Book Review – Understanding the Process of Economic Change (2005) by Douglass North
Review By:
Arif Jinha
Master’s in Globalization and International Development
MDG 5123 - Global Economic Issues
North, Douglas (2005). Understanding the Process of Economic Change. Princeton: Princeton University Press.
In his 2005 book Understanding the Process of Economic Change, Nobel laureate Douglass North is in search of a deeper understanding of the dynamics of economic development, drawing on a historical analysis of success and failure of economic systems and an examination of the role of human consciousness. He explains that neo-classical theory from which our dominant economic paradigm is constructed, is a static theory not designed with the purpose of explaining the process of change. North believes that the understanding sought will enable us to better model the institutions that predict performance to avoid the failures humanity has endured and to reduce misery and abject poverty. North is the dean of the New Institutional Economics (NIE) school which attempts to understand economic performance as a function of the incentive structure provided by our institutions. This is seen by North to be insufficient, however, given the persistence of institutional structures that incentivize stagnation. The work of this book is meant to be an extension to further deepen our understanding on the subject.
North is in search of a real understanding of how humans erect structures to deal with an ever-changing reality, structures such as neo-classical economics itself. He theorizes that humans develop cultural understandings that evolve over generations, and that the evolution of economics is based essentially upon human intentionality with a strong drive reduce uncertainty. Uncertainty, however, can only be reduced, not eliminated. The reduction of uncertainty depends upon the stock of knowledge, but a society’s level of knowledge always leaves some residual uncertainty. North posits that humans have a universal underlying inference structure and yet an immense variation in performance of economies that reveals the importance of how that inference structure translates through culture into the successful and unsuccessful structures that humans erect.
The underlying inference structure often deals with residual uncertainty through non-rational beliefs such as religion, dogma, superstition etc. and that humans have a universal orientation to these. The rationality assumption central to classical economics is seen to be limited by this function of our consciousness. Beliefs, whether rational or non-rational, shape institutions which shape organizations’ policies which shape outcomes. Institutions are defined as the set of formal and informal rules that humans erect based on evolutionary cultural experience, and are distinguished from organizations and not confined to them.
North draws on an analysis of economic performance in history to compare successful and unsuccessful economies and societies, seeing success as linked to ‘getting it right or getting it wrong’ in terms of the scaffolds we erect – our institutions. Path dependence is a critical concern for North. Our current scaffolds are based on conditions that existed when they were erected. Since conditions change with novel situations, they may not necessarily apply the same way to new conditions. Adaptive efficiency is the degree to institutions can adapt to change by allowing for trial and error and risk and being open to change based on new knowledge. Institutions discriminate in their responsiveness to various actors, and some political and economic entrepreneurs may have more influence on institutions. They can be held rigid by vested interests created under incentives meant to deal with past situations.
North explores theory from cognitive science informed by socio-biology, evolutionary psychology and philosophy of mind to go to the root of human intentionality in consciousness. In our history, the evolution of greater motor control allowed us to form speech, advancing us from the limited expression of apes – the meme epoch. As speech became symbolic, we gained shared narrative and moved forward to the mythic epoch. As we were able to create generalizations from symbols, we moved to the ‘theoretic’ stage. We could gain mastery over the physical environment. North suggests that reduction in uncertainty in the physical environment increased complexity in the human environment. North reports on the genetic theories that govern innate behaviour that is cultural, but that create an underlying inference structure which interacts with the environment to create mental representations in a brain-world reaction. Thus, the unit of analysis for understanding individual choice includes the social and material environment. North supports the view that both computational and connectionist models represent mental function. Connectionism allows for the more sophisticated decision-making distinguishing humans from computers by modeling neural networks similar to the brain’s hardware and allowing for pattern recognition and heuristics. From this brain-mind-world interaction we begin to erect a set of rules to reduce the uncertainty in the human environment – this is culture. An individual in the theoretic epoch enters the world with the inference structure to reduce uncertainty, learns from a social and material environment through incentives, and creates and revises mental symbolic representations of reality that can be shared both personally and formally towards institutions. Depending on the sophistication of cultural learning through centuries of development, these institutions will be more or less successful and adaptive in generating successful economic performance.
