The institutional story of growth

Writing in the latest issue of the New York Review of Books, Robert Skidelsky, the prodigious biographer of John Maynard Keynes, says of the author of the book he is reviewing that he's "seized by a single idea, he tries to explain too much by it". As much can be said of Professor North, at least in this book, in which he grapples with the mystery of why some economies grow faster and better than others.

Douglas North, it might be recalled, won the Nobel prize in economics in 1993, along with Robert Fogel, an economic historian. North's contribution, said the Nobel committee, was in pointing out the role that institutions play in the process of economic change. Subsequently, institutional economics has become an important area of study.

Much of what this book contains can be found in North's Nobel lecture, including the terminology. However, although the basic idea for which North won the prize has been known to Indian thinkers since the time of Chanakya, one cannot blame an American for never having heard of him. (As usual I looked at the bibliography, just to see how far intellectual globalisation had proceeded. Not a single Indian scholar is mentioned, not even when trained in the US.)

In modern jargon, North's idea, which relies heavily on the work of Ronald Coase, is this. "The neo-classical result of efficient markets only obtains when it is costless to transact. Only under the conditions of costless bargaining will the actors reach the solution that maximizes aggregate income regardless of the institutional arrangements. When it is costly to transact then institutions matter" (Nobel Lecture, 1993).

In short, institutions are the grease in the machinery. Good institutions help growth and bad institutions don't. The problem is to find out why some societies have good institutions and others don't.

North says whether one or the other will happen depends on several factors, including belief systems in a society, not to mention technology, awareness, social structure, politics, etcetera. As Jacques Monod, another Nobel winner""but for medicine""said in the context of bio-chemistry, it is chance rather than necessity that determines the eventual outcome in evolution.

As societies grow in size, says North, it is necessary for them to move from personal exchange to impersonal exchange via markets. But whether the markets will be efficient or not""efficiency being defined as minimum transactions cost""depends on a great many things. In one place he says, "The necessary institutional changes required to realise the gains from large-scale markets require fundamental rethinking at odds with our genetic heritage." Genetic?

He also says that well-functioning markets require governments, "but not just any government will do. There must be institutions that limit the government from preying on the market" (page 85). That, in turn, requires not just political institutions but ones that "limit the discretion and authority of the government and of individual actors within government". Dr Manmohan Singh should explain this to Sonia Gandhi as he rethinks his Cabinet's decision to water down the Right to Information Act.

Indeed, there is a lesson for the Congress party as well, albeit in North's Nobel lecture, on which this draws so heavily. "The speed of economic change is a function of the rate of learning but the direction of that change is a function of the expected pay-offs to acquiring different kinds of knowledge. The mental models that the players develop shape perceptions about the pay-offs."

---

UNDERSTANDING THE PROCESS OF ECONOMIC CHANGE

Douglas North
Academic Foundation
Price: Rs 695; Pages: 187