Summary of JOIE article ( First View 26 January 2021) by Daniel Seligson, Palo Alto, CA, USA, and Anne E. C. McCants, MIT, Cambridge, MA, USA. The full article is available on the JOIE Website,
The notion that institutions matter has circulated for millennia. The dynamics of their interaction with the economy has been hinted at, but never reduced to practice. This paper is a reduction to practice.
The New Institutional Economics (NIE) of the last half century stipulates that institutions are humanly-devised behavioral constraints that reduce uncertainty and lower transaction costs to the benefit of the economy. Institutions, therefore, must play a role in economic development, and in Douglass C. North’s Ur-slogan of the NIE, institutions are the rules of the game.
That pronouncement would come as a surprise, if not an outright absurdity, to financiers or shopkeepers who, seeking to build inventory to meet growth’s demands, understand that ‘Cash is King!’ Cash, then, is also a source of economic growth, suggesting by analogy that institutions are not humanly devised constraints that reduce uncertainty, but rather humanly devised sources of economic growth. Is that distinction real, or is it one without a difference?
Institutions, Institutional Change, and Economic Performance is the title of North’s most influential monograph. Its third sentence informs the reader that institutional change is not just essential to economics, but to all of history. But no time-dependent or dynamic theory of such change has been advanced. Game theory—the preferred analytic framework for a dynamic, rules-based NIE—has thus far failed to deliver. It is here, in the domain of dynamics, that the distinction between institutions as rules and institutions as sources becomes real, as we shall see.
North made other keen, if less well remembered observations. First, his monograph reminds us that not only do institutions change, but they do so in concert with the economy; that is the two coevolve. But coevolution demands a dynamic theory, which has been wanting. Meanwhile, coevolution has been gradually written out of the NIE. Second, North observed that cultural norms or informal constraints had a pervasive influence on development that could not be explained by the NIE which gives pride of place to written law or formal constraints. Though Oliver Williamson seconded this in 2000, and expressed only bewilderment as to its cause, this paradox of informal constraints has also been written out of the NIE.
That the NIE ignores these problems does not make them go away. Instead, it makes the NIE ripe for critique. We aver that the resolution of the paradox lies in embracing coevolution at the expense of the NIE’s embrace of institutions as rules. While coevolution is beyond game theory, it is old hat for the first toolkit of dynamic theorists, differential equations. We use its centuries-old methods to construct, and to solve, coupled equations for institutional and economic growth. This we call r-Theory.
What, though, does an equation for institutional growth look like? It depends. Some institutions, for instance laws, or the brick and mortar embodiment of laws, e.g. legislative and judicial infrastructure, change in tandem with the economy on a time scale of at most a generation. Others, for instance cultural norms, change on a time scale of centuries. These differences rest on concrete temporal characteristics of each, rather than an ill-defined distinction between formal and informal. The differences ripple through the system of equations in such a way that infrastructure coevolves with the economy while norms come to sit alongside climate, geography, and other barely mutable environmental factors. They are, metaphorically, social climate. Just as the effect of natural climate is a brute fact of life with consequences for development, so is social climate. Thus r-theory resolves the paradox of informal constraints, and it does so without having specified which norms matter. Norms are culture, and it is beyond the scope of this paper to give cultural analysis its due.
Coevolution of economies and infrastructure leads to an equilibrium condition wherein both are weak or both are strong but never are they very different. This explains then, the observation that spurred institutional economics in the days of Weber and Veblen. The confluence of good governance and good economies is not causal, as claimed by the NIE, but rather it is a consequence of the coevolutionary dynamics.
The equilibrium condition states that what we call development, the sum of an economy’s performance and its infrastructure (in appropriate units) is constant on a time scale much, much longer than a generation. The distribution of development across the globe is thus predicted to be constant on that same time scale. To test this, we compute the autocorrelation function of the distribution of the UN’s Human Development Index (1990 to 2017) and of Escosura’s Index of Human Development (1870 to 2015). The time scale of decorrelation is more than 600 years, confirming the prediction. Theories or models of long term development that do not conform to this constraint are ahistorical fiction. Examples are identified within. The constancy of the distribution of development over long time scales permits us to model that distribution in terms of (mostly) slowly changing factors. A 4-variable model is presented.
It follows from the presentation of r-theory, and the simple dynamical systems equations which define its moving parts, that there can be no such thing in this world as being rich in money alone. And indeed, the set of places on Earth where incomes are high but people die young, or which have state-of-the-art transport systems but terrible education, or where good governance and the rule of law stand alongside low trust and political repression, is the null set. These facets of the experience of wealth are no more separable than the faces of a cube. Nor is it an accident that we find them working hand in hand in the historical past and in the world today. The imperative of life is to live, and those factors just named are examples of humanly devised systems that facilitate our lives on Earth. Individually and collectively, we do what is necessary – whether that is learning from the past, borrowing from our neighbors, or inventing the future – to satisfy the imperative. r-Theory explains both the system and its mechanisms that yield long, prosperous, lives beneath an umbrella of good governance.