The core argument
People form beliefs, and humans create their institutions on the basis of these beliefs. These shape organizations’ policies which shape outcomes in economic performance. Outcomes bring us full circle to shape the environment – the ‘world’ from which brain and mind interact to form beliefs. The relationships are clearly not completely linear nor circular (organizations influence institutions, policies influence organizations etc.), but nor is it a chicken or the egg situation. North sees institutions as the critical determinant of economic performance through the shaping of organizations (such as governments, universities, corporations, unions etc.) and beliefs as the critical determinant of institutions. Intentionality is what separates the evolutionary argument of culture from the biological evolution of species (Darwinian evolution), and steers us away from a mechanistic view of how our man-made structures come to be formed.
Extensions of the core argument
Where institutions are failing due to path dependence, human intentionality through political and economic entrepreneurs can change institutions to adapt. However, imperfect information, erroneous beliefs, the interference of non-rational beliefs and power structures vested by the current institutions can produce unsuccessful outcomes. North identifies three important factors governing how humans shape institutions – the demographic characteristics of society, the stock of knowledge that a society can rely on, and the deliberate incentive structure as defined by the nature of institutions. These interact dynamically, however, institutional structure is seen as central, and can shape the demography and the stock of knowledge.
North sees some quite specific features of institutions that contribute to successful economic performance. He draws on game theory to demonstrate the functioning of cooperative and non-cooperative markets. Non-cooperative markets are seen to function better as exchange moves from personal to impersonal and as the scale of the market increases. He also draws on a historical example of the differences between Jewish traders operating under the Islamic system of mutually enforced cooperation and Genoese traders operating under a system of formal constraints, incentives and enforcement. There are other examples as well, where North discusses the difficulties with personal exchange. The impersonal, competitive, incentive-based system is seen to lower transaction costs and increase productivity. In order to have a regular system like this, property-rights and personal rights must be protected and enforced. If rights and privileges are up for grabs, clearly no clear incentives exist for production and trade. So, the first principle of North’s ideal economy has an institutional matrix that produces a set of organizations and establishes rights and privileges. The second is to have a stable structure of exchange in political and economic markets. Third is an underlying structure that commits state to set of rules and enforcement that protects organizations and exchange relationships. Fourth is conformity to the regime through some mixture of norm internalization and coercive enforcement
Contextual arguments
North devotes a chapter each to a discussion on the Rise of the Western World and another on the Rise and Fall of the Soviet Union. In the chapter prior to this, he compares the United States with Latin America. He also compares consensual polities with authoritarian regimes. The rise of institutions that created regularized property rights is seen to have created the productive efficiency of the West, while fair participation of organizations (civil society, universities, unions, political parties), democracy, incentives for increasing the stock of knowledge and the rise of science contributed to its adaptive efficiency. The cultural memory of British institutions in America after independence was seen as critical to the American success, along with a striking limitation on government’s interference in markets. North rejects, however, the libertarian position seeing laissez-faire as a type of illusion that incentivized Enron and other irresponsible market players at the start of this millennium. Clearly, North sees a role for government in managing the incentive structure by providing impersonal and stable exchange in political and economic markets. North also cites non-market developments as critical to America’s success in human development as measured by the Human Development Index, specifically public health.
Though North insists that the difficulties with neo-classical economics is that it is static, he has not nor does he feel it is possible to create, at least presently, a general dynamic model but we can do more to understand the dynamics. He insists that much more needs to be known about cognitive science to understand human consciousness and therefore behaviour that shapes institutions. Mostly, he seems puzzled by the poor performance of developing countries. He provides a history of Latin America, citing the differences in the colonial regimes as compared with the U.S. The institutional memory left over from the Spanish crown led to struggles over resources and power, and a long history of fighting between groups. In looking at Sub-Saharan Africa, little history is provided. There is only a comparison with the collectivist agriculture culture as compared to a more property-rights oriented culture in Asia which was seen to be more successful.
