North’s model of the ideal institutional framework is derived from his extensive research in economic history. Under this framework, property rights are protected, contracts are enforced and political authorities do not interfere with the choices made by economic entrepreneurs. This framework enables markets to operate efficiently over time. The time dimension is crucial since, as an economic historian, North was aware that, in order properly to evaluate institutions, it is essential to take into account their durability over time. An efficient institutional framework readily adapts to changing circumstances.Footnote 67 Such a framework provides economic and political entrepreneurs with incentives that encourage decentralized decision-making, enabling society to maximize opportunities for resolving social problems and promoting successful economic change.Footnote 68 Adaptively efficient institutions are thus a necessary condition for achieving successful economic change. Yet, the disparity between levels of economic growth between rich Western countries and poor countries in the rest of the world suggests that very few countries have managed to achieve efficient institutional frameworks. Why is this so? North’s theory of institutions attempts to answer this question and offers a conceptual framework to explain economic growth and institutional development.
North’s celebrated definition of institutions provided him with the starting point to develop his theory. He defined them as follows: ‘Institutions are the rules of the game in a society, or, more formally, are the humanly devised constraints that shape human interaction.’Footnote 69 Institutions are established to reduce the obstacles arising from imperfect and asymmetrical information. The obstacles that institutions are meant to overcome are described as transaction costs. North distinguished two kinds of constraints: formal and informal. Together, these constraints comprise what he called the rules of the game.Footnote 70
In this section I argue that, despite many positive and interesting features, North’s theory is ambiguous and even contradictory owing to three related features: the pervasive and dominating influence of the principles of neoclassical economic theory; his exclusive focus on an end-point model based on successful Western economies; and, his reluctance to account for the role of organizations in the process of change.
Although North acknowledged that neoclassical economics has serious shortcomings, his own theory did not significantly depart from its principles and is thus susceptible to the same shortcomings. North’s focus on Western economies as the end model for all states led him to regard any institutional framework that do not meet the ideal standard as deviant cases and therefore not meriting close investigation. His reluctance to offer a clear explanation about the role played by organizations in past and present institutional frameworks enabled him to leave social conflict out of his analysis and to ignore the complex nature of contemporary organizational structures.
This section begins with some observations about North’s methodological premises. It then examines the origins of the so-called rules of the game, explains the distinction between formal and informal institutions and discusses his views on institutional change. It concludes by considering his attempt to explain the link between economic and political processes and the implications of the distinction between institutions and organizations. Throughout this section, I make several references to the link between North’s notion of rules of the game and legal rules. However, I do not discuss law in detail as I do this in Sect. 4.
Neoclassical Economics and Transaction Cost Analysis
North’s theory draws mainly from the principles of neoclassical economic theory.Footnote 71 He regards the market and the price mechanism as a fundamental component of productive economies, is firmly committed to the view of individuals as utility maximizers and accepts the principle of methodological individualism.Footnote 72 In philosophy, methodological individualism holds that the study of anything involves the study of individuals since in reality only individuals, or collection of individuals, are the subject of study.Footnote 73 Under this view, collective entities are not real. The version of methodological individualism, accepted by most economists, is generally consistent with the view put forward by Joseph Schumpeter in 1908: the individual is the basis for the study of economics, in particular for the study of the price system.Footnote 74 Schumpeter, however, does not extend the application of methodological individualism beyond the operation of the price system. North, by contrast, employs methodological individualism to the study of political and other social processes, as evidenced by his comprehensive approach to transaction costs, which I discuss in more detail below. For the moment, it is important to note that North adheres to the view that institutions are the product of intentional human action and are not predetermined by economic or any other logic.
North’s agreement with the basic principles of neoclassical economics is, however, subject to an important qualification. In his view, neoclassical theory is unable to account for economic growth since it is only concerned with the operation of markets, not with the way markets develop overtime.Footnote 75 As a consequence, it ignores the role of institutions, regarding growth exclusively as a function of the size of the population and the rate of savings.Footnote 76 Hence, neoclassical theory only explains economic performance at a particular time, but is unable to explain dynamic change.Footnote 77 Nevertheless, North’s intention is not to replace neoclassical theory, but merely to improve its capacity to explain change over time. His main departure from orthodox economic theory is in his rejection of the rationality assumption relating to economic agents. According to neoclassical theory, market players repeatedly face the same choices and their preferences remain stable. As a consequence, players are capable of maximizing their preferences, and market outcomes reflect a stable and efficient equilibrium. Although neoclassical theory acknowledges that players might have incorrect information, it asserts that the competitive process provides them with feedback, which enables them to take rational decisions and pursue their maximizing objectives. Neoclassical theory, according to North, can afford such unrealistic assumption about individual behaviour because it takes institutions for granted.Footnote 78 Since institutions play a critical role in determining the choices individuals make, economic analysis cannot afford to take institutions for granted. Thus, in order to bring institutions into his analysis North proposes that the rationality assumption should be loosened, though not dropped. In the real world, according to North, individuals do not face repetitive choices, their access to information is generally inadequate and their ability to process information is often blurred by their mental models. As a consequence, the competitive process, without the support of adequate institutions, cannot by itself generate suitable conditions to enable market players to adjust their preferences and decisions to the environment.Footnote 79 Once it is accepted that markets do not yield efficient outcomes, the study of institutions becomes an essential component of any research project interested in explaining the origin of markets, their performance over time and the mechanisms that generate self-sustaining growth.
