by Linda Yueh
North spent his career trying to find the reasons behind economic disparity, which he formalized as: ‘What accounts for societies experiencing long-run stagnation or an absolute decline in economic well-being?’4 This is the question posed in this chapter, and is also, perhaps, the key economic challenge of our time.
The life and times of Douglass North
Douglass North was born in 1920 in Cambridge, Massachusetts. His father’s job as an insurance executive meant that the family moved frequently during North’s childhood. He lived in both Canada and Switzerland as well as in several US states. For his first degree, North pursued a triple major in philosophy, political science and economics at the University of California at Berkeley. His recollection of his studies will give many hope: ‘My record at the University of California as an undergraduate was mediocre to say the best.’5
He became a navigator in the Merchant Marine in the Second World War after graduation. He had hoped to go to law school, but the war intervened and he ended up serving. North explained: ‘I was a conscientious objector. I didn’t want to kill anybody. I picked something where other people would shoot at me but I wouldn’t shoot back.’6
It was during these three years, which North said gave him time to read, that led him to relinquish his plans for a career in law. Instead, he thought that he should become an economist or a photographer. They were certainly diverse choices. The former won out because, as he recalled: ‘what I wanted to do with my life was to improve societies, and the way to do that was to find out what made economies work the way they did or fail to work’.7
Towards the end of the Second World War, North married for the first time and subsequently fathered three sons. His second marriage was in 1972, to Elisabeth Case. They met when she was an editor at Cambridge University Press, having previously worked at Michigan University Press. After their marriage, she was credited with editing some of his articles.
After the war, North returned to the University of California at Berkeley to earn a PhD in economics. His first academic job, which he took up in 1951, was at the University of Washington. He remained there for 32 years until he joined Washington University in St Louis, where he spent the rest of his career. He also held visiting professorships at Cambridge, Stanford and Rice Universities, though none of North’s permanent appointments were at top-ranked universities. This illustrates not only that it is possible to succeed outside of the top universities, but also how difficult it is to gain acceptance from them for unorthodox ideas.
As noted, after four decades of research he won the highest prize in the discipline, receiving the Nobel Prize in economics in 1993 for his pioneering work on institutions and how they influence economic development. This was a question that interested North from the very start of his career. Even his PhD dissertation focused on explaining differential regional growth rates within the US, and was the basis of his first book, The Economic Growth of the United States from 1790 to 1860, published in 1961.
In 1966–67 came a change of focus as North decided to study European economies after he received a grant to live in Geneva for a year. It was an intellectual turning point:
I quickly became convinced that the tools of neo-classical economic theory were not up to the task of explaining the kind of fundamental societal change that had characterized European economies from medieval times onward. We needed new tools, but they simply did not exist … it was not possible to explain long-run poor economic performance in a neo-classical framework. So I began to explore what was wrong.8
It was a long road, and one that eventually led him to work with political scientists in the 1980s. That research culminated in his seminal work, Institutions, Institutional Change and Economic Performance, published in 1990. His research filled a gap in economics, offering an explanation of why so many countries remain poor:
The disparity in the performance of economies and the persistence of disparate economies through time have not been satisfactorily explained by development economists, despite forty years of immense effort. The simple fact is that the theory employed is not up to the task.
… Put simply, what has been missing is an understanding of the nature of human coordination and cooperation. Now, that certainly should not surprise a disciple of Adam Smith. Smith was concerned not only with those forms of cooperation that produced collusive and monopolistic outcomes, but also with those forms of cooperation that would permit realization of the gains from trade.9
North created a new way of thinking about economics, which put human behaviour at the core. It led to a long career of not just research but also policy engagement. North was advising countries around the world on applying institutional analysis to their growth policies while in his eighties!10
Douglass North believed that institutions are the key to understanding the development of an economy. In the Preface to Institutions, Institutional Change and Economic Performance he wrote: ‘History matters. It matters not just because we can learn from the past, but because the present and the future are connected to the past by the continuity of a society’s institutions.’11
He was not the first scholar to deploy history in economic argument, but he pioneered the incorporation of institutions into economic analysis. North defined institutions as: ‘the rules of the game in a society … Institutions reduce uncertainty by providing a structure to everyday life.’12 So, institutions can be formal, such as laws, or informal, such as those that police societal norms of behaviour. North believes both can evolve over time, which is why history matters a great deal in understanding how development occurs. His work rejected the separation of political and social institutions from the workings of the economy.
North argued: ‘Institutions affect the performance of the economy by their effect on the costs of exchange and production.’13 In other words, poor institutions are costly. At a minimum, excessive regulations are burdensome and add cost to doing business. At the extreme, economies cannot grow if there are unstable political institutions that lead to war or conflict.
