The recent publication of Gregory Clark’s A Farewell to Alms has helped to reignite the lively debate concerning economic development as a means to understanding why some countries grow rich while others stagnate. More specifically, this whole area of research is attempting to discover why the Industrial Revolution first took hold in England and later in the rest of Western Europe and not in other places around the globe. Indeed, the question of societal prosperity and its dispersion across countries and across time is one of the most important questions facing economics as a discipline.
Superficially, many of us think that the path to progress is a fairly simple matter of encouraging developing nations to adopt the capitalist reforms that have long been a central feature of the developed nations of the West. This mindset has been readily internalized by international lending organizations such as the IMF and the World Bank which have made loans to poor nations dependent upon progress on such matters as fiscal and monetary policy, the legal system, international trade, and political representation. The depressing thing about such matters has been our lack of success in raising the living standards of these nations, even after such reforms have been implemented. Such poor outcomes have led many people to investigate other factors which may be integral to successful economic development. The number of answers which have been proffered to remedy this lack of knowledge have been quite numerous.
Jared Diamond, in his top selling book Guns, Germs, and Steel, helped to spark this renewed interest in alternative theories of sustained economic growth. Diamond sees growth as a story of geography, climate, and environment. Clark, meanwhile, has suggested that the quality of labor, developed by a process of slow biological evolution in British society towards citizens who value bourgeois values such as hard work and thrift, explain their rise as an economic power. Meanwhile, others has suggested plausible theories of their own, such as the adoption of new technologies, the growth of science and the scientific method, or capital accumulation.
Yet another great economist, Douglass North, has produced his own theory as to why the West grew rich. For him, the story of development is a story of institutions. Institutions, broadly interpreted, define the ways in which individuals and organizations interact with each other in society. They are the “rules of the game,” as North is famous for saying. A country can not expect sustainable, long-term economic growth unless the proper institutional structure has been put in place to promote such growth. This is a much broader concept than just a few, hodgepodge economic reforms to bring societies closer to some capitalist ideal. Instead, institutional reforms must cover all facets of society, whether it be economic, political, military, religious, or educational. And for North, the three required conditions which any society must develop to even consider the possibility of sustainable economic growth are the rule of law for the elite members of society, perpetually-lived organizations those same elites, and political control of the military.
At first, it might seem curious to define the rule of law and creation of perpetually-lived organizations for elite members of society only as a necessary precondition for development. We would think that such developments would need to be applied in a broad-based manner to all members of society in order to be effective as a means to encourage exchange and trade. However, the reason for this dichotomy comes from the distinction North makes between developing and developed societies.
Economic history has demonstrated that societies have traditionally evolved in fairly predictable ways. This evolution has three distinct stages, referred to by North as orders: primitive orders, limited-access orders, and open-access orders. Primitive orders are the original hunter-gather societies of early human existence with just the most rudimentary forms of exchange and specialization. The first great development in social organization is the rise of limited-access orders, or natural states as North is fond of calling them, about 10,000 years ago.
Natural states are able to reign in the constant violence of the previous age by implementing a more powerful government composed of elite members of the society in question. This governing coalition is held together through the granting of special privileges which these states confer upon its elite supporters. For instance, the governing authority may give a certain member within its coalition monopoly rights over the production or trading of some resource such as cotton, tobacco, fish, etc. As such, only the elite members of society have the right to establish organizations to exploit these artificial opportunities. These privileges provide substantial rents for those in possession of them, thereby assuring that the interests of the elites coincide with the furthered existence of the government in power.
Indeed, the key benefit of the rise of natural states is their ability to bring a semblance of peace to what is otherwise a violent social order. This stability provides the opportunity for the elite members of this society to extend the degree of specialization and the division of labor within their respective organizations. By doing so, they are better able to take advantage of their special privileges from the government and increase their profits. These developments are also advantageous to the non-elite members of this society as they are less likely to be called into combat and can therefore enjoy the fruits of a more peaceful society.
Unfortunately, the key features of a natural state which provide the above benefits also highlight their most significant limitations. Government-granted monopolies will produce their goods at a sub-optimal quantity and will charge elevated prices when compared to a perfectly competitive equilibrium. Thus the standards of living for the citizens of this society, though higher than that under a primitive order, will still be much lower than they otherwise could be. The truly unfortunately thing about this relationship, however, is the fact that these arrangements are extremely difficult to overcome. That is to say, transitioning from a limited-access order to an open-access order (the key to modern economic growth) is a rare occurrence in human economic history.
