Understanding the Process of Economic Change (review)

Viewing recent economic history, no one can doubt that changing institutions to allow economic growth is “hard, really hard!” This latest work by Professor North attempts to explain just why it is so hard. Part I, “The Issues Involved in Understanding Economic Growth,” lays the basis for understanding why, once humans have created institutions and embedded them within a cultural belief system, they are so difficult to change, even when they become economically dysfunctional. Part II, “The Road Ahead,” surveys specific examples of the difficulties encountered in making the institutional changes necessary to achieve economic growth. Chastened, perhaps, by recent economic history but also by his conclusions in Part I, North concludes with an agenda for future research, rather than specific policy prescriptions. All business and economic historians will find a place for our work within North's agenda.

Drawing upon work by evolutionary psychologists, North argues that people try to reduce uncertainty mainly by devising simple rules to apply in the face of each economic challenge. The resulting human “intentionality” creates informal institutions, culturally accepted ways of coping with the vicissitudes of economic life. Eventually, informal institutions and their decisions are reinforced by formal institutions, which define economic privileges that the governing classes enforce. Both the informal and formal institutions can vary wildly, depending on the cultural conditioning of both populace and rulers, but both sets of institutions have to demonstrate adaptive efficiency in the face of surprise shocks if economic growth is to continue.

North then notes the findings of evolutionary psychologists that human cognition and belief systems are mutually reinforcing, leading to cultures that sustain a given set of formal and informal institutions. Evolutionary psychologists, however, are continually confounded by the dysfunctional responses humans often make to instances of “cognitive dissonance” when things do not work out the way we believe they should.

On the other hand, the results of the “Ultimatum Game”, constructed by experimental economists to test if the assumption of rational, income-maximizing behavior basic to most economic models, is valid in practice shows that most humans, regardless of their cultural setting or economic experience, will try out cooperative strategies when confronted with a new situation. The Ultimatum Game gives one player control over a sum of money, but to keep it, she or he has to offer to share some of it with a second player. The second player, in turn, must accept the offer or the entire sum is lost to both. Alas, for basic economic theory, the vast majority of first players offer close to a 50–50 split and only then does the second player accept.

When several experimental economists tried out the Ultimatum Game with players from a wide range of pre-modern societies in remote regions of Africa, the South Seas, and South America, they found again that players rejected the canonical model of economists. However, the basis of rejection varied and depended largely upon whether the tribes playing the game had either experience with payoffs to cooperation, as in whale hunting, or with market integration, as in offering labor for wages. The less the cultural conditioning for the players on either dimension, the less likely they were to reject the canonical model of economists.

Part I concludes by reiterating the complexity of interplay of beliefs, institutions, implicit incentives, and political systems for enforcing the formal and informal rules that make it so difficult to displace dysfunctional institutions with more effective alternatives.

Part II, “The Road Ahead,” begins with an overview of how we arrived at the current impasse with reprises of North's themes of the importance of institutional changes that reduce transactions costs, but with emphasis on the divergent paths followed by different societies. North acknowledges that both consensual political systems (Switzerland) and authoritarian rules (Singapore) create political order that is necessary for economic growth. However, disorder will emerge inevitably in either case so it is critical that the interplay of beliefs, institutions, and...