North’s conceptualization of institution also relies on an expanded interpretation of Ronald Coase’s transaction cost analysis. That North should embrace transaction cost analysis is unsurprising because the main point that Coase sought to emphasize was that market transactions could not be properly understood without taking into account institutions. Coase’s transaction cost analysis is so widely accepted that it seems almost self-evident.Footnote 80 Coase noted that in a world of zero transaction costs the initial allocation of a property right is a matter of indifference because the market will eventually assign it to the most valued user. Yet, since a zero transaction cost world is merely a hypothesis, what Coase sought to highlight was that institutions play a crucial role in facilitating, or obstructing, market transactions. Coase does not offer a detailed analysis of market supporting institutions, but notes that in the real world – a world of positive transaction costs – the role of legal systems is critically important.Footnote 81 Despite the enormous influence of his work, in 1991 Coase complained that his followers had failed to grasp his main objective, which was to encourage others to study transactions in the real world, rather than focusing on building unrealistic models of market exchange: ‘The time has surely gone in which economists could analyze in great detail two individuals exchanging nuts for berries on the edge of the forest and then feel that their analysis of the process of exchange was complete, illuminating though this analysis may be in certain respects.’Footnote 82
Coase’s transaction cost analysis is applied by Oliver Williamson and Douglass North, both leading figures within New Institutional Economics. Williamson’s approach, also known as transaction costs economics, is concerned with alternative forms of governance as means of overcoming costs brought about by the incomplete nature of contracting.Footnote 83 North, for his part, developed Coase’s transaction cost analysis in a more ambitious direction. Not only does he apply transaction cost analysis to examine costs directly associated with market transactions, but extends it to include society as a whole. Thus, North’s broad conception of transaction costs includes trading costs from the transfer of property rights in the market as well as the costs incurred in running and operating economic and political systems.Footnote 84 He defines transaction costs as ‘the costs of specifying and enforcing the contracts that underlie exchange and therefore comprise all the costs of political and economic organization that permit economies to capture the gains from trade’.Footnote 85 This broad approach to transaction costs enables him to interpret the past, trace the evolution of institutions and assess the relative merits of institutional arrangements regardless of whether they are economic or political.Footnote 86 Transaction cost analysis thus provides North with a powerful instrument to explore non-economic issues without using concepts from other disciplines. North’s confidence in the suitability of transaction cost analysis to explain social phenomena across cultures and time is forcefully expressed in an article on Karl Polanyi. In this article, he addresses Polanyi’s argument that modern economics concepts should not be used to explain pre-market societies. He rejects this view, arguing that transaction cost analysis ‘is a promising analytical framework to explore non-market forms of economic organization’.Footnote 87 His reasoning is that all societies employ some mechanism to assign rights and allocate benefits even though in some societies property rights in the Western sense may not exist. Therefore, since wealth maximization is a universal principle, it can be assumed that the same reason (transaction costs) that prompts economic actors to choose substitutes to the market can also be used to explain the rationale of economic institutions in pre-capitalist societies.Footnote 88 Some have strongly criticised North’s broad conception of transaction costs.Footnote 89 Milonakis and Fine describe his broad conception as an attempt that purports to explain almost anything while distorting historical events.Footnote 90 Such a broad approach also oversimplifies the analysis of social processes because it turns the concept of efficient markets into a gold standard for the analysis of non-economic factors in society.Footnote 91
North applies transaction cost analysis to study issues that are not generally regarded as appropriate for economic analysis. Interestingly, the use of economic analysis to explain non-economic issues was also considered by Schumpeter. By contrast to North, however, his approach was restrained. In his view, economics should respect the sphere of competence of other disciplines because its proper role is to explain economic factors. He did not advocate extending economic analysis to the study of non-economic factors.
When we succeed in finding a definite causal relation between two phenomena, our problem is solved if the one which plays the ‘causal’ role is non-economic. We have then accomplished what we, as economists, are capable of in the case in question, and we must give place to other disciplines. If, on the other hand, the causal factor is itself economic in nature, we must continue our explanatory efforts until we ground upon a non-economic bottom.Footnote 92
North does not heed Schumpeter’s advice, relying instead on economic methodology to analyse and explain economic and non-economic factors. This approach enables him to exclude from his framework relevant research from other social sciences, especially those that provide insights into social conflict and social structure. Having excluded other social science disciplines, he resorts to psychological explanations. As Udehn explains,
[T]he rule guiding this form of methodological individualism says that no economic explanation is considered successful until all exogenous variables have been reduced to psychological states of individuals and natural constraints. Social institutions may appear in the models of neoclassical economics, but only as endogenous variables.Footnote 93
Fortunately, North does not apply this methodology consistently. His discussion on the origins of rules, the nature of institutional change and the link between political and economic processes forces him partly to depart from methodological individualism.Footnote 94 In the end, however, his methodology becomes a straightjacket and is one of the main reasons that explain the shortcomings of his theory.Footnote 95
Rules of the Game
According to North, ‘institutions are created by individuals – evolve and are altered by individuals’.Footnote 96 He distinguishes institutions from organizations. Institutions are the rules of the game while organizations along with individuals are players in the game. This distinction, however, is not as clear as it seems. Indeed, North acknowledges that, in some cases, which he does not specify, organizations are also institutions since they provide a structure for human interaction.Footnote 97 He insists, however, that, although organizations may be regarded as institutions, it is the individual, who, as a member of an organization, makes choices leading to the establishment or change of institutions.Footnote 98 I will return to North’s distinction between institutions and organizations, but it is sufficient here to note that, in his view, individuals are the originators of institutions, even though, occasionally, they are so as members of organizations.