This is because the arrangements which produce the natural state create a sort of political-economic equilibrium through its mutually compatible incentive structure. The elites depend upon the state for its economic success while the state depends upon the elites for its very existence. No one within this governing coalition seemingly has a reason to change the status quo, explaining the dogged persistence of natural states as a social order.
The key to understanding how an improbable transition from the natural state to an open-access order can occur is to understand the fundamental nature of a natural state. A successful natural state must strictly limit access to the governing coalition in order to produce enough rents for each elite member so that the benefits of maintaining support for the state is greater than the benefits of retracting such support. If too many people enter the governing coalition, the profits to each individual member may subside to the point where the coalition breaks down and the government is no longer able to survive.
Alternatively, the key feature of an open-access order, as it name would suggest, is the free access to organizational structures by all members of society. Thus, the key to a successful transition to sustained economic prosperity depends upon the ability of an increasing number of citizens to establish and to enter organizations to compete with those organizations which were previously the purview of the few elite members of the governing coalition…and to do so in such a way that the natural state does not regress back towards anarchy in the meantime.
It is important to note that this is not a deliberate process undertaken by the governing coalition to expand access to its own institutions. The elite accrue significant benefits with respect to their relationship with the state and they have no intention of letting go of these privileges. Thus, any changes to the institutional relationship between the elite members of the governing coalition which bring us closer to an open-access order must be perceived to be in their own best interest but which ultimately serve to undermine the very arrangements they had intended to solidify. The question remains as to what institutional reforms the state would undertake that would spur these unintended consequences.
This brings us back to the three “doorstep” conditions which we mentioned at the beginning of the essay. The first of these institutional reforms which North had in mind as an impetus to progress towards an open-access order was the rule of law for the elite members of a society. Over time, members of the governing coalition will repeatedly interact with each other on a number of issues with respect to state policy and their personal organizations. These interactions lead to the informal establishment of appropriate behaviors and norms between the participants of the governing coalition. The state could have a desire to codify these mores into a more formal legal structure as a way to effectively adjudicate disputes between members and to better run the state apparatus. The elites, meanwhile, are able to easily understand and interpret the rules by which they must play in order to participate in the governing coalition.
The second condition, the creation of perpetual organizational forms, allows the various elite organizations to cooperate with one another with greater confidence. When organizations can not be legally separated from the constituent members of that organization, credible commitment problems can result as the future heads of elite organizations may not feel under any obligation to honor the agreements of their predecessors. This can hamper the amount of exchange which takes place between the elite organizations as there is always the risk of one side reneging on their obligations. Perpetual organizations are able to sidestep this problem by making the organization legally separate from the people which run it. That is to say, these organizations exist as an entity all their own, legally bound to honor all the commitments which have been made under its moniker.
The last condition is the creation of a military which is subservient to the political establishment. A major problem of natural states is that the military resources of a country are often dispersed among many of the members of the governing elite. This is a defensive mechanism so that no individual or group within the governing coalition becomes so powerful as to gain the ability to overthrow the existing order in favor of a new one with themselves at the lead. However, this can also escalate the probability of eventual conflict between groups within the governing coalition, something which could undermine the entire social structure to the detriment of everyone involved. At a minimum, the wide dispersion of military capabilities leads to a less stable environment in which to produce and exchange.
This third condition is a particularly difficult one for natural states to adopt as there is no incentive for any individual group within the governing coalition to give up whatever military resources they have at their command. To voluntarily relinquish control of their military component simply leaves them vulnerable to the predations of the other members of the governing coalition. The natural state is seemingly stuck in an unforgiving game of prisoner’s dilemma, leading to a sub-optimal outcome from a social perspective.
And even if a separate military organization independent of the elites could be formed, there is no assurance that this military apparatus would remain under their political control. Concentrating the military resources of a nation within a single organization poses a significant risk to the governing coalition as this new establishment could conceivably overthrow their former supporters. In order for a viable military organization to be established, there must exist clear rules of conduct concerning the use of violence and powerful non-military organization with the clout to punish transgressions by the military.
The effect of all three of these reforms, which build upon one another in succession, leads to the possibility of inducing a transition to an open-access order and the sustained economic growth it entails. The reason for this is explained by the effects these conditions have on the social dynamics of those involved in the governing coalition. Essentially, the implementation of the above three institutional reforms reduce the necessity for elites to have personal connections with those they exchange with in the coalition. Recall that the natural state exists by severely limiting the number of participants to the few, select elite members of that society. It is fundamentally a group connected through its interpersonal relations. This familiarity is used to ensure members of the coalition that it is indeed relatively safe to transact within this select group.
