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An Institutional Road-Map to Plenty
From these per capita income estimates and other evidence, and from North’s fascinating time capsule summary of human existence, it is clear that the road out of poverty is new. It has been traveled by few societies: Western Europe; the United States, Canada, Australia, and New Zealand (Britain’s offshoots); Japan, Hong Kong, and Singapore; and few others. What steps did Western Europe and its “offshoots” take to lead humanity along the road to plenty? Why is China, the world’s most populous country (almost 1.3 billion), now far ahead of India (second with 1 billion), when merely fifty years ago both nations were about equal in per capita income and more impoverished than most poor African nations today? Is there a roadmap leading to a life of plenty, a set of policies and institutional arrangements that developing nations can adopt to replicate the success of advanced modern economies? An honest answer to this question is disappointing. Economic development organizations like the International Monetary Fund, the World Bank, and countless scholars who have committed their professional lives to the study of economic growth and development are fully aware of the limited theoretical structure yet pieced together. The heartening news is that while we cannot map out a clear highway to wealth, there are clear road signs to point us in the right direction and away from cliffs.
Well known is the fact that a nation’s total output is fundamentally determined (and constrained) by its total inputs, measured in terms of natural resources, labor force, stock of capital, and entrepreneurial talents; and by the productivity of those inputs, measured as the output or service produced per input(s). However, to measure standards of living we rely on output (or income) per capita, rather than total output, and for changes in income per capita, productivity advance dominates the story. For example, if a nation’s population increases by 10 percent, and the labor force and other inputs also increase by 10 percent, output per capita remains essentially unchanged unless productivity increases. Two hundred and fifty years ago, and for many centuries preceding that, most people (80-90 percent of the labor force) everywhere were engaged in agriculture, with much of it being subsistence, self-sufficient, noncommercial farming. Today that proportion is under 5 percent in most advanced economies (3% in the U.S.). During this two-and-one-half century transition, people grew bigger, ate more, and worked fewer hours and days in greater safety and comfort.6 The sources of productivity advance that have raised output per farmer (and per acre) and allowed sons and daughters of farming people to move into other (commercial) employments and careers and into cities include advances or improvements in:
- technology (knowledge);
- specialization and division of labor;
- economies of scale;
- organization and resource allocation; and
- human capital (education and health).
These determinants are especially useful when analyzing the rates and sources of economic growth for single nations, but less satisfactory in explaining why productivity advances and resource reallocations have been so apparent and successful in some parts of the world but not in others.
To explain why some nations grow faster than others, we need to look closely at the way nations apply and adapt these sources of productivity change. To use this perspective, we need to assess the complex relationships of the laws, rules, and customs of a society and its economic performance (North, 2005). For example, the dissolution of the Soviet Union and the difficulties of building market-based economies there have made us acutely aware of the importance of the rules of economic and social interaction. Likewise, in Afghanistan and Iraq, we are continually reminded of both the difficulty and the necessity of gaining popular acceptance of changes designed to promote peaceful exchange and economic growth.
Consider just one of the sources of productivity change – technological change—and how it is intimately tied to the institutions, the laws, rules, and customs of a society. A new technology can introduce a whole new product and service, such as the airplane and faster travel, or it can upgrade and improve an existing one; we have come a long way from the 1930’s Model A Fords to today’s luxury BMWs and state-of-the-art hybrid fuel technologies. A new technology can also affect the cost of production; the introduction of relatively light but strong aluminum changed the cost of producing a whole range of goods and services, from soft-drink cans to airplanes.
In short, technological changes can be thought of as advances of knowledge that raise or improve output or lower costs. They often encompass both invention and/or modifications of new discoveries, called innovation. Both require basic scientific research, then further trial and error and study to adapt and modify the initial discoveries and put them to practical use. The inventor or company pursuing research bears substantial risk and cost---including the possibility of failure and no commercial gain. How are scientists, inventors, entrepreneurs, and others encouraged to pursue high-cost, high-risk research ventures? How are these ventures coordinated and moved along the discovery/adaptation/improvement path into commercially useful applications for our personal welfare?
This is where laws and rules, or institutions as they are called, help us better understand the causes of technological change. They establish, positively or negatively, the incentives to invent and innovate. Patent laws, first introduced in 1789 in the U.S. Constitution, provided property rights and exclusive ownership to inventors for their patented inventions. This path breaking law ultimately spurred creative and inventive activity, albeit not immediately. As legal interpretations extended exclusive ownership rights to ideas including the right to sell, a market for new, patented ideas emerged, with inventors often selling their patents to people who specialized in finding commercial uses of new inventions. The keys here are the laws and rules, the institutions, that lay out the incentive structures that generate dynamic forces for progress in some societies and stifle creativity and enterprise in others. In advanced economies, laws provide positive incentives to spur enterprise and help forge markets using commercial, legal, and property rights systems which allow new scientific breakthroughs (technologies) to realize their full commercial-social potential. Properly constructed institutions generate productivity advances through specialization and division of labor, allowing universities, other scientific research institutions, corporations, and other business entities (and lawyers and courts, too) to cooperate through interrelated markets (production and exchange) hastening the growth and spread of technological advances (for elaboration, see Rosenberg and Birdzell, 1986, and Mokyr, 1990).
Getting the institutions right and sustaining institutional changes that realize gains for society as a whole are fundamental to the story of growth. The ideologies and rules of the game that form and enforce contracts (in exchange), protect and set limits on the use of property, and influence people’s incentives in work, creativity, and exchange are the key institutional components paving the road out of poverty.
Examining the successful economies of Europe, North America, and Asia suggests
a partial list of the institutional determinants that allow modern economies
to flourish:
- the rule of law, coupled with limited government, and open political participation;
- rights to private property that are clearly defined and consistently enforced;
- open, competitive markets with freedom of entry and exit, widespread access to capital and information, low transaction costs, mobile resource inputs, and reliable contract enforcement; and
- an atmosphere of individual freedom in which education and health are accessible and valued. (For advances in education levels see Appendix 1.)
North’s study of economic progress confirms that “it is adaptive rather than allocative efficiency which is the key to long-term growth” (North, 1994). The ability or inability to access, adapt, and apply new technologies and the other sources of productivity advances is fundamentally determined by a society’s institutions. Institutions can open doors of opportunity or throw up road blocks. In addition, institutional changes often come slowly (customs, values, laws, and constitutions evolve), and established power centers and special vested interests and religious beliefs sometimes deter and delay changes conducive to economic progress. How accepting is a society of risk and change when change creates losers as well as winners (Shumpeter, 1934), or transgresses religious beliefs?