North does not restrict the concept of institution to economic institutions so his theory applies to any set of rules that govern social interaction. It is not immediately clear whether North’s rules of the game are merely heuristic devices to help us make sense of economic processes, constitute the activity itself or are the cause that determines the activity of individuals. He does not explicitly address these questions. He simply states that institutions set the rules of the game and players – individuals and organizations – play the game in accordance with these rules.
While North does not offer a clear explanation about the nature of the rules of the game, he addresses this question, albeit indirectly, in his discussion on the origins of formal and informal rules. He describes formal rules as a set of rules within a normative hierarchy similar to those found in modern legal systems. His account about the origins of informal rules suggests that they originate in the mind of individuals, but are a reflection of prevailing cultural conditions. Thus, not surprisingly, some observers describe his approach as culturalist.Footnote 99 Others argue that his theory of institution is close to the Old Economic Institutionalism because it relies on social habits and tradition as sources of institutions.Footnote 100 To clarify these points it is necessary to look closer look at North’s conception of formal and informal institutions.
Formal institutions, according to North, have a hierarchical structure similar to legal norms, which runs from the constitution to statute and common law, to bylaws, and contracts. ‘The rules descend from polities to property rights to individual contracts.’Footnote 101 Contracts reflect the incentives generated by the prevailing structure of property rights. In other words, the opportunity set of economic actors is derived from the prevailing structure of property rights.Footnote 102 ‘The existing structure of rights (and the character of their enforcement) defines the existing wealth-maximization opportunities of the players, which can be realized by forming either economic or political exchanges.’Footnote 103 North’s description of formal institutions seems to equate this type of institution with officially enacted legal rules. While this characterisation might seem unproblematic, especially for lawyers, it is not easy to reconcile with his proposition that institutions are largely made and changed by individuals. Indeed, his account of formal institutions entails a top-down conception of institutions as imposed on individuals by external forces and hence is inconsistent with his view that individuals are originators of institutions. This problem is also manifest when he discusses the role of elites in framing social order and shaping the link between economic and political processes.
Informal institutions or informal rules play an important role in North’s theory. In Institutions, Institutional Change and Economic Performance he acknowledges the importance of informal constraints, including conventions, customs and codes of behaviour, but does not fully explain how informal rules originate. He simply states that subjective perceptions are both culturally derived and modified by experience. He does, however, argue that changes in relative prices have the effect of gradually altering cultural norms and ideology.Footnote 104 Fifteen years later, relying on principles of cognitive science, he presented a more refined interpretation of informal constraints, linking them firmly to individuals’ shared mental models and belief systems.Footnote 105 Informal constraints, according to North, originate in the mind and can be traced back to cultural values. As a consequence, any attempt to bring about economic or political change will either be facilitated or obstructed by prevailing cultural values.Footnote 106 Indeed, North repeatedly noted that the reason why so many plans to reform the economy fail is because reformers focus on changing the formal rules of the game, but disregard informal constraints. Those who want to bring about institutional change must ensure that the informal rules of society are consistent with the outcomes that the formal rules seek to achieve.Footnote 107 Although North did not claim to have a fully developed theory about cultural beliefs or ideology, in his recent work he focused on the learning process as a means of understanding how particular belief systems emerge.Footnote 108 This process takes place in the mind of the individual, but its cumulative effect has a societal impact beyond the control of any single individual.Footnote 109 Thus, choices made by individuals are shaped by their mental models embedded in widely shared belief systems, which, in turn, are the product of repetitive feedback from the social environment. North explains the link between mental models, belief systems and institutions as follows: mental models are the predictions the mind makes about the environment; these models are revised or confirmed depending on the feedback individuals get from experience; mental models that are repeatedly validated become beliefs; and finally, when beliefs are widely shared they become belief systems.Footnote 110 Thus, institutions are ‘nothing more than shared mental models or shared solutions to recurrent problems of social interaction. Only because institutions are anchored in people’s minds do they ever become behaviorally relevant’.Footnote 111
The influence of culture and informal rules is pervasive, according to North. Indeed, in his view, the reason why, throughout history, most societies have failed to grow is because they are trapped in institutional frameworks that do not create incentives to develop impersonal exchange. As a consequence, they are unable to benefit from the division of labour.Footnote 112 His views about the importance of culture and belief systems in the process of institutional change are closely linked to his views on path dependency. He regards the relationship between belief systems and institutions as intimate. Belief systems are the internal representation of reality, while institutions are structures that individuals impose on reality.Footnote 113 As a consequence, successful institutional change requires changing collective belief systems.Footnote 114 Since bringing about this type of change is difficult, institutions tend to endure overtime and change slowly. The obstinate durability of institutions is what he calls path dependence.Footnote 115 Path dependence is relevant to understanding how informal institutions originate and evolve. The dilemma is, of course, whether reformers wishing to establish efficient institutions should engage in a campaign to shift cultural values from collectivist ideologies towards individualistic approaches. North shies away from this task because ‘the degree to which such cultural heritage is ‘malleable’ via deliberate modification is still very imperfectly understood. At any time it imposes severe constraints on the ability to effectuate change’.Footnote 116 In the end, he advises would- be reformers not to ignore cultural heritage.
