This article first appeared in Forum, The Edge Malaysia Weekly, on December 21 - 27, 2015.
THE sometimes caustic but always affable economic historian, Douglass North, died last month at the age of 95. He has had a significant influence on my thinking as an economist, broadening my perspective well beyond the mechanisms of price and value theories towards the role of values and institutions in determining economic outcomes.
Some may argue that it is much more demanding to be analytically rigorous with words than with mathematics. That was certainly the case with North, who equipped economics with tools that not only explained why we obtain certain outcomes but also why we failed, by introducing concepts of institutions, their underlying values and the idea of transaction costs.
North, together with Ronald Coase, Oliver Williamson and Elinor Olstrom, defined what is known as the new institutional economics. All of them were separately awarded the Nobel Prize in economics, with North recognised in 1993 together with another economic historian, Richard Fogel.
Institutional economics moved away from the general equilibrium framework of neo-classical economics in determining prices and allocation. It seeks to understand the role of social and legal norms and rules — institutions — and how their evolutionary process shapes economic behaviour. The premise is that institutions form the incentive structure of a society and the political and economic institutions are the underlying determinant of economic performance.
In many ways, this approach to economic analysis is more robust at explaining economic outcomes and changes, especially in development economics. While classical growth theory rightly identifies technological progress and human capital investments as crucial elements, it ignored the incentive structure embodied in institutions that determine societal investments in these elements to begin with.
Differences in development outcomes can be better explained by the different incentive structures for society to choose to do the right things and make the efficient choices and ones with small transaction costs.
Upon finding out about his passing, I re-read his Nobel lecture — a lecture where the winner himself defines his own work in contrast to the citations for why he was chosen as a winner. It reminded me why I find North to be so compelling. His words and arguments are subtle but have the same rigour as the elegant neo-classical mathematical models.
There is a section in the lecture where he delved into learning and appealed to the theories of cognitive science. This linkage of the fundamentals of learning and macroeconomic outcomes is intellectually scintillating. Of course, it also has immense policy implications.
Economic change, North argued, is a ubiquitous, ongoing and incremental process that is a consequence of the choices made by economic actors. Some of these choices require revisions and re-contracting outside the existing structure of property rights and political rules.
At the same time, norms of behaviour that guide these exchanges also change, altering institutions in the process. The demand for change happens because economic actors believe they can do better, and the primary source of this belief comes from learning — by individuals as well as by organisations. Therefore, how society and its economy change depend on how it learns, which then affects how it decides.
Learning is a complex process that begins with developing structures to interpret the various signals received by the brain. There are the usual nature and nurture dimensions to the learning process and capabilities, with the latter being the results of experiences from the socio-linguistic environment one is exposed to.
These cognitive structures evolve into mental models that will be continually redefined by new experiences but forms the basic infrastructure for learning. These mental models are influenced by belief structures, which then suggest that how one operationalises religion and form myths and dogmas will have a bearing on how one learns.
More broadly, belief structures get transformed into societal and economic structures by institutions — both the formal rules and informal norms of behaviour. North concluded that while mental models are internal representations of individual cognition of his environment, institutions are external mechanisms individuals create to structure and order their environment.
Societies that developed are those with institutions that incentivised acquisition of knowledge, and given that new knowledge or innovations are disruptive, these societies are also those that tolerate these disruptive innovations.
The Industrial Revolution, which saw the world’s first onset of real economic development, was fuelled by the eventual societal perception of the utility of scientific inquiry. It was this virtuous cycle of learning and the right incentive structures that fuelled the industrial and post-industrial economic development, but this phenomenon was however largely a western one.
It may be relevant to note that the Reformation and the Age of Enlightenment also preceded the Industrial Revolution. There was a liberation of the mind before the mind started innovating.
Asian societies that have developed proved the point about learning and developing institutions that incentivises the right behaviour and lower transaction costs. The Japanese, and to a lesser extent, the Korean values of individual honour and community welfare induce a certain level of cooperation that greatly reduces transaction costs.
The other lesson is on path dependence — why do economies, once a path of growth or stagnation, tend to persist? Reversing one’s fortune, once on a bad path, depends very much on the belief systems of the actors.
These concepts raise pertinent questions for Malaysia. What are the mental models of Malaysians that determine how we learn collectively? Is there a convergence of these models hence, the formation of strong national institutions, or is there a set of disparate mental models that therefore suggest weak national institutions?
Contrary to neo-classical models that emphasises both productive and allocative efficiency, North emphasises adaptive efficiency — successful systems evolved flexible institutional structures that are resilient to shocks and evolve accordingly.
How well have our institutions adapted to changes? Can we reverse a bad path dependency?
Dr Nungsari Radhi is an economist and managing director of Prokhas Sdn Bhd, a Ministry of Finance advisory company. The views expressed here are his own.