The importance of institutions in shaping economic development is now widely acknowledged. Institutions matter because they affect incentives. The institutional framework of a society determines the degree to which its members will pursue wealth-creating activities. But the historical record shows that effective -- that is, growth-promoting -- institutions have been the exception and not the rule. In the nineteenth century, relatively few countries achieved sustained economic growth. Britain, the United States, France, Germany, and Japan come to-mind. More recently, the East Asian highfliers -- South Korea, Taiwan, Hong Kong, and Singapore -- have grown impressively. But a country can achieve sustained growth and then lose momentum, lapsing into stagnation and even decline. Argentina is perhaps the classic example. Economic growth is hard to come by and easy-to forfeit.
The new institutional economics has given us a way to understand why economic development does not come easy. This type of analysis began with Ronald Coase's insight that when exchange is costly, institutions make a difference (1960). In a world of zero transaction costs, institutions do not matter. Any assignment of well-defined and enforced property rights will result in an efficient outcome because different parties will have an incentive to bargain with one another to capture the gains from trade. The property rights will ultimately be held by the party who can make the most profitable use of them. Neoclassical economic explanations are all we need, as Douglass North expresses it, "because the competitive structure of efficient markets leads the parties to arrive costlessly at the solution that maximizes aggregate income regardless of the initial institutional arrangements" (1990, 15).
Of course, transaction costs are usually positive, because information is costly. Goods and services have attributes that often are not immediately obvious. Buying a used car is a familiar example. Finding out about these attributes requires an investment in searching for information. Then comes the problem of enforcement, for "without institutional constraints, self-interested behavior will foreclose complex exchange, because of the uncertainty that the other party will find it in his or her interest to live up to the agreement" (North 1990, 33). Measurement and enforcement together determine the costs of transacting.
When it is costly to transact, institutions come into their own. Institutions are "the humanly devised constraints that structure political, economic and social interaction." (North 1991, 97). They consist of both formal constraints such as constitutions, laws, and property rights, and informal constraints such as customs and codes of conduct. According to North, "Institutions provide the incentive structure of an economy; as that structure evolves, it shapes the direction of economic change towards growth, stagnation or decline" (97). Effective institutions create an economic environment that encourages greater productivity.
North has devoted most of his academic career to applying the Coasean analysis to economic history. As he has pointed out,
economic history is overwhelmingly a story of economies that
failed to produce a set of economic rules of the game (with
enforcement) that induce sustained growth. The central issue of
economic history and of economic development is to account for
the evolution of political and economic institutions that create an
economic environment that induces increasing productivity.
North distinguishes three general types of exchange. The type most common in the past has been "personalized exchange involving small-scale production and local trade" (1990, 34). Here the costs of transacting are low because the trading parties engage in repeat dealings among themselves, they are few in number, and they are well informed about one another. By the same token, production costs are high because there is little scope for specialization and division of labor. Personalized exchange entails limited markets and does not lead to sustained growth.
Under the second general pattern of exchange, the prospects of gains from trade improve substantially. This involves impersonal exchange where "the parties are constrained by kinship ties, bonding, exchanging hostages, or merchant codes of conduct" (1990, 34-5). But as production costs decline, transaction costs go up. As exchange extends far beyond the face-to-face dealings of a few parties who know one another well, the problem of cooperation has to be handled in different ways, hence such new institutional devices as merchant codes of conduct and the exchange of hostages. The state may also play a more prominent role, as in early modern Europe, where the protection of merchants brought with it clear prospects of revenue gains for the public guardian. "However," states North, "in this environment the role of the state was at best ambiguous, because the state was as often an increasing source of insecurity and higher transaction costs as it was protector and enforcer of property rights" (1990, 35).
A third form of exchange, impersonal exchange with third-party enforcement, has been crucial for modern economic growth. Here the increasing role of the state was essential to the emergence of advanced economies. As societies became more complex, monitoring based on frequent personal contact within small groups became less common, and the returns rose on "opportunism, cheating and shirking." A coercive third party was essential if growth was to take place. North (1991) asserts that "Historically the growth of economies has occurred within the institutional framework of well developed coercive polities. We do not observe political anarchy in high-income countries. On the other hand the coercive power of the state has been employed throughout history in ways that have been inimicable to economic growth" (14).
Even in the most economically developed countries the state has interfered obtrusively to favor interest groups with relative bargaining strength. Tariff protection, subsidies, and tax exemptions have proliferated in advanced Western countries. When the state is present, redistribution cannot be avoided. But the institutional mix still provided enough incentives for activities that resulted in net productivity gains and thereby created wealthy societies.
The obvious question is: How do such efficient institutions emerge? The answer is not obvious. North has questioned the standard public-choice portrayal of the role of the state as merely responding to the rent-seeking pressures of interest groups and lobbies. As he puts it: "It is no accident that economic models of the polity developed in the public choice literature make the state into something like the Mafia -- or, to employ its terminology, a leviathan. The state becomes nothing more than a machine to redistribute wealth and income" (1990, 140). Yet if it is a Leviathan, it is a relatively passive one. It represents the largest concentration of power in society, but is at the same time subject to the pressures of the dominant political and economic groups.
North argues that we must look beyond the struggle for redistribution. The informal constraints such as customs, traditions, and codes of conduct give rise to ideologies: the subjective interpretations by which individuals impose coherence on their perceptions of the social world. Ideology modifies narrow maximizing behavior. Ideology economizes on the information costs and thereby helps individuals deal with the external world. North notes that "It is simply impossible to make sense out of history (or contemporary economies) without recognizing the central role that subjective preferences play in the context of formal institutional constraints that enable us to express our convictions at zero or very little cost. Ideas, organized ideologies, and even religious zealotry play major roles in shaping societies and economies" (1990, 43-44).
An obvious example of the role of informal constraints, to which North often refers, is the different fates of federal constitutions in the United States and Spanish America. Federalism worked in North America, arguably because of patterns of decentralized government and control that already existed in the colonial period. In Spanish America it soon collapsed as the centralist bureaucratic structure and tradition of the colonial centuries asserted themselves. Constitutional forms as such were not decisive. What mattered was that the inhabitants of the United States were already a free people when the Constitution was created in 1787, whereas the peoples of Spanish America had never experienced self-government when colonial rule collapsed early in the nineteenth century. Ultimately, the development of the two regions of the Americas reflected the whole preceding course of English and Spanish history, respectively.
South Africa before the Mineral Revolution
The economic development of South Africa has had a variety of rather special features, reflected in institutions that have attracted wide comment. Writing in 1938, S. H. Frankel observed of the sector of the economy mainly responsible for the country's growth: "The creation of the present European economy in South Africa possibly owes as much to the surplus wealth resulting from the peculiar organization which it has been able to adopt in exploiting its mineral deposits, as to the favourable climatic conditions which distinguish it from the northern territories" (13). And, in a wider context, "African economic development is governed by numerous monopolistic and sectional interests, by particular fiscal policies and by exceptional social techniques and institutions. Diverse politico-economic policies have in the past influenced, and continue to affect, the flow of resources" (15).
Western capitalism arrived in South Africa in a paradoxical form. For a century and a...