Structure and change in economic history: The ideas of Douglass North

John Joseph Wallis

27 November 2015

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Douglass C. North recently passed away at the age of 95 at his home in Benzonia, Michigan. He was among the most important and influential economic historians and economists of the late 20th century. He will be deeply missed by his family, friends, colleagues, and students.

North was a leader of the generation of economic historians who brought neoclassical economics directly into the study of history – the ‘new’ economic history. And then realising the incompleteness of the neoclassical tools for understanding long-term change, he was a leader of a generation of economists and social scientists who brought the importance of institutions into a central position within economics – the ‘new’ institutional economics.

North long emphasised the importance of history and of neoclassical economics. He criticised both disciplines for their complacency about the adequacy of the current conceptual and methodological consensus on how history or economics should be done. He always operated within a framework of individuals who act intentionally (neoclassical economics matters) and who perceive the world through cognitive lenses that are part inherited from their culture and part derived from their own experience (history matters).

Individual actions are governed by interests shaped by relative prices, endowments, and constraints (institutions) as well as by perceptions of how the world around us works (cognition and beliefs). Social outcomes are the sum of individual actions, but the summation process is not a simple adding up, since interactions between individual decisions and beliefs critically influence the behaviour of everyone. Here, I want to highlight four of his major contributions.

The evolution of North’s thinking continuously shaped his willingness to pursue the interesting questions he was unable to address in his last book or paper, not by what was currently hot in the profession. Testimony to the power of his insight is that the profession has followed him, for he certainly didn’t follow the profession.

Cliometrics

His first book (North 1961) was one of the first examples of quantitative economic history or ‘cliometrics’, North’s first major contribution to economics and economic history. The book presented a very neoclassical theory of economic development that emphasised the importance of geographic specialisation and division of labour, and which led him to investigate the sources of falling transport costs over the 19th century.

In North (1958), he laid out a technology-based neoclassical framework for thinking about declining freight rates. But ten years later, in North (1968), he concluded that: “The conclusion one draws is that the decline of piracy and privateering and the development of markets and international trade shared honours as primary factors in the growth of shipping efficiency over this two-and-a-half-century period.” (p. 967). Essentially, the costs of shipping were falling because costs other than the costs of operating ships were falling. Those cost reductions were the result of institutional change. The paper marks North’s turn towards both transaction costs and institutions as important elements of economic change over time.

Transaction costs and institutions

The turn towards transaction costs and institutions did not mean a turn away from neoclassical economics, however. The assumption of zero transaction costs and unchanging institutions could be relaxed within the context of neoclassical theory. As North (1971) argued: “What we need is a body of theory which encompasses the traditional models of the economist and both widens its scope and allows us to include an explanation of the formation, mutation and decay of organisational forms within which man cooperates or competes.”

North was moving towards a neoclassical theory of institutions in which the form of institutions or organisations was itself determined by traditional neoclassical rationality and constraints. The idea that neoclassical theory could be used to explain why institutions functioned as they did was a fundamental breakthrough and North’s second major conceptual contribution. The idea was implemented in a series of papers with Lance Davis and with Robert Paul Thomas, which led to two books (Davis and North 1971, North and Thomas 1973).

Both books argue that we can explain changes in the organisation of human interaction (institutions) on the basis of the rational interests of individuals attempting to structure the world around them in ways that maximise net benefits. The classic application of the technique is North and Thomas’s explanation of how the rising price of labour in fourteenth century Europe as a result of the Black Death, led to the institution of wage labour in western Europe and a return to the institution of serfdom and slavery in Eastern Europe. The same relative price shock led to two different, but both rational, institutional changes.

Two lines of thinking emerged from the idea of neoclassical institutions, and they were not entirely consistent with one another. In one line, institutional change occurs because of short-run variations in relative prices that create, at some point in time, the incentives to restructure human organisations. For some reason, these changes persist.

This led North to investigate both path dependence and transaction costs. Transaction costs play a key role, because they are both a reason to change institutions to reduce (or increase) transaction costs, and because transaction costs subsequently can make it difficult to change institutions and so contribute to institutional persistence.