Critique
Methodological bias
The problems of development are dealt with fairly poorly in a book which aims to develop an understanding giving us greater capability to reduce the abject poverty and misery largely visited upon developing countries. It is a highly theoretical work that doesn’t grapple deeply with human experience, despite the focus on beliefs, culture and consciousness. Much of what North writes owes a great deal to ideas given to us from philosophy of mind and cognitive science. Psychology has diverse traditions, of which the philosophy of mind/cognitive science school has brought fascinating ideas such as the Turing machine and Artificial Intelligence – ideas which are highly abstract and theoretical, developed through a rational mathematical modeling approach where empirical methods are used to test models. On the other pole you have grounded empirical and experiential approaches to both consciousness and behaviour where empirical methods develop theory from data, and of course there are approaches that fall somewhere in between. As an economist exploring philosophy and psychology, North has chosen the top-down theory-driven abstract dimension in psychology to support his theory of consciousness and game theory for experimental support for his institutional matrix. The weakness of all these approaches lies in the limited external validity from which we can draw generalizations about the real world. From the other direction, Daniel Kahneman is a psychologist who has been tackling economics for several years with the help of Alan Krueger, an economist. The two have developed the U-index, which provides an empirical measure of the presence of misery itself and the possibility of comparison across countries (Kahneman and Krueger, 2006). Such evidence may inform our examination of institutions and challenge our beliefs about the performance of economies in relation to well-being. As someone who graduated with a psychology degree after two years of studying philosophy as well, I look forward to the integration of various theoretical and grounded approaches to the psychological dimension of economics, which has long been treated rather crudely.
There is discussion of poor performance owing to faults in the institutional matrix contributing to the breakdown of expectations through corruption and clientelism, with personal exchange undermining predictability required for people to engage productively in the larger, and now global markets, which are impersonal. Much of this is to be commended for its explanatory power, but what is lacking is some reflection and critical analysis about whether the author’s own beliefs about the core determinants of ‘getting it right and getting it wrong’ are well-supported by the historical evidence. Are we at risk of erecting yet more scaffolding based on a cursory understanding of economic and political history?
Reflexivity toward beliefs
One of the achingly annoying aspects of philosophy is the constant reflexive doubting of one’s assumptions and conclusions, the most irritating example being Descartes Meditations. As annoying as this process is, it seems necessary for some reflection and testing of one’s own positions with alternative explanations to occur in a book which is attempting to get to the roots of consciousness and beliefs that shape institutions. It is not simply good enough to take the consequent effects, such as the success of the United States or the lack of success in Africa as evidence for the role of the antecedents. If we assume the truth of the relationship of beliefs through to outcomes of comparative success in economic performance, North’s argument appears to be as follows:
A: the West is successful compared to others.
B: The beliefs of the West developed differently than others.
C: The others beliefs are related to their lack of comparative success.
Yet, this assumes that the various regions in the world developed on the basis of their own comparative beliefs, but one could argue that in actual fact the beliefs of one group or person about another group or person can shape their outcomes, particularly if the others beliefs have a greater effect on the structures which condition success than their own and of course this is an issue of relative power. This is well-documented in psychology and supported by history. An alternative explanation may be:
A: the West is successful compared to others.
B: the West had beliefs that shaped the outcomes of the others.
C: the beliefs of the West influenced the relative success of the others.
Both explanations are consistent with the relationship of beliefs, institutions, organizations, policies and outcomes. If we remember that at the same time that the West was rising, nearly all the rest of world was colonized by the West, suggesting some evidence for the second explanation that should at least be explored. Colonialism is not mentioned in the book. Another question is whether the extent to which the problematic is in the interaction, in wars and conquest and the winners and losers. The argue the consequent would be to suggest beliefs that lead to military conquest over others relate to successful economic outcomes – ‘might is getting it right’. This is not the argument North wants to make and the model does not deal with interactions between societies. North never mentions the dark side to the belief systems that existed in the West toward other societies, non-rational beliefs that informed the West’s approach to these societies over centuries of development, which is a length of time very relevant to North’s argument. North would do well to examine how our belief systems erect scaffolding such as racist colonialism which in turns shapes the society who is the object of our mental representations and outcomes such as slavery which had centuries long impact. Too many stones are left unturned as far as beliefs – institutions – policies – outcomes, chiefly by ignoring interaction.