But with the establishment of the rule of law, long-lived organizational forms, and a military hierarchy under the command of the political authority, impersonal exchange become a more viable means of transacting business through a drastic reduction in the transaction costs of such activities. This greatly expands the possibilities for trade as an organization is no longer bound to interact only with other familiar elites within the governing coalition. And with this greater trade comes greater specialization and a more advanced division of labor, bringing such a society ever closer to the threshold point after which sustained economic development is at hand.
The key, however, is understanding how these developments lead to greater access to organizational forms for the non-elites of a society. Even with the benefits of impersonal exchange, the elites must counterbalance such rewards with the loss of rents that would occur if they were to embrace the more open social order. North suggests several explanations, which he calls transition mechanisms, that would induce the elites to adopt open access. Among these reasons are the fiscal benefits to the state to increased trade, regulatory changes favorable to greater competition, incremental improvements in citizen representation in government, or international competition based on a nation’s relative strength compared to its neighbors.
This is a slow, incremental process as small changes in the institutional structure come to sustain themselves and even to encourage further reforms. It can be better described as an evolutionary process than a revolutionary one. The truly interesting thing about this development is how the open-access order readily adopts many of the institutions of the natural state by tweaking them in order to accommodate the new social order. This strikes at the heart of the last major point North is trying to make in his work: the way institutions manifest themselves between the two more developed social orders can differ wildly, even if the institutions themselves remain essentially unchanged!
For instance, North describes how elections in natural states, in the absence of any political competition, bare little resemblance to elections in developed societies with viable alternative organizations competing for power. And yet, the electoral institution established in natural states can be readily tweaked to accommodate greater access. In short, North adroitly notes that free elections are much more likely to take hold when an electoral process – free or otherwise – has already been institutionalized in that society.
A similar process occurred with another organizational from which was established in Renaissance and Enlightenment Europe: the corporation. These organizations were originally formed to take advantage of the monopoly privileges granted to it by the state. However, these organizations evolved over time as the state allowed more and more people to take advantage of its special characteristics. Thus, open access transformed an institution designed to limit trade to one that has become the defining feature of our modern free market economy.
North provides a very compelling view of how societies evolve over time and how modern economic growth can come about within this context. His solution is quite simple in theory but its practical application is very difficult to achieve: the implementation of institutions which promote, not hinder, access to organizational forms. Other conceivable explanations for economic growth do not convince North, who sees factors such as geography, climate, culture, and technology as things which can influence the type of institutions which come about but do not directly promote progress. But the specific institutions which do develop, as influence by those above factors among others, are not nearly as important as the ultimate results of such institutions – their effects on open access. Given that a society has developed an open-access political system, for instance, the actual manifestation of that system, whether it be parliamentary or American-style democracy, takes on much less significance at least with respect to economic development. It is the flexible, adaptable nature of this model to different societal contexts which is one of its most appealing features.
A greater description concerning the origins of the state itself would have been useful, especially given the way North eschews several fundamental assumptions about the existence of a state. For instance, he flatly rejects the idea, pretty commonly accepted by most academics studying the state, that governments enjoy a monopoly on violence within a certain geographic region. He does this since natural states are not a single, united entity but rather an amalgam of many diverse members, each of whom have the capabilities to maintain a military presence. He also denies that the ultimate objective of a state is to maximize its own tax revenue, but rather it is to simply survive. This last assumption does, however, help give North a ready explanation as to why most states utterly fail to usher in an era of sustained economic growth: it simply isn’t their main concern! States are willing to sacrifice this goal in order to assure their own survival within the social order.
But given North’s preoccupation with the origins of economic growth, it is not at all surprising that he spends most of his time attempting to understand the transition between natural states and open-access orders and not between natural states and primitive orders. The transition process to an open-access order is an eminently interesting one, given the self-sustaining tendencies of natural states. But there does seem to be a few loose ends ripe for clarification concerning this process in which so many factors must come together in the right way at the right time to reach that threshold of economic development.
Probably the most notable of these is his admission that the three doorstep conditions are necessary, but not sufficient, to bring a natural state into an open-access order. Even a society that somehow is able to implement all of these difficult institutional reforms is not guaranteed an advancement of their social order. The doorstep conditions, instead, only provide for the possibility of impersonal exchange among the elite members of the coalition. The advancement of an open-access society will not commence until doorstep conditions are combined with mechanisms allowing for increased access to these institutional reforms.
