Understanding the Process of Economic Change

Despite what the title might suggest at first, Understanding the Process of Economic Change does not offer a clear-cut, straightforward prescription for evolving economies. In fact, Douglass North frequently, and quite convincingly, warns against simplistic and reductionist approaches to economics. Through the exploration of key factors and mechanisms of every economy, he clarifies the pitfalls of prescriptive roadmaps to economic prosperity that lack a comprehensive understanding of the social, political, demographic, and institutional characteristics of the economy.

Douglass North (1920-2015) (Figure 1) was a Laureate Nobel Prize (The Sveriges Riksbank Prize in Economic Sciences) winner in economics and one of the prominent figures of the New Institutional Economics school. Understanding the Process of Economic Change is an archetypal example of the school’s method of analysis, with emphasis on institutions, social structure, knowledge, demographics, learning, and transaction costs.

Douglass North
Figure 1 – Douglass North (source: NobelPrize.org)

The message of the book, as summarised in North’s own words, is:

 

‘You have to understand the process of economic growth before you can improve performance and then you must have an intimate understanding of the individual characteristics of that society before you are ready to try to change it. Then you must have an understanding of the intricacies of institutional change to be effective in undertaking that change.’ (p. 165)

 

In the following, I provide a brief overview of the book and the key parameters it proposes as influential in the process of economic change. The parameters include the stock of knowledge, institutions, and demographic characteristics. I also provide few comments on the book and its method of analysis that, in my opinion, could have made the book even better.

Knowledge

The stock of knowledge is a key element of North’s theory. Knowledge shapes our encounters with the world and transforms novel phenomenon to familiar ones. Confronting new situations, whose mechanisms and characteristics are unknown to us, can lead to one of the following:

  • Uncertainty: When we can have a probability distribution of the outcome of the situation.
  • Ambiguity: When we cannot even construct a probability distribution for the situation. [i]

We can reduce the level of uncertainty by imposing structures to our social, political, and economic interactions. However, we cannot entirely eradicate uncertainty because

  • Our understanding of the reality is always imperfect
  • Our formal rules and the informal enforcement mechanisms are imperfect.

The imperfection of our knowledge stems from the nonergodic, dynamic, ever-changing, and inherently time-dependent nature of the world. The nonergodicity of political-economic systems renders us unable to ever develop a perfect understanding of their ‘reality’.

Despite the impossibility of perfect knowledge, we do not refrain from constructing belief systems about the reality of the world. We constantly build and renovate such systems, which are both positive and normative. They are positive in the sense that they describe the social, political, and economic systems. They also prescribe how those systems should be and thus, they are also normative.

The belief systems constitute an important part of cultures. The reaction of agents to unfamiliar problems depends on the novelty of the situation and their cultural heritage. Culture accumulates partial solutions to problems encountered in the past. It transfers to a new generation what its predecessors learned through their lifespan. In this way, the new generation is equipped with an inventory of potential solutions to problems it might face in future.

The cultural heritage creates an artefactual structure, which includes ‘beliefs, institutions, tools, instruments, [and] technology’. A rich and favourable artefactual structure reduces uncertainty in decision making and helps individuals and the society overcome novel difficulties. In other words, the richer the artefactual structure, the more successful the society.

While culture transfers the learnings of the past and in doing so, helps the solution of future problems, it also partly conditions the learnings of the future. The learning process is influenced by previous experiences and encounters with the world; and by the belief system and the way it filters the information gathered from those experiences. Combining the acquired knowledge in a useful manner requires an effective price system as well as institutions and organisations to handle essential public goods, asymmetric information, and ubiquitous externalities.

Institutions

The endurance of uncertainties and the impossibility of attaining perfect knowledge leave a gap between an agent’s competence and the decisions she makes (Heiner 1983). Despite this gap, we construct belief systems about the economy and the world. These systems are both normative and positive, i.e., they both contain descriptions of how the world does and ought to work. Based on our beliefs, we build constraints to restrict the flexibility of our decisions. These constraints, built by our intentionality, are institutions. ‘Institutions are the rules of the game, organizations are the players; it is the interaction between the two that shapes institutional change’ (North 2005: 59).