Understanding this link between institutions and development points the way to the necessary reforms. For instance, North attributes the success of the United States to its institutions: ‘US economic history has been characterized by a federal political system, checks and balances, and a basic structure of property rights that have encouraged the long-term contracting essential to the creation of capital markets and economic growth,’ and contrasts that with its southern neighbours that have struggled to develop beyond middle-income status: ‘Latin American economic history, in contrast, has perpetuated the centralized, bureaucratic traditions carried over from its Spanish/Portuguese heritage.’14
Through studying these economies, North concludes that the institutions that have been good for development include the rule of law as well as openness to globalization. Those institutions provide positive incentives for people to engage in business and productive activities, which generate economic growth. Specifically, he points to market-supporting institutions as important: ‘the underlying institutional framework persistently reinforced incentives for organizations to engage in productive activity’.15 In particular, North believed that institutions mattered for technological progress, a key element of economic growth. North found this was common among prosperous economies, such as the United Kingdom: ‘The security of property rights and the development of the public and private capital market were instrumental factors not only in England’s subsequent rapid economic development, but in its political hegemony and ultimate dominance of the world.’16
He believed that the lack of such good institutions is why some developing countries have lagged behind. In his view, many of their institutions do not provide the sort of positive incentives that exist in the US and UK: ‘The opportunities for political and economic entrepreneurs are still a mixed bag, but they overwhelmingly favor activities that promote redistributive rather than productive activity, that create monopolies rather than competitive conditi
ons, and that restrict opportunities rather than expand them. They seldom induce investment in education that increases productivity.’17
He also believed that institutions perpetuate themselves. This view that good and bad institutions tend to self-perpetuate implies there is ‘path dependence’ in economic development. Path dependence was used by North to explain vicious circles of poverty and virtuous circles of growth. In a virtuous circle, the government invested in education and technological improvements that reinforced the good institutions, which generated growth that helped such good institutions to persist. In other words, path dependence means that good or bad institutions lead to persistently good or bad institutions, which reinforce an economy’s growth path – either positively or negatively. What comes next depends on what has come before.
For North, path dependence helps to explain differential long-run economic outcomes. It’s also why he posited that it’s hard to reform economies to change their course, which will require political and social change that can be slow to bring about: ‘Reversal of paths (from stagnation to growth or vice versa) … will typically occur through changes in the polity.’18
Before we look at what North would say about how to address the current development challenge, let’s first examine in more detail why so many countries remain poor.
The development challenge
One aspect of the development challenge may not exist for long. The United Nations, with the support of all countries around the world, and the World Bank have set an ambitious target of ending extreme poverty by 2030. It would mean that, for the first time, there would be no one who lives on less than $1.90 per day, adjusted for what a dollar buys in the country or ‘purchasing power parity’. What would it take? Could we really see the end of poverty?
First, there has been a great deal of progress already. The poverty rate in the developing world has fallen dramatically since 1981. Back then, more than half (52 per cent) of the global population lived on less than $1.25 per day. That’s dropped to around 10 per cent under the comparable measure of $1.90 per day.
One of the UN’s Millennium Development Goals (MDGs) was to halve poverty by 2015 from 1990 levels. In fact, this was achieved five years early. In 1990, more than one-third (36 per cent) of the world’s population lived in abject poverty. That was halved to 18 per cent in 2010, due largely to China’s rapid economic growth, and progress in the East Asian region. Four out of five people lived in poverty in 1981 and that has fallen to 8 per cent. On current trends, the fastest growing region in the world could see the end of poverty within a generation.
Sub-Saharan Africa is the only region where the number of people living in extreme poverty has increased during the past three decades. Even though the percentage of the African population living in extreme poverty is slightly lower than in 1981, population growth means that there is a greater number of people living in poverty. They account for more than half of the extreme poor in the world, despite Africa making up only 11 per cent of the global population.
In all, over a billion people have been lifted out of poverty worldwide since 1990, which is an extraordinary achievement. For the first time in history, just one in ten people live in extreme poverty around the world, and both the United Nations and the World Bank believe we are moving towards the historic goal of ending extreme poverty by 2030, so achieving the first of the Sustainable Development Goals (SDGs) adopted in 2015.fn1
Could we really be the first generation in history to succeed in eradicating global poverty? What precisely does the end of poverty look like? It doesn’t mean that no one lives on less than $1.90 per day. The World Bank assumes that a 3 per cent poverty rate is equivalent to the end of poverty since there will be some who move into poverty only temporarily, perhaps when they lose their jobs. This is known as ‘frictional’ poverty.
To get to that point would take a heroic effort. The number of poor people will have to decrease by 50 million every year until 2030. That is the equivalent of a million people per week. That pace is daunting. If met, it would mean lifting all but a quarter of a billion people out of an estimated 8.6 billion people on the planet then out of abject poverty.