Among informal institutions North includes superstitions, religions, myths, prejudices and fundamentalist creeds, which he describes as a reflection of our universal addiction to non-rational explanations of reality.Footnote 117 This extensive list presumably also includes ideology, although by 2005 he had largely abandoned the use of this concept.Footnote 118 Scientific theories are rational explanations, but not all scientific theories meet North’s rationality test. For example, North regarded the economic theories developed by the UN Economic Commission for Latin America and the Caribbean (ECLAC) in the 1950s and 1960s as examples of erroneous mental constructs that obstructed the path towards economic growth. In his view, ECLAC economists’ mistaken attempt to attribute the plight of Latin American economies to the deterioration of terms of trade was a rationalization that had the effect of reinforcing the prevailing inefficient institutional framework.Footnote 119 This astonishing critique reflects a level of insularity that is rare in North’s scholarship. His views on religious and irrational beliefs are interesting, but not fully developed. Although he refers to Max Weber’s celebrated book The Protestant Ethic and the Spirit of Capitalism, he refrained from taking sides in the longstanding debate over Weber’s thesis on Calvinism and capitalism. He noted, however, that along with Protestantism, the Catholic counter-reformation may have contributed to promoting market-friendly behaviour.Footnote 120 His views on Islam were less cautious. He attributed the failure of Muslim countries to follow the dynamic scientific changes of the West to culture.Footnote 121
North’s main concern, however, was to identify cultural conditions (informal institutions) that foster impersonal market exchange. Drawing on Avner Greif’s work, he compares the approach of Maghribi and Genoese traders in the eleventh century.
Maghribi traders were a cohesive community who developed a range of informal mechanisms that enabled them to apply sound and effective trading practices. When trade expanded and became impersonal their practices proved inadequate. By contrast, Genoese traders, who were individualistic, developed bilateral legal mechanisms that enabled them successfully to carry out impersonal trade.Footnote 122 In the context of North’s views on informal institutions, it is relevant to ask how Genoese traders acquired their individualistic values. Was it social interaction? If so, why did Maghribi traders involved in comparable activities, fail to develop similar values? If the Genoese traders did not develop individualistic values through their trading practices, how did they acquire them? North does not address this issue, but refers, approvingly, to Alan McFarlane’s study on the origins of individualism in England.Footnote 123 McFarlane traces its origins to the thirteenth century, long before market relations became dominant. If his interpretation is correct, then the obvious question is how did English peasants acquire their individualism? A similar question could be asked about the ideology of the traders from the Maghreb. If they were engaged in activities similar to those of the Genoese traders, why were they unable to discard their collectivist ideology? Interestingly, Barrington Moore, in his magisterial Social Origins of Dictatorship and Democracy, poses a similar question in relation to Japanese merchants during the Tokugawa period. Why did Japanese merchants during this period not oppose traditional values, thus failing to develop an outlook similar to that of their counterparts in the West? Moore rejects, as question begging, explanations that focus on the psychological traits of Japanese merchants or their value system. Instead, he argues that the answer can be found in history, examining factors such as the country’s isolation, the long political dominance of the warrior class and the merchants’ long association with them.Footnote 124 North’s approach is different. He does not carry out this type of inquiry. Instead, he attributes the behaviour of the Genoese and Maghribi traders to their mental maps. Nevertheless, his views here reveal considerable ambivalence, as reflected in his brief comments on a study by Jean-Philippe Platteau and Yujiro Hayami, which discusses the origins of social norms in African and Asian communities.Footnote 125 In their work, Platteau and Hayami attribute the origins of these norms to structural economic and demographic factors rather than to belief systems. While North acknowledges that their argument is not unfounded, he avoids further discussion claiming that ‘we are some distance from a definitive understanding of the source and implications of diverse cultural backgrounds’.Footnote 126 Ultimately, he refuses to consider specific historical conditions as possible explanations for the diverse behaviour of different social groups. Neither does he regard social interaction, even market interaction, as relevant to the generation of cultural values.
North’s notion of culture poses a dilemma for his interpretation of economic and political change. Indeed, as he constantly reminds his readers, while formal rules can be changed by the stroke of the pen, informal rules are not easy to change.Footnote 127 This is why the same rules applied in different societies often lead to dissimilar outcomes, while different rules often yield the same result.Footnote 128 The role of informal constraints in understanding the process of change is crucial. Indeed, it would seem that, provided that informal rules favour market outcomes, economic growth will take place, even when prevailing formal rules may not be market-friendly.Footnote 129 Thus, while the efficacy of formal rules is dependent on favourable informal constraints, the same is not necessarily true for informal rules. This is why North argues that governments interested in improving economic performance must ensure that belief systems in their respective societies favour the enforcement of efficient property rights. ‘Institutions and belief systems must change for successful reform, since it’s the mental modes of the actors that will shape choices.’Footnote 130 He does not, however, explain how this change of beliefs should come about, other than saying that it took the West a long time to bring informal rules in line with the substantive demands of the market.Footnote 131 Nonetheless, he is convinced that the collectivist orientation prevailing in some non-Western countries accounts for their failure to develop sound economic systems.Footnote 132
North is undoubtedly correct in pointing out that people’s beliefs about institutions are important. When collective beliefs are in accord with the prevailing institutional framework, the legitimacy of institutions is enhanced. Yet his analysis of informal institutions does not explain how people, as a group, acquire their beliefs.