The other line of thinking was a growing dissatisfaction with neoclassical economics altogether as a way to understand the process of economic growth specifically, and more broadly to understand the process of economic change over time. His third significant breakthrough was the realisation that neoclassical theory was not just inadequate, but that it was unable to explain long-term economic and institutional change in any society, growing or not.

North directed his first clear criticism at economic historians, while acknowledging the important contribution that economic theory and quantitative techniques made to advancing our understanding of historical processes, nonetheless. “From my quite subjective perspective, the new economic history has made a significant contribution to revitalising the field and advancing the frontiers of knowledge. Yet I think it stops short – far short – of what we should be accomplishing in the field.” (North 1974, p. 1).

Criticism of neoclassical theory in economic history

His criticism of neoclassical theory in economic history, development, and growth would culminate in North (1981), which many (including myself) believe to be his best book. The introduction and second chapter extend the argument that we must have more than a history of markets to understand economic change. The third chapter titled “A Neoclassical Theory of the State”, lays out a logical neoclassical argument for why, in the presence of transactions costs, political systems do not inevitably evolve institutions that promote economic growth. Indeed, as long-term economic history suggests, the tendency is for political systems to evolve that do not support growth. Chapters four and five argue that we need a theory of organisations as well as a theory of beliefs and ideology if we are to understand long-run change, particularly long-run change that does not inevitably produce growth and development.

The contradiction between the two lines of thinking is clear in North (1981). On the one hand, there is a strong argument that neoclassical economics is incapable of delivering the full range of explanations necessary to understand economic change, particularly ideologies and beliefs. On the other hand, there is a strong argument that rational individual behaviour is consistent with institutional choices that retard, rather than promote, economic growth. One wonders whether the question is to be neoclassical or not to be neoclassical?

The real question the book is trying to grapple with is: Persistence or change? Going back to North and Thomas (1973), institutions change when there are gains from doing so, but then persist because of the high transaction costs of changing them.

In North (1981), beliefs and ideologies persist. Because beliefs (and norms and culture) are based on the cumulative experience of society passed down through culture and formed through repeated interactions of many people through norms of behaviour, beliefs do not change quickly and it is extremely difficult to for social actors to manipulate beliefs in current time.

As a result, beliefs are always a function of what happened in the past and can impede change in the present for good or ill. It is the persistence of beliefs and institutions from the past (culture) that explain why changes in the present often produce results that impede rather than promoting growth and development. The importance of beliefs in this framework plays a major role in North (1990) and it is the central focus of North (2005).

The framework in North (1981) includes two different time patterns of institutional change. One is episodic and discontinuous, like the move towards wage payments after the Black Death in Western Europe; the other is continuous and marginal. Changes in beliefs and ideologies, in norms, and in informal and formal rules occur constantly and, while changes sometimes persist, they need not. Neither continuous nor episodic institutional change is necessarily persistent.

Fleshing out these ideas in the 1980s produced a classic example of change during a crisis that persists: the analysis of constitutional institutions in seventeenth-century England in North and Weingast (1989). This paper’s emphasis on institutional mechanisms explains why particular institutions are self-enforcing and persist over time. At the same time, North was writing his 1990 book Institutions, Institutional Change, and Economic Performance. Persistence plays a large role in this book, which regularly emphasises that the function of an institution is to provide stability and predictability to human behaviour.

The big contribution of the 1990 book, however, is the definition of institutions that North called the sports analogy. Institutions are the rules of the game and the means of enforcement, and organisations are the teams that play the game. The definition motivates three behavioural choices that organisations can make: one is to maximise under the rules; the second is to devote resources to changing the rules; and the third is to cheat. The alternatives are not mutually exclusive, and they comprise a framework for understanding the dynamics of institutional change.

Institutions and organisations

North’s fourth major contribution was to separate institutions and organisations. Since his earliest books, North always included a discussion of organisations as important, but organisations were treated as manifestations of institutions. Organisations usually disappeared from the conceptual framework, which was always neoclassical in its focus on individuals.

