The Grand Theory Of Institutions And Development

Does the NIE provide a different and better solution to the problem of the development of appropriate institutions than those proposed over a century and a half ago by Mill and Hegel? Does it illuminate micro-economic problems of the kind that have been illustrated above and, more importantly, offer a grand theory of social science? Exciting intellectual possibilities abound, and have evoked some over-excited responses. Development used to be defined as economic growth plus structural change. The NIE suggests that development should be redefined as economic growth plus appropriate institutional change, meaning institutional changes which facilitate further economic growth. Appropriate institutional change has been elevated by the NIE to a central place in the theory of development, by contrast with neo-classical growth theory's central focus on saving and population growth.

The neo-classical answer to the question of how institutions can develop 'appropriately' is that market forces not only generate the most Pareto-efficient outcome possible in a static framework, but they also do so in a long-run dynamic framework. The unrelenting pressure to improve economic performance which they produce means that institutional adaptations which favour Pareto-efficiency are favoured over the long term, while those which do not are abandoned. The NIE rejects this simple view of unilinear institutional progress driven by the market itself. It is right to do so, but for reasons which do not derive specifically from NIE assumptions. The neo-classical view involves an implicit appeal to the biological analogy of natural selection, in which institutions which are ill-adapted to their conditions become gradually extinct. The process of natural selection of living organisms in the natural world is based on a mechanism which has no place for conscious motivation, decision-making or choice. It is, therefore, most implausible to suggest that it can be applied to social practices which reflect human aspirations and endeavours. All discussion of the survival or development of institutions has to be placed in this context of human willing and striving. It is idle to think that an evolutionary 'mechanism' could be found outside this context. The existence of norms, customs and organisations does not require that people have no choice about how to relate to them. People surely have to choose how conventional to be and whether they want to join certain institutions, or to try to subvert them. The problem with the biological analogy is not that people cannot choose between institutions, but the exactly opposite one—that they can.

When we contemplate the survival of institutions we have to ask whether they are desired or desirable from a human point of view. We know that undesirable institutions do survive—untouchability, female circumcision, institutionalised racism, cruel and unusual punishments, for example. Explanations of these survivals is given in terms of human decisions—perhaps that it is rational for an individual to suffer unpleasant institutions because individual attempts to subvert them would bring down on his or her head even more unpleasant consequences. Explanations of the non-survival of undesirable institutions often include martyrdom—the willingness of individuals to suffer those even more unpleasant consequences, in order to break through the social defences of undesirable institutions. In short, people can and do choose how they address their institutions and that is precisely why there can be no general presumption that institutions will become 'appropriate' (or when), and that it will be market forces alone that work the trick.

The NIE approach to the grand theory of institutional development distances itself from the market-driven, natural selection explanation of longrun development. It stresses, by contrast, the limited information available to different groups and the diverse mental modelling of available information within distinct ideologies and cultures, which in turn generates their own institutional arrangements—including both organisations and social practices. The question is then posed: how do societies with different cultures and institutions adjust to new opportunities for trade and technological innovation? It is assumed (as with the market-driven model) that competitive pressures are ubiquitous, but the rate of learning both about the nature of these pressures and how to adjust to them will differ. The incentives embodied in existing organisations will also influence the process of adaptation. Thus change will be on the one hand slow and incremental and path dependent, hardly able to deviate much in the short run from a trajectory set by the initial institutional arrangements. Since the state is a central part of the institutional complex, given its ability to define property rights, it will be weighty in determining the path of development that is followed. But the state may be too concerned with maximising its own revenues to be willing to change property rights in a way that will lead to more efficient dynamic outcomes for society. In that event, the eventual outcome will depend on the size of the 'political transactions cost' of changing the nature of the state (North 1989b).

The NIE theory of development, as expounded by North, has a distinctly eighteenth-century flavour, and indeed represents a repetition of many of the views of Montesquieu. North, like Montesquieu, takes as a major theme, 'how Commerce Emerged in Europe from Barbarism'. Both share the perception of trade as the engine of economic growth. Both perceive the development of new institutions which facilitate trade to be powerful sources of increased prosperity: recall Montesquieu's admiration for the inventions of the bill of exchange and of foreign exchange arbitrage. Both see institutional advances in the economic sphere as cumulative. Both note spillover effects from economic progress facilitated by institutional change to political progress, through the pressures for better (more limited) government which ensue. Both believe that, where reason is weak, men's interests can bridle their passions— Montesquieu's thesis of doux commerce.