Undoubtedly many collective beliefs are acquired over time and fall within the category of traditions that are part of a group’s cultural heritage. Yet, many beliefs, in the realm of politics, religion and commerce, are purposely created by powerful groups. Although North refers to ideology he does not consider how ideological manipulation might be related to people’s belief systems.Footnote 133 Indeed, while it is true that not all beliefs and practices are ‘amenable to deliberate human manipulation’,Footnote 134 not all value systems and norms grow spontaneously in communities. As Barrington Moore explains,
[t]o maintain and transmit a value system, human beings are punched, bullied, sent to jail, thrown into concentration camps, cajoled, bribed, made into heroes, encouraged to read newspapers, stood up against a wall and shot, and sometimes even taught sociology. To speak of cultural inertia is to overlook the concrete interests and privileges that are served by indoctrination, education, and the entire complicated process of transmitting culture from one generation to the next.Footnote 135
While North might have shared Moore’s views, his analysis of informal institutions suggests that they are rigid and almost impossible to change. Yet, his views on ideology were ambivalent. His concept of ideology is broad and undistinguishable from cultural factors. It includes the individual’s subjective perceptions, as well as religious and political ideology, which in 1990 he described as organized ideologies.Footnote 136 In this sense he acknowledges that ideology is an external force that plays a role in changing behaviour.Footnote 137 He is also confident that the impact of organized ideology does not last forever. Indeed, in relation to the economic and political liberalization that took place in Eastern Europe, he notes that socialist ideology, despite its enormous power, was swiftly dislodged by individuals’ proclivity to maximize their wealth.Footnote 138 Despite his ambivalence, what emerges from his analysis is that a critical source of informal institutions is the community or as he describes it, ‘the cultural transmission of values’.Footnote 139 Thus, he effectively removes the individual as the primary source of informal institutions.Footnote 140 Informal institutions are not the product of isolated entrepreneurs who strive to maximize their utility. On the contrary, informal institutions emerge spontaneously from ‘a process of innovation and imitation that takes place in a social group that is learning collectively. Individuals respecting conventions, following moral rules, and adopting social norms cause (as an unintended outcome of their action) the emergence of social order’.Footnote 141 North did acknowledge Friedrich Hayek’s influence in the development of this evolutionary conception of informal institutions.Footnote 142
North’s conceptual framework envisages institutional change, but change, when it happens, is incremental and unlikely to shift in the direction of adaptive efficiency. Indeed, his ideal end point for institutions seems beyond the reach of most countries. He attributes this to unfavourable cultural and political conditions prevailing in countries outside the small magic circle of advanced industrialized economies. This unpromising situation explains why, in 1990, North warned his readers that his theory ‘provides no guarantee of a happy ending’.Footnote 143 This subsection explains the reasoning underlying his pessimism and considers whether it reflects an irredeemably flawed reality or exposes the shortcomings of his theory.
The main sources of institutional change are variations in relative prices and in players’ tastes. Changes in relative prices include changes in the ratio of factor prices, in the cost of information and technology. Some changes are exogenous (for example, caused by the outbreak of a major epidemic) while some are endogenous (brought about by the internal dynamic of the economic process) and reflected in the maximizing efforts of economic actors.Footnote 144 Institutions establish a structure of incentives that enable economic entrepreneurs to adjust while maximizing their utility. High returns for certain productive activities prompt economic actors to invest in them. Thus North states that ‘[I]f the highest return in an economy is to piracy we can expect that the organizations will invest in skills and knowledge that will make them better pirates.’Footnote 145 If his maximizing entrepreneurs do not focus on becoming better pirates it is because social norms, conditioned by changes in tastes, bring about institutional changes that outlaw piracy (or slavery and similar activities). Likewise, he attributes the abolition of slavery not to economic factors relating to efficiency or transaction costs, but to the emergence of norms that question the legitimacy of one person owning another.Footnote 146 However, he does not explain the political, social or economic factors underlying the shift in moral preferences.
North’s assessment of the role of individual entrepreneurs in the process of institutional change is not encouraging. He notes that, while changes in relative prices provide the lone entrepreneur with the incentive to seek institutional change, the likelihood of achieving success is limited. Imperfect markets, bounded rationality, path dependency and ideological prejudices are all factors that account for the frequency of inefficient outcomes. As a consequence, the entrepreneur is left with two unattractive choices: either to accept minor and unsatisfactory adjustments to the rules of the game or express dissatisfaction by refusing to comply with prevailing rules. But since the option of non-compliance is risky, most people prefer to wait for others to take the initiative.Footnote 147 Thus, efficient outcomes – that is, market outcomes that yield the lowest possible production and transactions costs – are elusive, while free-riding on the efforts of others seems to be the social norm.Footnote 148
Efficient political outcomes are also elusive. Indeed, they are exceptional since political markets are even less perfect than economic markets. The most important function of rulers is to specify, enforce and protect property rights. But rulers are inclined to safeguard their narrow interests rather than achieve outcomes that further productive activities.Footnote 149 Two main reasons explain their behaviour: (1) they face competitive constraints compelling them to establish property rights that benefit powerful groups in the polity; and, (2) they face transaction cost constraints because since enforcing an efficient system of property rights is costly they would not necessarily benefit from such a system in terms of revenue. As a consequence, rulers are inclined to grant monopoly rights rather than encourage competition.Footnote 150 Under this view, rulers (or the state) are indispensable and inadequate: indispensable because they establish and specify property rights that facilitate market exchange; and inadequate because they consistently fail to design an ideal structure of rights. These factors explain why institutional change, when it occurs, is slow and rarely culminates with the establishment of efficient institutions. Thus, North’s theory of institutional change leads to a deadlock. Economic processes do not yield efficient outcomes because entrepreneurs operate in imperfect markets and do not have the capacity or incentive to promote changes. Likewise, political entrepreneurs are also incapable of providing efficient solutions because they represent the interest of powerful groups who are generally satisfied with the prevailing structure of property rights and other political advantages. This unpromising situation explains why North warns his readers that his theory does not guarantee a happy ending.