By defining institutions as the rules of the game and means of enforcement, and then separating the rules from the organisations that actually play the game, it became possible to have a dynamic relationship between the interests and incentives facing the organisations and the structure of the rules. The descriptive concept that comes out of the dynamics is ‘adaptive efficiency’. In some societies, the interaction of institutions and organisations produces a series of institutional changes that get incrementally better, rather than a sequence that is sometimes good and sometimes bad for economic performance.

Rather than resolving (or integrating) the tension between the long- and short-term forces leading to institutional change, North (1990) exacerbated it. The rules of the game include formal rules, informal rules, and norms of behaviour. By stressing the function of institutions as providing stability and predictability, and emphasising the importance of beliefs and norms, the book effectively claimed that the persistence of institutions was not a matter of real-time economic and political forces, but an outcome of the natural limits to human capacities for cognition and culture.

North pressed farther down this road with his 2005 book. The interaction between organisations and institutions was a central focus of his last book with Barry Weingast and myself (North et al. 2009). I will leave it to others to evaluate that book.

Personal reflections

I was lucky to have known Doug for most my life, beginning as his advisee for my undergraduate honours thesis in 1975. He was an exceptional human being, with a full appetite for life in many dimensions. He owned his own plane, sailboat, two ranches, and loved food, wine, and music.

He profoundly appreciated how little we know about how societies actually work and how, as individuals and social scientists, we interpret what we see and experience through the ideas – theories, histories, and frameworks – we construct for ourselves. This appreciation not only gave him a life-long interest in cognition, but it was also a wellspring for his continuing ability to question what he and we believe.

All four of his major contributions came because he probed what we did not understand, obviously important questions for which we had no answers. His unerring sense of what best next question to ask flowed from his awareness of our collective ignorance. Not knowing and a willingness to admit it are personal characteristics rarely in evidence at the level of intellectual accomplishment that Douglass North reached. We all are better for his unique combination of confidence and humility.

References

Davis, Lance E and Douglass C North (1971), Institutional Change and American Economic Growth, Cambridge, UK: Cambridge University Press.

North, Douglass C (1958), ‘Ocean Freight Rates and Economic Development 1750–1913’, Journal of Economic History 18(4): 537-555.

North, Douglass C (1961), The Economic Growth of the United States 1790–1860, Englewood Cliffs, NJ: Prentice-Hall.

North, Douglass C (1968), ‘Sources of Productivity Change in Ocean Shipping, 1600-1850’, Journal of Political Economy 76(5): 953-970.

North, Douglass C (1971), ‘Institutional Change and Economic Growth’, Journal of Economic History 31(1): 118-125.

North, Douglass C (1974), ‘Beyond the New Economic History.’ Journal of Economic History 34(1): 1-7.

North, Douglass C (1978), ‘Structure and Performance: The Task of Economic History’, Journal of Economic Literature 16: 963-978.

North, Douglass C (1981), Structure and Change in Economic History, Cambridge: Cambridge University Press.

North, Douglass. C (1990), Institutions, Institutional Change, and Economic Performance, New York: Cambridge University Press.

North, Douglass C (1993), ‘Douglass C. North, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1993: Autobiography’, Vol. 2010, The Nobel Foundation.

North, Douglass C (2005), Understanding the Process of Economic Change, Princeton: Princeton University Press.

North, Douglass C, and Robert Thomas (1973), The Rise of the Western World: A New Economic History, New York: Cambridge University Press.

North, Douglass C, John Joseph Wallis, Steven B. Webb, and Barry R. Weingast (eds) (2013), In the Shadow of Violence: The Problem of Development in Limited Access Societies, New York: Cambridge University Press.

North, Douglass C, John Joseph Wallis, and Barry Weingast (2009), Violence and Social Orders: A Conceptual Framework for Interpreting Human History, New York: Cambridge University Press.

North, Douglass C, and Barry R. Weingast (1989), ‘Constitutions and Commitment: The Evolution of Institutions Governing Public Choice in Seventeenth-Century England’, Journal of Economic History 49:4.

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Topics:  Economic history

Tags:  Douglass North, cliometrics, economic and institutional change, neoclassical economics

Professor in the Department of Economics, University of Maryland

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