But eighteenth-century optimism needs to be tempered. Additional reasons why any institutional adaptation will be slow and incremental are adduced by Matthews (1986). One of these is discussed under the heading of 'inertia', although that term perhaps gives a misleading impression of what is involved. The problem is better seen through Matthews's explanation of this 'inertia'.

Institutional arrangements are about interpersonal relations and...there are inherent reasons why it should be more difficult to make changes where other people's consent is needed than where they can be made by individual fiat.


The purpose of every institution—not always achieved, needless to say—is to create settled expectations both for those inside and outside it, over a wider sphere of action than would be possible without it. The process of doing this inevitably creates conflicts between the interests of the institution (in achieving its purpose) and the interests of the individuals who compose it, which are only partly convergent. Hence the need for the patient negotiation of any change. The institution, as an embodiment of collective action, experiences all the problems which the theorists of collective action have identified.

It is worth noting, parenthetically, that the acceptance of this view leads to a criticism of Williamson's 1975 account of the firm. He views the firm as an authority structure defined as a 'command system', proposing that the division of activities between the firm and external markets will be determined by their respective transaction costs. The criticism is that the idea of the firm as a command system is an over-simplification. The firm is an institution like others—including military forces, which have a 'command system' par excellence—in which the effective exercise of authority rests on (partial) consent and (sufficient) trust. The firm which disregards the state of its interpersonal relations will soon experience transaction costs of a magnitude that will put it out of business.

If this is so, it is clear why institutional change driven from the inside can only be gradual. Externally imposed change can be much faster, and this is why reforms to institutions are so often externally driven. The external pressures for change can originate either from markets or from non-market sources. Market pressures will tend to winnow out firms that fail to minimise the sum of production and transaction costs. But this does not guarantee the survival only of firms with low transaction costs. To take an example, aluminium producers who put intensive effort into negotiating special low-cost power sources can succeed in driving out minimally administered competitors who pay normal power rates.

The main source of non-market external pressure is the state. One of its roles is to set the framework within which the market pressure can operate. In our aluminium company example, the state is likely to regulate the activities of the power companies, perhaps setting the rules under which special deals may be concluded by them. The state often mediates the operation of market pressures, and can do so in a way which is not conducive to the survival of the most efficient companies. The state also intervenes directly to reform institutions which are not subject to market pressures. But such reforms are typically plagued by information problems, as argued by Niskanen (1971). One way of overcoming them is to begin by establishing a committee of enquiry, on which impartial representatives of the community exhaustively compile the relevant information—historical as well as current—before making recommendations for change. This itself militates against rapid externally driven reform. The other option is to reform on the basis of political intuition. This is rapid but not likely to be conducive to efficiency, particularly in view of the complexity of most institutions.

The complexity of institutions is the third of Matthews's reasons (after inertia and the pervasive role of the state) why reform is so difficult, and why therefore the evolution of efficient institutions is so problematic. One facet of the life of institutions which tends to be forgotten once we lose sight of its human context, is its constant search for fresh recruits to replace those who have resigned, retired or died. The purposes of some of its internal rules is unlikely to be understood by all of the individuals who compose it, and the practices which have become habitual may be at variance with its rules. The very purpose of the institution may shift subtly over time, without any overt acknowledgement, in response to the creative activities of its leading figures. The reforms imposed on it by external non-market agencies may simply be misconceived because these complexities are not understood.

In summary, there are many reasons why one cannot presume that institutions will evolve efficiently, even over long periods of time. They are all rooted in the fact that individuals can and do choose to address existing institutions in a multitude of different ways. Even those political philosophers like Mill or Hegel—or, even earlier, Kant—who had confidence that people would learn (in different ways) from accumulated experience did not say whether the learning process would take generations, centuries, millennia or aeons.

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