North rightly identifies the problem that leads his theory into a deadlock. It is the conceptualization of the link between economic and political processes. Accordingly, in his most recent book, Violence and Social Orders, he sets out to provide a systematic account of this link, focusing in particular on the way societies have handled the problem of violence.Footnote 151 In the opening pages, he and his co-authors confidently state that, hitherto, social scientists have failed to understand the connection between the economy and the polity because they have not seriously studied the problem of violence.Footnote 152 This bold evaluation of the contribution of social science to the study of political development is undoubtedly controversial. My task, however, is not to assess its validity, but to ascertain whether his new approach resolves the deadlock in his theory of institutions.
North divides social orders that have existed historically into three types: foraging orders, limited-access orders and open-access orders (hereafter OAOs). Foraging orders, no longer in existence, prevailed in hunter-gatherer societies. Limited-access orders, or natural states, have been around for more than ten thousand years. Open- access orders date back to the middle of the nineteenth century, and are associated with sustained political and economic development of the type that led to the establishment of successful market economies in Western Europe and North America. Today, only a minority of states fall within the OAO category – no more than 25 – and includes only 15 % of the world population.Footnote 153 The rest of the world lives in limited-access orders. OAOs are easy to identify as they follow closely the ideal features of liberal democracies in advanced market economies. OAOs have the following characteristic: (1) a widespread belief in inclusion and equality; (2) no entry restrictions to economic, political, religious, and educational activities; (3) support for the establishment of organizations designed to further these activities; (4) impersonal exchange; and, (5) impartial enforcement of the rule of law (ibid:114). A critical feature of OAOs is that they resolve the problem of violence by asserting democratic control over the military.
While it is easy to recognize the kind of political regime underlying North’s description of OAOs, this is not the case with his description of natural states. His characterization of these states is not based on the features of any single country or group of countries. Instead, using OAOs as the ideal standard, he proceeds to identify the feature of countries that do not meet this standard. Thus, by contrast with OAOs, natural states have not fully resolved the control of violence and are therefore unable to guarantee auspicious conditions for productive trade and investment. Members of the dominant coalition in natural states have access to violence and grant each other special privileges to assets and valuable activities. Natural states remain stable, but only as long as the dominance of the ruling coalition is unchallenged. While natural states favour some forms of productive activities, they cannot guarantee secure property rights or orderly economic processes because they arbitrarily allocate political rights and economic privileges. Natural states do not fully control the sources of violence, and organizations established in these states tend not to survive beyond the life of their founders. Moreover, by contrast with OAOs, natural states restrict peoples’ access to economic and political activities, do not treat them as equals, do not enforce the law impartially and do not establish conditions that promote impersonal market exchange.
North’s description of natural states is too general to be helpful. It reads almost like a caricature of the political economic structures of developing countries. Indeed, the notion of natural state is so broad that countries as different as Argentina and Malawi, India and Sudan, or Malaysia and Myanmar, are all in the same group. Anticipating criticism North distinguishes three types of natural state: fragile, basic and mature.