The mantra of this book is that beliefs shape institutions which foster organizations which create policies which shape outcomes. However, this logic can be applied to reach different conclusions when other historical factors are selected for study and alternative explanations are considered for the fall or stagnation of civilizations. African under-development is attributed the outcomes of African collectivist beliefs by North. In the introductory section, North states that the Muslim world today faces many difficulties and is very different from the West, suggesting an explanation to come. Yet in that explanation, he speaks only of the divergence the divergence in economic approach displayed by the Genoese and Jewish Islamic traders, and no other explanation is suggested for the Rise of the West and the decline of the Islamic world. Islamic history of that period however, tends to trace the end of highly successful pluralist societies that were making great strides in scientific, economic and intellectual development largely to the Mongol invasions. These invasions, along with the wars against the Crusaders, not left the political states in ruin, but destroyed libraries and ended patronage of arts and science, advances in medicine, and the social systems. We have no way of knowing whether a) the Islamic trading system would have continued to succeed or b) the states adaptive efficiency would have created new and improved systems of trade. The beliefs had little to do with it since the institutions were destroyed, we cannot draw any comparative conclusions here. To add to this, were in not for the non-rational aggression based on beliefs that led to the invasions, who is to say that the cooperation of Jewish and Muslim and Christian would not be more prevalent and well-known today than the antipathies that exist that detract from the success of the West and the Middle East.
Today’s situation may require institutions of the form that North suggests, but if the comparisons of success and lack of success are erroneous, than our beliefs may be erroneous – in regard our own institutions, but especially where our own institutions’ shape policies directed towards development in the South. This reflexivity is absent from North’s analysis. In the discussion of non-market development for instance, North admits that the most significant factor for the American ranking on the HDI was public health investment. If we want to explain stagnation in Africa today, in large measure the scourge of HIV/AIDS, preventable infectious water-borne diseases, malaria, tuberculosis and the so-called ‘neglected diseases’ can all be traced to the lack of public health infrastructure, whose underdevelopment can certainly be traced to austerity measures, which are traced to beliefs held by IMF economists, rather than those held by local cultures. The IMF is frequently surprised that people do not react as expected to prescriptions that work in theory, perhaps because they ignore the interactive component. Drawing on a positivist heritage, they are unsure how to incorporate the role of the observer in the analysis, or in the case of economics, the dynamics of their influence on what is influenced.
North’s primary historical reference for ‘getting it right’ is Britain and his primary current reference is the United States. In both cases and at both times, these countries were the most powerful in the world, meaning they exerted enormous influence through their beliefs about the rest of the world, on the rest of the world. Further, it is not simply the institutional matrix explained by North that can explain success. North could discuss, for instance, the contribution of the labour movement to the HDI in the West. The United States as a reference point for success on the HDI, however it is not the most successful country on this index despite being the wealthiest. Scandinavian countries had a strong influence on the labour movement’s achievements in the United States. We do not know where the U.S. might rank without this influence. Scandinavian countries have long occupied the highest ranks on the HDI. Their institutions represent a variance in the institutional matrix that is arguably more successful, perhaps owing to the emphasis of a balance of property rights with a strong public commons – the so-called mixed economies. In international development, it can be argued as well that these nations are not only the most generous contributors of aid, but are also the less problematic in their influence on developing countries. The United States has often found it difficult to escape religious dogma finding its way into disastrous consequences for the developing world as with the Mexico City Policy. Further, in 2008, the United States becomes an even more troubling example of success, with a dire economic situation at home, a $9 trillion dollar debt largely spent on a war started under erroneous beliefs.
North has provided a compelling new looking-glass on the dynamics of human consciousness, institutions and economics, but a more complete picture can only be arrived through charitable criticism from diverse sources of what North has accomplished to date.
References
Kahbeman D, Krueger, A. 2006. Developments in the Measurement of Subjective Well-Being. Journal of Economic Perspectives; 20 (1):3-24.