Unfortunately, these transition mechanisms, the benefits to the elite for allowing expanded access to their exclusive organizational forms, leave something to be desired. As briefly described earlier, the four main avenues of encouraging more open access were fiscal, regulatory, representational, and international impetuses. Superficially, the fiscal mechanism has the most plausibility. Greater impersonal exchange allows for better developed specialization and division of labor, leading to greater economic growth from which the state can benefit through taxation. There must come a point at which the benefits of greater access exceed the losses from reduced rents.
But this would seemingly be true only under traditional assumptions of the state as a revenue-maximizer. Remember that North has explicitly rejected such an assumption, explaining that the state must first solve the question of maintaining its own existence. Indeed, it is such a goal that brings about the natural state itself. It is left to be determined at which point exactly does the state transition from one which simply desires to survive into one which desires to maximize its economic extraction from the populace.
North’s response would probably describe how institutional changes within the governing coalition will occur in order to benefit those members, but which ultimately serve to undermine the coalition itself in favor of greater institutional access. Here is how North puts it: “The changes in institutions, organizations, and behavior…must be explained as intentional acts consistent with the interests of the dominant coalition, but the results of those changes need not be consistent with their intentions.”
Ultimately, North is claiming that the members of the governing coalition must be either short-sighted or simply irrational. That is, the governing coalition must not be able to recognize that allowing a fiscal mechanism to take hold will only serve to undermine their own state structure. Given the ability of the governing coalition to establish itself initially, it would seem to be able to understand at least the rudiments of its own establishment, thereby making somewhat less plausible the possibility that they are simply ignorant of the environment around them.
Of course, North may simply be arguing that the elites will no longer have an incentive to maintain a natural state once the doorstep conditions are in place. Once the rewards are great enough, they will be willing to allow greater access for the fiscal benefits they will accrue. But he should still reconcile this with the natural state’s ultimate goal of survival. A more detailed exposition of this process would probably help to rectify these concerns.
As to the other transition mechanisms he provides, they are probably even less convincing than the fiscal mechanism (which though somewhat contradictory to his model, at least provides some plausibility). His idea of regulation as a transition mechanism is not very well developed and his single example of the fourteenth century wool trade in England conjures up as many questions as it answers. Meanwhile, his conjecture of representation as a possible mechanism suffers from even less explanation. Indeed, he provides only a single sentence in support of this idea.
His last mechanism, international competition, does seem to be the proper avenue in which natural states are induced to accommodate institutional reforms promoting greater access. Opposing states which are able to harness the economic benefits of open-access could become a real threat to those natural states still attempting to control trade. But this argument presupposes the existence of another state which has already advanced to a greater level of development. This just simply begs the question as to how this more advanced state was able to transition to an open-access order. We could appeal again to international competition, but eventually we will regress backwards in time to the first society that was able to incite such a transition. At this point, we will no longer be able to appeal to international competition as a transition mechanism; we will have to determine which of the other three mechanism induced changes in this original open-access order.
Despite these possible concerns, however, this is a very elegant model, one that is begging to be empirically tested to see how these theories play themselves out in the real world. Ultimately, the most interesting applications of this theory will be in its use to chart the historical development of those societies which have been able to make that transition from natural states to open-access orders. However, testing such a model may involve some difficulties which will need to be overcome.
For one, such a model is not conducive to a concise mathematical formulation. This research provides a more verbal exposition more in the line of the “softer” social sciences where econometric techniques will be more difficult to apply. And even if we could develop a more precise model, our data collection efforts could very well be hampered due to the particular exigencies of the theory. For instance, the existence of the doorstep conditions is certainly not a binary variable; different societies can certainly have adopted them to varying degrees. More specifically, the identification of specific institutions would have to be carefully considered to adjust for the fact that institutions behave differently in different social orders. North raises this concern himself when suggesting potential problems with traditional studies analyzing the link between institutional and economic development. To raise an example we addressed earlier, a researcher must be careful to consider how an institution like the corporation can operate very differently in two different countries. Simply acknowledging that such an institution exists without appreciating the social conditions which surround it can lead a rather biased account concerning the role such institutions play in economic progress.
Of course, the jury is still out concerning the factors which most attribute to sustained economic growth. Indeed, the debate today may be as fractured and intense as it ever has been. But it is certainly true that Douglass North has contributed immensely to that debate by positing a legitimate theory linking economic development to the institutions that envelop that society.