Fragile are those that are on the verge of collapse and are unlikely to survive any threat of violence. Basic natural states have an organizational framework that defines the structure of the state and regulates relations among members of the dominant coalition. Mature natural states are more advanced and are capable of maintaining independent elite organizations. But, how do mature natural states become OAOs? North offers no clear answer. Instead, he identifies three conditions, described as doorstep conditions, which once in place might generate incentives towards establishing OAOs. They are: rule of law for elites; perpetually lived organizations in the public and private spheres and consolidated control over the military.Footnote 154 He defines rule of law for elites as the case where relations among members of the elite are governed by legal procedures partly protected by a judicial body. Perpetually lived organizations foster the existence of impersonal relationships and exchange, thus securing the inviolability of contracts and the protection of property rights.Footnote 155 Consolidated control over the military requires an organization that is embedded within the structure of the state and controls all the military resources.Footnote 156 North does not, however, explain why doorstep conditions emerge in some countries and not in others. Neither does he offer a satisfactory account about the transitions from mature state to open-access order. In his view, the transition begins when the elites transform their privileges into impersonal rights. Yet he does not explain what prompts them to make this concession. Instead he states that they do so when they ‘perceive that their privileges will be more secure from intra-elite competition when those privileges are defined as commonly shared rights rather than personal prerogatives’.Footnote 157 In any event, he points out that asking what prompts elites to give up their privileges is the wrong question and suggests an alternative question: ‘Why do elites transform their unique and personal privileges into impersonal rights shared equally among elites?’Footnote 158 The answer to this is that they do so when it is in their interest to do so. However, this answer does not address a more fundamental question: what prompts them to realise that they no longer need to cling on to their privileges? North does not address this question, finding it superfluous. He regards institutional change as a smooth process that happens when enlightened and self-interested elites realise that it is in their interest to transform their privileges into abstract rights. This interpretation seemingly resolves the question of the link between political and economic processes since the elites oversee and determine the timing of the institutional transition from natural states to OAOs. The difficulty, however, is that it fails to take into account that, throughout history, elites have consistently used force to defend and enhance their privileges. The history of countries classified as OAOs offers well-known illustrations of the diverse strategies employed by elites to protect their privileges. As noted earlier, North attributes the abolition of slavery to changes in moral preferences, not to political and social struggles. Likewise, the relatively recent struggle for civil rights in the United States is another case that shows that elites do not make political concessions merely because they are enlightened. North acknowledges, in passing, that the 1964 Civil Rights Act in the United States was preceded by violent confrontation.Footnote 159 Yet, he does not regard this, or similar experiences in other countries, as contradicting his view that elites make concessions when it is in their interest to do so. In any event, most historians, and even lawyers, are fully aware that the extension of rights to subordinate classes in nineteenth-century Europe was not conflict-free nor was it the product of gracious concession by enlightened elites.Footnote 160
A point North failed to develop is related to the possibility of transplanting institutions modelled on OAOs regimes so as to speed up the process of change. In Sect. 4 (below), I explain that North was critical of development assistance projects that disregard the cultural heritage and political structures of recipient countries. This, he believed, was futile because social orders have their own logic that should not be disturbed. Indeed, institutions transplanted from outside will either fail to work or, worse, may disrupt the social order of natural states. Intriguingly, however, when he traced the history of the transition to OAOs of countries that he described as the first movers (England, France, Holland and the United States), he acknowledged that, elsewhere in the world, subsequent transitions achieved similar institutional outcomes regarding key institutions and the widespread extension of citizenship rights. He rejected the view that these similar outcomes can be explained as an incident of modernity. Yet, in characteristically eclectic style, he concluded that ‘the first movers deliberately constructed social tools that supported more sophisticated organizations and made those tools available to all elites’.Footnote 161 The notion that the first movers made their institutional tools widely available to elites elsewhere in the world might suggest that agencies promoting the establishment of similar institutions in developing countries are not necessarily following such an unreasonable policy. Unfortunately, North did not pursue this point.
Institutions and Organizations
North’s distinction between social orders offers an academically interesting classification of regime types, but neither resolves the issue concerning the link between economic and political processes nor offers a persuasive alternative theory of political development. Also he fails to link, explicitly and systematically, his findings in Violence and Social Orders with his theoretical work. It could well be that this book was only a prolegomenon to future work. For the purpose of this paper, what needs to be examined is why did North fail properly to address the link between economic and political processes. To do this, it is necessary to discuss his approach to the following three related issues: the relationship between informal and formal institutions; the distinction between institutions and organizations; and the link between the behaviour of individuals and macro social processes. In brief, why is it that, in North’s conceptualization, the lone entrepreneur is unable to have a wider societal impact? Why is s/he permanently blocked by selfish political entrepreneurs? In other to answer these questions it is necessary to examine how North envisages the relationship between the individual and social institutions.
According to North, institutions are created and altered by individuals. However, he does not consistently adhere to the view that individuals are the sole originators of institutions. As noted above, informal institutions are not generated by the action of isolated individuals, but are the product of belief systems, developed and validated by cultural and community values. There is no doubt that North’s insights into the relationship between culture and economic change are valuable. Nevertheless, his theory fails to explain how informal institutions are transformed into formal institutions. In the final paragraph of his 1990 book, Institutions, Institutional Change, and Economic Performance, he acknowledges that he failed to find an answer to this important issue.Footnote 162 Nonetheless, did not revisit this question. Although he repeatedly observes that informal and formal institutions should be properly aligned to achieve positive outcomes, he does not consider how informal institutions become formal institutions. An explanation for this omission may be that while his conception of informal rules is largely psychological, his conception of formal rules is top down and legalistic. His description of formal rules is hard to distinguish from a lawyer’s description of the hierarchy of rules in a modern legal system. Therefore, it is hardly surprising that he has been unable to link informal and formal institutions other than by warning that formal institutions should not ignore prevailing cultural constraints. In any event, North’s top-down account of formal institutions overrides his fundamental premise that institutions are created by individuals. Legal rules, are created, interpreted and changed by organizations, not by lone individual entrepreneurs or selfish political operators. If this analysis is correct, why then does North fail to acknowledge that the rules of the game do not emerge spontaneously from the minds of individuals, but instead are artefacts created by organizations? Although he does not completely ignore this question, his response is incomplete and does not dispel the ambiguity in his theory.
