All Commentary
Thursday, July 8, 2010

Understanding the Process of Economic Change

New Institutional Economics Explains Interactions Between Man and Social Institutions

In the late 1980s, as the Soviet empire began to collapse in central Europe, a burning policy issue emerged: how to transform socialist economies into functioning market-oriented societies. As this discussion developed, it was astounding to discover how little the economics profession was able to contribute. For example, at an annual meeting of the American Economic Association, a number of prominent economists admitted they had no idea how to create the institutional order needed to establish a market economy.

In the first half of the twentieth century, a growing number of economists became increasingly interested in trying to make economics “rigorously scientific.” In their eyes this required quantitative model-building, in which men and their actions were reduced to “dependent variables” in a series of mathematical equations. The individual became a mere passive “reactor” to various “constraints” in the arena of exchange. The surrounding political, legal, and economic institutions were simply the analytical “background” for people’s constraint-determining choices. How these institutions emerge and evolve, and how men’s ideas and actions might influence and change these institutions over time, were almost never discussed.

Over the last 30 years, however, there has slowly developed a field called the New Institutional Economics, which focuses precisely on the interaction between man and social institutions. One of the path-breaking contributors in this field has been Douglass C. North, the 1993 recipient of the Nobel Prize in economics for his writings on American and European economic history. In his recent book, Understanding the Process of Economic Change, North explains the importance of institutions for improving the human condition, and the difficulties in developing theories and policies for bettering society.

North’s starting point is to emphasize the inherent uncertainty and unpredictability of the world in which man lives, a condition that precludes the application of the type of static and deterministic mathematical models that dominate most economics textbooks. The “scientific method” has worked wonders in enabling man to master the laws of the physical world, but it has inherent shortcomings when applied indiscriminately to the human condition.

Man possesses qualities that are uniquely distinct from the objects of study in physics and chemistry: intentionality and creativity. Man thinks, imagines, and plans. This introduces an element of unpredictability not present in the study of inanimate nature. Nor is human action open to stable statistical probability.

Adapting some themes from cognitive psychology, North argues that man is less a logical problem-solver and more a reasoning pattern-discoverer. In other words, the human mind seems to have evolved in such a way that it looks for order and relationships among things and events, even when they may not be there. As a result, man mentally searches for patterns and relationships in the world in order to attain both intelligibility and a degree of predictable certainty.

This is the origin of man’s systems of beliefs and ideas about “how things work,” from primitive superstitions to the most complex theories about the nature and functioning of the social order. These belief systems become intergenerationally transmitted and solidified in customs, traditions, and the other cultural institutions. Thus the institutional order is the cumulative result of generations of interacting minds.

The rules that men live by, North argues, have been generated by man’s quest for reductions in social uncertainty. By constraining his own actions and those of others in his community through norms, values, and interactive procedures that define and determine the codes of conduct, as well as the rationales for legitimacy and obedience, man superimposes degrees of predictability on social and economic processes.

Some of these institutional rules and procedures are formally designed through legal and political codification. But a great many, if not the larger number of them, are informal rules that are learned through being born into and living in a particular society and that are often not fully articulated.

The great transformation in human societal evolution, North explains, occurred when exchange relationships changed from the personal to the impersonal: from the small tribe with its face-to-face relationships to the extended market in which men separated by time and space, and unrelated to each other, became increasingly interconnected through money transactions.

Beliefs and ideas about what was fair, just, and right began to evolve in ways that made possible the development over the centuries of the institutions of modern market economies. North summarizes a number of these historical shifts in Western Europe, especially in banking, bills of exchange, and commercial contracts, which set the stage for the beginning of economic growth and rising prosperity in the Western world during the last five centuries. Greater respect for private property, acceptance of open and relatively unrestricted market competition, more individual liberty under the impartial rule of law, and limits on the regulatory and taxing power of governments liberated the creative energies of men in general and entrepreneurs in particular.

North also shows the inherent rigidities and potential corruption that arise when wrong beliefs and ideas generate institutions that place increased power in the hands of government—whether in its extreme form in, say, the Soviet Union, or in the milder, but no-less-damaging, form of the modern interventionist welfare state.

The dilemma, North argues, is that the right “lessons” are not always learned from these historical experiences. As he puts it, there is often too much “noise” in the historical processes; it is not always clear which causes (institutional and policy changes) have led to which effects (changes in economic well-being, including degrees of freedom). Furthermore, much of the information and interpretation about institutional and policy changes come to us through intellectual and political intermediaries who have their own agendas and misunderstandings about the actual societal processes at work.

The real danger from all this, North warns, is not only that many countries which have never developed the right market-oriented institutions may fail to do so. It is also that freedom and prosperity are not forever guaranteed in any society. In other words, even successful societies can regress and decay, sinking back into economic stagnation and political tyranny, due to the rise of beliefs and ideas that bring about wrong institutional change. North’s hope is that the New Institutional Economics can assist us in seeing that this does not happen and can be used to reverse some of the bad policies already in place.

  • Richard M. Ebeling is BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel in Charleston, South Carolina. He was president of the Foundation for Economic Education (FEE) from 2003 to 2008.