The belief systems are not rigid but change with the expansion of our experience. Our interactions with the society and the world provide feedback to our belief systems, leading to their eventual modification and development. The entire process can be summarised in this way: we have a perception of the reality of the world and human interactions. We build a system of beliefs on the foundation of the perceived reality. We construct institutions to constrain our interactions and shape our decision-making procedure. These constraints demonstrate themselves in policies, which, in turn, alter and shape our perception of the reality. This process is schematically demonstrated in Figure 1.

Economic Change Figure 1 Dianoetic
Figure 1- The process of perception and institutional change

As the schematic suggests, the relation between the stock of knowledge and institutions is not one-way but mutual. We construct institutions based on our knowledge and perception of the reality. However, the currently established institutions determine what information can be absorbed in our belief system. In other words, the institutional structure dictates the type of adopted knowledge.

The institutional matrix together with general economic constraints determine the opportunities available to the agents. They also determine the type of organisations that emerge and grow in the economy. The continuous interaction between institutions and organizations in the economic setting of scarcity and competition is the key to institutional change. Institutional change, however, is essentially incremental and path dependent because of the economies of scope, complementarities, and network externalities of an institutional matrix.

Competition forces organizations to continually invest in skills and knowledge to survive. The kind of skills and knowledge that individuals and their organizations acquire will shape evolving perceptions about opportunities and the choices that will incrementally alter institutions. At the final analysis, the competition among organisations leads to institutional change. The more vigorous is the competition, the more rapidly institutions evolve.

To progress and prosper, we impose institutional change by altering and manipulating the structures of social interactions. However, the result is not always in line with the intentions, and consequently, much of economic change has been the unwanted outcome of institutional change. The unintentional results are symptoms of ‘faulty’ belief systems.

Order

Order is a necessary, although not sufficient, condition for economic growth because its lack increases uncertainty and thus, the costs. The persistence of disorder and thus, uncertainties, is directly related to the fact that our beliefs are both normative and positive; that we not only have a view of society’s working but also of how it should be working.

A key challenge in establishing order is to overcome negative cultural heritage. It is more difficult to establish consensual orders in societies with a significant history of disorder. In contrast, societies with the history of order and stable institutions, recover from disorder more rapidly.

Discussion

The book is a great read. It vividly demonstrates the complexities involved in the analytical investigation of economic change, let alone in the provisioning and implementing it. North warns against simplistic and reductionist approaches to economic analysis and practice.

The book is well-written and informative, and I learned a lot from it. However, I also encountered several points that were not quite clear, failed to persuade me, or even seemed to be contradictory. I do not claim that North was wrong but simply point to the need for further clarification, discussion or research (probably on the part of the reader).

1)     Polity vs Economy

The most contentious idea of the book, in my view, is separating the realms of polity and economy. This obvious Weberian approach to human society is spread throughout the book and constitutes a founding element of North’s analysis.

The distinction between the political and the economic becomes quite conspicuous when North directs the focus of analysis to the political arena. He views political markets as inherently imperfect because of the complex environment, high information costs, and lack of credible commitment. Bargaining strength and transaction costs are different in political markets than in the economy. That is why it is ‘worthwhile for groups to shift the issues to the political arena’ (p. 55).

The Weberian distinction between ‘markets and states’ (Robinson 2002) may seem analytically facilitating, for it can significantly reduce the level of complexity of the problem by dividing it to two separate problems. However, decoupling the polity and the economy may present a problem radically different than the real problem. The interaction between the two components is an intrinsic and foundational part o the whole problem.

An example can help better clarify the issue. Water (H2O) is made up of hydrogen (H) and oxygen (O). In the laboratory, you can create water by combining the two elements or vice versa, extract hydrogen and oxygen by electrolysing water. However, it is impossible to deny that the properties of water are intrinsically different than that of hydrogen or oxygen. The chemical bonds between atoms are themselves constitutive components of the final molecule. 

The relation between the polity and the economy in the whole society is not the same as between oxygen and hydrogen in water. Nevertheless, the analysis of the combined phenomenon should not neglect the constitutive nature of their bond.  The decoupling is particularly detrimental to North’s argument. One of his main goals of the book is to warn against reductionist approaches. Separating markets and states can be one of such approaches.  

2)     Personal vs impersonal exchange

North views the shift from personal to impersonal exchange a vital factor for economic growth. The emergence of large-scale markets could not have occurred without this specific shift in human interactions. It did not happen and cannot be achieved rapidly due to several reasons.