Which policies might get us to that outcome? A country that we can perhaps learn from is fast-growing China. It had a higher poverty rate in 1990 than Africa, yet it has accounted for the bulk of global poverty reduction in the past few decades. But growth alone is clearly not enough, since Africa, the second fastest growing region in the world after Asia, has failed to make similar progress.
Drawing lessons from one country or region to another always needs to be done carefully and the Chinese economy is in transition from central planning under the governance of a one-party state, as discussed in the Marx chapter. That means, for instance, that land is effectively owned by the government and leased from the state. It doesn’t mean that some haven’t become very wealthy developing land gained through government favour, but most people have been lifted out of poverty through self-employment and not by exploiting the land and its resources. This is in contrast to Africa, where, as Oxford economist Paul Collier points out, unlike China, income growth has been based on natural resources and the gains have not been widely shared.19
In China, policies were designed to raise the productivity of agriculture, which lifted hundreds of millions out of poverty in rural areas. The World Bank has proposed similar targeted growth policies, such as supporting agricultural productivity, in developing countries.
Unlike Africa, China did not rely much on overseas aid, a standard tool in poverty alleviation policies. This has contributed to the mixed evidence about the impact of aid on reducing poverty, which has led to a fiery debate. Still, the UK-based Overseas Development Institute (ODI) believes that there is a role for aid, but that there needs to be an overhaul of the way it is used.
So, it is tricky to apply lessons drawn from the past to the remaining stubborn pockets of poverty. Around half of the extreme poor live in Africa and another third in South Asia. For instance, Tanzania, which has grown well and been devoid of conflict, has seen the number of poor increase from 9 million two decades ago to 15 million. South Asia also lags in terms of the progress made in East Asia despite its growth, so again it is not possible to count on growth alone to lift the remaining 767 million people out of poverty.
Doubtless, the circumstances of individual countries matter a great deal in terms of what works, as North would stress. But if the progress made in the past couple of decades can be replicated in some fashion and tailored to individual countries, then it’s possible that the remaining poor could be lifted out of abject poverty. That would imply that the 36 per cent poverty rate in 1990, which had dropped to 18 per cent in 2010, would fall by a comparable magnitude by 2030. It would indeed mean the end of poverty in our lifetimes. As Nobel laureate Robert Lucas, Jr, remarked:
Is there some action a government of India could take that would lead the Indian economy to grow like Indonesia’s …? If so, what, exactly? If not, what is it about the ‘nature of India’ that makes it so? The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else.20
There is also the prospect of a crisis derailing economic growth. That has been a feature of developing countries in the post-war period. Once prone to crisis, Douglass North’s theory of path dependence would suggest that it is not surprising that it occurs time and again.
A history of crises
Even among emerging economies or emerging markets, which are alternative terms for developing countries that have a track record of economic reform and good growth prospects, the past few decades have been characterized by a series of financial crises that has prevented sustained growth spells. China may have had a four decade-long growth spell that has not been interrupted by crisis and it has nearly eradicated extreme poverty, but that is not the case for many other developing countries.
What i
s known as the first-generation currency crisis refers to the Latin American crisis of 1981–82. Countries such as Brazil, Mexico, Argentina and Chile had three traits that made them vulnerable: a large budget deficit, so their governments were borrowing to spend, a large trade or current account deficit, so they were importing more than they were exporting, and high inflation, so prices were rising fast. These traits put pressure on their fixed exchange rate against the US dollar, known collectively for those four countries as the tablitas. Large deficits and inflation in a country often cause investors to sell their holdings of its currency and buy others that are more stable, usually the dollar, which is what happened in Latin America. The ‘twin deficits’ (budget and trade) and high inflation are why emerging economies are viewed as vulnerable to growth-derailing crises.
The second-generation currency crisis refers to the collapse of the European exchange rate mechanism (ERM) in 1992. Even though that was a crisis involving developed economies, there are similar features to the Latin American episode. Many Britons still recall Black Wednesday, when sterling and other currencies, such as the Italian lira, left the peg to the Deutschmark (DM) that they had signed up to two years earlier. A loss of market confidence meant that to keep their currencies pegged would have meant raising interest rates to unacceptable levels if investors were to be persuaded to buy sterling and maintain the exchange-rate peg. UK interest rates had reached 15 per cent, and the impact on economic growth of staying in the ERM would simply have been too detrimental during a recession. High interest rates made borrowing more expensive and depressed investment, so worsening growth. Unlike the Latin American economies, the troubled European nations did fairly well after the crisis. Weaker currencies made what they sold abroad cheaper, so exports became more competitive and Britain, for instance, grew well during the 1990s. One difference between Latin America and Europe is that the latter had more stable institutions such as well-regarded central banks, which emerged from the debacle with their reputations more or less intact, whereas in Latin America the crisis led to a loss of confidence in their economic systems and investors pulled out for the long term. This is in line with North’s theory that good institutions persist and breed prosperity even through crises.