Economic historians such as Robert Fogel, David Landes, and Douglass North have argued that the rich world is rich today because, over the centuries, it has devised institutions that have enabled people to improve their material conditions of life. This is a deeper explanation. It says that people in rich countries work with superior technologies, are healthier, live longer, are better educated, and produce many more productive ideas, because they have been able to get on with their lives in societies whose institutions permit – even encourage – the economy-wide accumulation of such factors of production as machines, transport facilities, health, skills, ideas, and the fruits of those ideas. The accumulation of productive capital assets is only a proximate cause of prosperity, the real cause is progressive institutions.
One can peel away the conceptual onion some more, and ask how and why past people in today’s rich countries were able to fashion their institutions in ways that enabled those proximate causes of prosperity to explode there. One can even ask whether institutions did it, or whether it was the enlightened policies of the rulers that were responsible for the explosion. But then, policies aren’t plucked from the air, they emerge from consultations and deliberations within institutions. Nor is it likely that a policy designed to bring prosperity to a country will actually work unless the institutions there are capable of implementing it.
These dilemmas are of enormous importance for today’s poor countries. What institutions should they adopt and what policies should their governments be encouraged to follow? There is little point in embarking on grandiose projects (steel mills, petrochemical plants, land reform, public health programmes, free education) unless a country’s institutions have the necessary checks and balances to limit corruption and wastage. This brings us back to our earlier question: how did those institutions that promoted economic growth in today’s rich countries become established and flourish? Despite the attention the question has received from the world’s most outstanding economic historians, the matter remains unsettled. In the next text, I shall show why it is inherently so difficult to find a satisfactory answer (which, I guess, is itself a mark of increased understanding). In view of the difficulties, it is safest to regard institutions as the explanatory factor when we seek to understand why Becky’s and Desta’s worlds differ so much in terms of the standard of living.
The Oxford English Dictionary defines the institution as ‘an established law, custom, usage, practice, organisation, or another element in the political or social life of a people’. We shall follow that lead, but recast it so as to stress the role of institutions in economic life. By institutions, I shall mean, very loosely, the arrangements that govern collective undertakings. Those arrangements include not only legal entities, like the firm where Becky’s father works, but also the bidder to which Desta’s father belongs. They include the markets in which Becky’s family purchase goods and services, and the rural networks Desta’s household belongs to. They include the nuclear household in Becky’s world and the extended kinship system of claims and obligations in Desta’s world. And they include that overarching entity called government in both their worlds.
Institutions are defined in part by the rules and authority structure that govern collective undertakings, but in part, also by the relationships, they have with outsiders. The rules on the factory floor (who is expected to do which task, who has authority over whom, and so on) matter not only to members of the firm, they matter to others too. For example, rich countries have laws relating to working conditions in factories. Moreover, environmental regulations constrain what firms are able to do with their effluents. In every society, there are layers of rules of varied coverage. Some rules come under other rules, many have legal force, while others are at best tacit understandings.
The effectiveness of an institution depends on the rules governing it and on whether its members obey the rules. The codes of conduct in the civil service of every country include honesty, but governments differ enormously as to its practice. Social scientists have constructed indices of corruption among public officials. One such index is based on the perception private firms have acquired, on the basis of their experience, of the bribes people have had to pay officials in order to do business. The index which is on a scale of 1 (highly corrupt) to 10 (highly clean) – is less than 3.5 for most poor countries (African countries and Eastern Europe are among the worst) and greater than 7 for most rich countries (Scandinavian countries are among the best). It used to be argued that bribery of public officials helps to raise national income because it lubricates economic transactions. It does so in a corrupt world: if you don’t pay up, you don’t get to do business. But corruption isn’t an inevitable evil. There are several poor countries where corruption is low. Having to pay bribes raises production costs; so less is produced. Citizens suffer because the price they have to pay for products is that much higher.
Economists have speculated that government corruption is related to the delays people face in having the rule of law enforced. The thought is that delays are a way of eliciting bribes to hasten legal processes. To enforce a contract takes 415 days in the poor world, as against 280 days in the rich world. It may be that corruption is also related to government ineffectiveness. To register a business takes 66 days in the poor world, 27 days in the rich world. In poor countries, registering property takes 100 days on average, while in rich countries the figure is 50 days. Some economists have suggested that government officials in poor countries create lengthy queues (that’s government ineffectiveness) so as to elicit bribes from applicants if they want to jump those queues (that’s corruption).
