If you were to ask a mainstream economist about the most important factor in long run economic growth and development, they would most likely reply with the word “institutions” (i.e. political institutions). One of the most vocal proponent of this position, Nobel Prize winning economist Douglas North, wrote in his famous book Institutions, Institutional Change, and Economic Performance:

I wish to assert a fundamental role for institutions in societies: they are underlying determinants of long-run performance of economies – Third World countries are poor because the institutional constraint define a set of pay-offs to political/economics activity that do no encourage productive activity. (North 1990: 107)

For the most part, I would agree with this claim. However, when it comes economic development, I believe that this view has some major problems.

In 1769, Johan Jacob Meyen wrote that “it is known that a primitive people does no improve its customs and institutions, later to find useful industries, but the other way around.” Instead of the typical logic, that institutions create a reliable framework for economic development and improvement in the means of production, it’s the other way around. An improvement or change in production allows for institutional change, leading to economic development. In other words, the causation between institutions and modes of production is backwards. This picture is similar to view perpetrated by Marx and Engels in the Communist Manifesto:

The bourgeoisie, by the rapid improvement of all instruments of production, by the immensely facilitated means of communication, draws all, even the most barbarian, nations into civilisation. The cheap prices of commodities are the heavy artillery with which it batters down all Chinese walls, with which it forces the barbarians’ intensely obstinate hatred of foreigners to capitulate. It compels all nations, on pain of extinction, to adopt the bourgeois mode of production; it compels them to introduce what it calls civilisation into their midst, i.e., to become bourgeois themselves. In one word, it creates a world after its own image. The bourgeoisie has subjected the country to the rule of the towns. It has created enormous cities, has greatly increased the urban population as compared with the rural, and has thus rescued a considerable part of the population from the idiocy of rural life. Just as it has made the country dependent on the towns, so it has made barbarian and semi-barbarian countries dependent on the civilised ones, nations of peasants on nations of bourgeois, the East on the West.

In order to truly understand economic development, we can’t just study the relationship between economic growth and institutions in isolation. To do so would ignore history, knowledge, demand, and the activity specific nature of economics development (e.g. some activity, such as manufacturing, contributes more to economic development than say farming).

For example, understanding the development of mercantilist institutions and mercantilist policies is extremely difficult outside the context of activity specific practices and the history of industrialization in Europe. Despite the claim of many mainstream economists, mercantilist writers were not misguided, naive, or part of an “irrational social order”. In actuality they were more practical men that based their writings on the economic history of Spain, France, and other European countries. This is why, as Cosimo Perrotta points out, “Mercantilism was born in response to the failure of Spain.” One thing that many mercantilist writers noticed during this time period is that wealth left the nations producing raw materials (even if those raw materials were gold or some other precious metal) and accumulated in nations that had a well established manufacturing sector. This is exactly what happened in Spain. By 1550, Spain was increasingly indebted to foreign bankers and has gradually lost its financial independence. Inflows of gold caused rampant inflation and many spanish industries such as silk, iron, and steel had died out. The Spanish economy was de-industrialized and flooded with imports, which in turn causes species to flow out of the country at a rapid rate. This is in direct contrast to the Dutch, which enjoyed the fruits of economic growth, synergy, and innovation as a result of it’s specialized manufacturing sector and mercantilist policies. What’s important to note is that the development of mercantilist institutions had more to do with the history and means of production in a specific country. Spain’s de-industrialized economy, which put more of an emphasis on farming, didn’t really development a coherent set of economic policies and institutions. On the other hand, the Dutch did exactly that because of their manufacturing sector.

The main point here is that institutions are a product of their history and in many cases they are the secondary effects of established types of economics activity. Understanding mercantilist institutions and the history of mercantilist policies is useless if you don’t look at it from the context of nations trying to escape a comparative advantage in producing raw materials. Understanding the establishment of insurance without looking at history of high risk caravans, ocean trade, and other forms of long distance trading is almost impossible. With this is mind, you can’t expect a Third World country to suddenly turn around if given the right institutional framework. The necessary economic activities and means of production haven’t been established to allow those types of institutions to thrive and develop properly. Studying the connection between institutions and economic growth in a pseudo-equilibrium framework and outside the context of desired change in not very meaningful.

References:

1. Allen, Robert C. Global Economic History: A Very Short Introduction. Oxford: Oxford UP, 2011. Print.

2. Chang, Ha-Joon. Institutional Change and Economic Development. New York, NY: United Nations UP, 2007. Print.

3. Marx, Karl, and Friedrich Engels. The Communist Manifesto. Harmondsworth: Penguin, 1967. Print.

4. North, Douglass C. Institutions, Institutional Change, and Economic Performance. Cambridge: Cambridge UP, 1990. Print.

5. Reinert, Sophus A., and Erik S. Reinert. “Mercantilism and Economic Development: Schumpeterian Dynamics, Institution Building and International Benchmarking.” In The Origins of Development Economics: How Schools of Economic Thought Have Addressed Development, edited by Jomo K. Sundaram and Erik S. Reinert, 1–23. Zed Books, 2005.

6. Reinert, Erik S. “Full Circle: Economics from Scholasticism through Innovation and Back into Mathematical Scholasticism: Reflections on a 1769 Price Essay: “Why Is It That Economics so Far Has Gained so Few Advantages from Physics and Mathematics?”.” Journal of Economic Studies 27.4/5 (2000): 364-76. Print.