One of the most confusing features of North’s conceptualization is his distinction between institutions and organizations. This distinction is unclear, as has been noted by several scholars.Footnote 163 Institutions, according to North, are the rules of the game, while organizations are players. Organizations consist of groups of individuals bound by a common purpose and are subject to the same rules as individuals. Yet, he admits that in some cases, which he does not identify, organizations can also be regarded as institutions, as they provide a structure for human interaction.Footnote 164 He insists, however, that, although organizations are players, it is the individual, who, as a member of an organization, makes decisions leading to the establishment, or alteration, of institutions.Footnote 165 Nevertheless, when he describes economic processes he assigns a critically important role to organizations. ‘Organizations are a response to the institutional structure of societies, and, in consequence, the major cause of the alteration of that institutional structure.’ And he adds:
As the organization evolves to capture the potential returns, it will gradually alter the institutional constraints from within. It will do so either indirectly, via the interaction between maximizing behaviour and its effect on gradually eroding or modifying informal constraints; or it will do so directly, via investing in altering the formal rules.Footnote 166
Given these statements, it is surprising that he does not explain the relationship between institutions and organizations. Instead, organizations simply disappear from his theory. Although in Violence and Social Orders he brings organizations back into his conceptualization – as permanently lived organizations – their role is merely as players in an otherwise tranquil environment of open access orders.
There are, undoubtedly, good reasons to explain why North chooses to ignore the link between institutions and organizations. One explanation is that had he developed the notion of organizations as creators of institutions, the clarity and simplicity of his model would have been disturbed. Just as the rationality assumption enables economists to offer a simple, persuasive and powerful explanation about the operation of markets, the exclusion of organizations from his theory could well be seen as a small price to pay for keeping the explanation simple. Some would regard this level of simplification as necessary in order to meet Ockham’s Razor test.Footnote 167 While this may well be valid regarding model building, ignoring organizations raises problems for North’s theory of institutions. Indeed, ignoring them at the theoretical level, while simultaneously acknowledging that they play a role in establishing and destroying institutions, leaves a major gap in his theory. Indeed, by failing to explain their interaction he takes organizations for granted. This is ironic, because, as already noted, North launched his investigation into institutions in the belief that neoclassical economics cannot explain growth since it takes institutions for granted. Yet, his theory does not account for entities that play an active role in shaping, interpreting and imposing rules of the game. In the absence of an explanation clarifying how institutions are transformed into concrete organizations; how institutional rules become binding on individuals; and how organizations relate to institutions, it is difficult to establish the extent to which his theory helps us to understand institutional and economic change in the real world.
North also fails to explain how individual choices have an impact at the macro level of society. He undoubtedly assumes – in line with the way most economists interpret methodological individualism – that the only valid focus of analysis is on choices made by individuals and that collective choices are merely the aggregation of individual choices.Footnote 168 From this perspective, social systems and social structures disappear and the only object of analysis is the individual. Nevertheless, because he admits that organizations also create institutions, it would appear that he accepts that organizations are social facts independent of individuals. Hence he seems to depart from methodological individualism. Yet, he refuses to reflect on this point and simply states that, even when organizations behave as institutions – that is, when they create rules of the game – those who make choices within the organizations are individuals.Footnote 169 This explanation does not take into account that individuals occupy positions and play roles requiring choices that are collectively determined by them as officers or role players within the organization, not in their individual capacity.
It is well known that organizations play an important role in contemporary societies. It is not necessary to embrace sociological holism to acknowledge this fact. Indeed, James Coleman, one of the leading proponents of methodological individualism in sociology, identifies as urgent the need to account for the role of organizations.Footnote 170 In brief, he argues that contemporary societies have seen the emergence of constructed organizations, a new type of social actor, which has rights and responsibilities that are not immediately linked to natural persons.Footnote 171 Constructed organizations have enormous economic power and the capacity to establish rights and obligations and to influence the direction of political events. According to Coleman, many conservative and liberal social theorists, such as Hayek, mistakenly assume that the path to a prosperous market society requires only minimum political interference by the state. Hence Hayek’s opposition to any form of organization established by the state and his celebrated views about the rule of law as a mechanism designed to provide a broad, but unobtrusive framework to support market processes.Footnote 172 There is no doubt that North shares Hayek’s views about the role of the state. Indeed, his open-ended and vague conception of institutions seems purposely designed to serve as a general framework that sets minimal conditions for the operation of markets. According to Coleman, however, the view that, in the contemporary world, economic problems can be resolved simply by reducing state interference fails to take into account the overwhelming economic and political importance acquired by organizations. In his view, ‘the existence of complex social relations in constructed social organizations makes possible a mode of social control in which rights, constraints, and rewards need not arise from two-party relations, but can be imposed by a third party, the corporate actor’.Footnote 173 As a counterbalance to this new force he proposes building social capital within these organizations, so recreating the solidarity and informality that existed when simpler relations of exchange prevailed. Interestingly, while Coleman calls upon social theorists and economists to take organizations seriously, North, who developed his theory at the same time as Coleman, ignores organizations, introducing instead a notion of institution that is difficult to relate to any concrete social organization. North, of course, does not share Coleman’s assessment of constructed organizations as potentially posing a threat to social order. On the contrary, North has no doubt that the emergence of ‘permanently lived organizations’ is desirable and is an unequivocal indication of progress towards the end goal that all states should be aiming for: the open access order modelled on Western liberal economic and democratic regimes. Regardless of whether Coleman’s assessment of the role of organizations is correct, the critical point here is that North’s failure fully to incorporate organizations within his framework results in a theory of institutions that is far removed from the real world. As explained, this failing is ultimately linked to his reluctance to shift away from the principles of neoclassical economics and his unwillingness to engage with the findings of other social sciences.