  • The genetic architecture evolved from million years of being hunter/gatherers, that favours personal exchange.
  • Eventual mental adjustment, ‘indoctrination’, to impersonal relationships
  • The development of necessary mechanism to enforce impersonal agreements
  • Creating a strong but limited polity to enforce property rights at low cost

At the same time, North maintains that we work more productively and efficiently in smaller groups. To deliver our best performances, our social interactions should be intimate, friendly, or at least, personal. This genetic propensity, according to North, has been inscribed into our brains and dominates their functions throughout millions of years of the hunter/gatherer life.

Here lies a contradiction. On the one hand, North acknowledges the importance of impersonal exchange in the emergence and growth of large-scale economies. On the other hand, he concedes that our performance is at its best when we are involved in the personal exchange. North does not make any attempt to solve the dilemma that why impersonal exchange, which is ‘at odds with our genetic heritage’ (p. 84), has given rise to economic growth. He does not answer the obvious questions such as

  • Does the contradiction mean that economic growth is at odds with our ‘origin’?
  • Or, is impersonal exchange a part of our evolution?

3)     Hunter/gatherer origin

The idea of the hunter/gatherer origin is quite commonly taken as granted when discussing the source of our traits and behaviour. It suggests that, for millions of years, we lived by hunting and gathering and eventually our brains’ neural networks have evolved and conditioned to that kind of life. Thus, even now, our conditioned brains render us predisposed towards activities and preferences that support that life and may not necessarily benefit our current way of life.

I am in no place to take a stance in favour or against the idea of a hunter/gatherer origin. However, I am certain that substantial evidence is required to explain our traits and behaviours. To associate a trait with biological/genetic factors or with social institutions, such as norms and cultures, is a difficult and painstaking task. Even explaining a biological trait solely based on a hunter/gatherer origin requires hard evidence that rejects such behaviour among other species, which do not live as hunter/gatherers.

The be fair, most of the book’s arguments are not based on the hunter/gatherer origin. Even during the small part of the book that he uses this origin, it does not play a significant role in the argument. My argument here is that the book would have fared better without bringing this origin into play.

Conclusion

In Understanding the Process of Economic Change, North demonstrates the complexities involved in the economic analysis and warns against simplistic or reductionist approaches to economic change. He maintains that it is unlikely to construct a general dynamic theory of economic change (p. 125-6).

To confront novel situations most effectively, North proposes the maintenance of institutions that permit trial and error. Moreover, he suggests that individualistic behavioural beliefs and the lack of large-scale political and economic order promote economic growth, particularly in the West. However, he warns that ‘the institutions that have emerged in the Western world, such as property rights and judicial systems, do not have to be faithfully copied in developing countries’ (p. 159).

Throughout history, according to North, failures, stagnation, and decline have been far more frequent than successes and prosperities. ‘Economic growth has been the exception’. Nonetheless, he proposes four key requirements to improve economic performance

  • A Clear understanding of the institutional and organisational origins of poor performance, for example by tracing transaction costs.
  • Clear understating of the institutional framework
  • Integrate the dispersed knowledge to improve performance.
  • A viable polity to establish and enforce necessary institutions·       

 

References

 

Dow, SC (2012), Foundations for new economic thinking: a collection of essays, London, Palgrave Macmillan UK.

 

Heiner, RA (1983), ‘The Origin of Predictable Behavior’, American Economic Review, vol. 83, pp. 560-595.

 

North, DC (2005), Understanding the process of economic change, New Jersey, Princeton University Press.

 

Robinson, WI (2002), ‘Capitalist globalization and the transnationalization of the state ‘, In Rupert, M & Smith, H (eds), Historical materialism and globalization, London, Routledge, pp. 210-221.

 

Notes

[i] This categorization is somehow reminiscent of and not entirely unrelated to the division between Babylonian and Cartesian/Euclidean modes of thought and their approach to uncertainty. In Babylonian thought, it is impossible to acquire full knowledge. Thus, information cannot be categorised into known or unknown. In Cartesian/Euclidean thought, knowledge is treated dualistically. It acknowledges risk in the sense that knowledge might be subject to the probability distribution. That distribution, however, is either known or unknown. This mode of thought excludes uncertain knowledge from theoretical systems (Dow 2012: 60).