luck plus shrewd judgments and unanticipated outcomes. Take American economic history as an example. From the earliest attempts at settlement, through the colonial era, to the perceptions leading to the Revolutionary War, the colonists had it, at best, half right. The Constitution, surely a classic of shrewd judgment, was aided by chance (the events of the 1780s), luck (the boycott of the convention by the antifederalists), and unanticipated decisions (the development of the independent judiciary and the Marshall court).
I wish to emphasize the limits to our understanding because there is a certain amount of hubris evident in the annual surveys by the World Bank and in the writing of orthodox economists who think we now have it right. It is important for us to understand that even if we do have it right for one economy, it will not necessarily be right for another, and that even if we have it right today, it will not necessarily be right tomorrow. I am not suggesting that we have failed to learn a good deal about determinants of economic performance. I began this essay by asserting that we have. But the implication of my brief survey is that in the sequence from our understanding of an economy, to the scaffolds we erect, to the policies we then enact to alter economic performance, there are innumerable junctures where we can and do get it wrong. Let me focus on three such junctures that are central to the issues of improving the performance of transition economies: the "scaffolds" we erect, the policies we enact, and time.
It is the scaffolds we erect that make path dependence so important. They consist of the political structure that specifies the way we develop and aggregate political choices; the property rights structure that defines the formal incentives in the economy; and the informal constraints of norms, conventions, and internally held beliefs. They have evolved over many generations, reflecting, as Hayek (1960) has reminded us, the trial-and-error process that has sorted out those behavioral patterns that have worked from those that have failed. Because the experience of every society has been unique, the scaffolds erected will differ for each economy. They constrain the choice set not only because the organizations of the economy have been built on the foundations of that institutional structure, so that their survival depends on its continuance, but also, and perhaps more fundamentally, because the belief system that is a complementary part of that scaffolding tends to change very slowly. Not only is the scaffolding what makes path dependence so important, but it is equally the explanation for the difficulties involved in reconstruction when much of the scaffold crumbles, as happened in 1989 in Eastern Europe.
The second critical juncture is the policies we enact to alter the performance of an economy. Even when we have a "correct" understanding of the economy and a (more or less) "correct" theory about its operation, the policies at our disposal are very blunt instruments. They consist of alterations in the formal rules only, when in fact the performance of an economy is an admixture of the formal rules, the informal norms, and their enforcement characteristics. Changing merely the formal rules will produce the desired results only when the informal norms are complementary to that rule change, and enforcement is either perfect or at least consistent with the expectations of those altering the rules.
Finally, time is important because change is a process in time, not a once-and-for-all occurrence as we are accustomed to thinking in static theory. Not only are the economies themselves continually changing, but also the policies we enact will have downstream consequences through time that must be taken into account. Specifically, a policy will typically affect the distribution of income, and those adversely affected, if they have access to the political process, may act to negate or alter the policy. In the extreme, the policy may produce a violent reaction. While nothing as elegant as a formal dynamic theory is even on the horizon, recognizing that policy enactment is a process in time is the beginning of the political economy we seek.
The implication of the foregoing analysis is that path dependence can and will produce a wide variety of patterns of development, depending on the cultural heritage and specific historical experience of the economy. Indeed, the success in China of TVEs (town, village enterprises)—a form of organization that is neither a firm nor a cooperative and does not fit our preconceptions about successful institutional/organizational structures—has been a sobering
reminder of how much we still have to learn about the process. A description of that process in China from the enactment of the household responsibility system traces a unique path that has produced (so far) rapid economic growth. I would hope that this essay would put to rest any simplistic general nostra such as "big bang" or "shock therapy" theories about magically overcoming a lack of development.
If path dependence can help us understand the variety of development patterns, it also speaks forcefully to the constraints that the "scaffolds" erected in an economy impose on institutional change. The historically derived constraints are supported not only by the existing organizations that will oppose change, but also by the belief system that has evolved to produce those constraints. The rate and direction of change will be determined by the "strength" of the existing organizations and belief system.
The demise of communism in Eastern Europe in 1989 reflected a collapse of the existing belief system and a consequent weakening of the supporting organizations. Policymakers were confronted not only with the restructuring of an entire society, but also with the blunt instrument that is inherent in policy changes that can only alter the formal rules, but not the accompanying norms. And even policymakers have had only limited success in inducing enforcement of policies. The relative success of policy measures (such as the auctioning of state assets and the reestablishment of a legal system) in the Czech Republic as compared with Russia resulted from the heritage of informal norms that made for the relatively harmonious establishment of the new rules.
In addition, we know all too little about political economy. One of the shortcomings of research is a lack of attention to the polity and the problem of aggregating choices through the political system. We simply have no good models of polities in Third World, transition, or other economies. The interface between economics and politics is still in a primitive state in our theories, but its development is essential if we are to implement policies consistent with intentions.
Let me conclude by talking about time. If one accepts the crude schematic outline of the process of change set forth above, it is clear that change is an ongoing, continuous affair, and that our institutional prescriptions typically reflect learning from past experience. But there is no guarantee that past experiences are going to equip us to solve new problems. Indeed, an historic dilemma of fundamental importance has been the difficulties of shifting from a political economy based on personal exchange to one based on impersonal exchange. An equally wrenching change can be the movement from a "command" economy to a market economy. In both cases, the necessary institutional restructuring—both economic and political—has been a major obstacle to development, and it is still the major obstacle for Third World and transition economies. The difficulty comes from the fact that the belief system that has