How do government corruption, ineffectiveness, and indifference to the rule of law translate into the kind of macroeconomic statistics we have been studying here? They leave their imprint on total factor productivity. Other things being equal, a country whose government is corrupt or ineffective, or where the rule of law is not respected, is a country whose total factor productivity is lower than that of a country whose government suffers from fewer of those defects. Some scholars call these intangible but quantifiable factors social infrastructure, others call them social capital.
Institutions are overarching entities. People interact with one another in institutions. A more basic notion is that of engagements among people. The possibility of engagements gives rise to a fundamental problem in economic life.
Imagine that a group of people have discovered a mutually advantageous course of actions. At the grandest level, it could be that citizens see the benefits of adopting a constitution for their country. At a more local level, the undertaking could be to share the costs and benefits of maintaining a communal resource (irrigation system, grazing field, coastal fishery); construct a jointly useable asset (drainage channel in a watershed); collaborate in political activity (civic engagement, lobbying); do business when the purchase and delivery of goods can’t be synchronized (credit, insurance, wage labour); enter marriage; create a rotating saving and credit association (iddir); initiate a reciprocal arrangement (I help you, now that you are in need, with the understanding that you will help me when I am in need); adopt a convention (send one another Christmas cards); create a partnership to produce goods for the market; enter into an instantaneous transaction (purchase something across the counter); and so on. Then there are mutually advantageous courses of action that involve being civil to one another. They range from such forms of civic behaviour as not disfiguring public spaces and obeying the law more generally, to respecting the rights of others.
Imagine next that the parties have agreed to share the benefits and costs in a certain way. Again, at the grandest level, the agreement could be a social contract among citizens to observe their constitution. Or it could be a tacit agreement to be civil to one another, such as respecting the rights of others to be heard, to get on with their lives, and so forth. Here we will be thinking of agreements over transactions in goods and services. There would be situations where the agreement was based on a take-it-or-leave-it offer one party made to another (as when Becky’s mother accepts the terms and conditions set by the firm called in by her to fix the plumbing). In other contexts, bargaining may have been involved (as when Desta’s mother purchases household fineries at the regional fair, which is not altogether different from a Middle Eastern bazaar). Later in these texts, we will see an idealized version of prices in the markets Becky’s family visits, where both buyers and sellers face take-it-or-leave-it offers. But we will not study how agreements are reached when bargaining is involved in either Becky’s or Desta’s worlds, nor look for principles of equity that might have been invoked during negotiation. To do that would take us into bargaining theory, a beautiful but difficult branch of the theory of games. We ask instead a question that is pertinent in both Becky’s and Desta’s worlds: under what circumstances would the parties who have reached agreement trust one another to keep their word?
Because one’s word must be credible if it is to be believed, mere promises wouldn’t be enough. (Witness that we warn others - and ourselves too - not to trust people ‘blindly’.) If the parties are to trust one another to keep their promise, matters must be so arranged that: (1) at every stage of the agreed course of actions, it would be in the interest of each party to plan to keep his or her word if all others were to plan to keep their word; and (2) at every stage of the agreed course of actions, each party would believe that all others would keep their word. If the two conditions are met, a system of beliefs that the agreement will be kept would be self-confirming. Notice that condition (2) on its own wouldn’t do. Beliefs need to be justified. Condition (1) provides the justification. It offers the basis on which everyone could in principle believe that the agreement will be kept. A course of actions, one per party, satisfying condition (1) is called a Nash equilibrium, in honour of the mathematician John Nash - he of The Beautiful Mind - who proved that it is not a vacuous concept. (Nash showed that the condition can be met in realistic situations.) The way I have stated condition (1) isn’t due to Nash, though, but to John Harsanyi, Thomas Schelling, and Reinhard Selten, three social scientists who refined the concept of Nash equilibrium so that it could be applied to situations where Nash’s own formulation is not adequate.
Notice that condition (1) on its own wouldn’t do either. It could be that it is in each one’s interest to behave opportunistically if everyone believed that everyone else would behave
opportunistically. In that case, non-cooperation is also a Nash equilibrium, meaning that a set of mutual beliefs that the agreement will not be kept would also be self-confirming. Stated somewhat informally, a Nash equilibrium is a course of actions (strategy, in economic parlance) per party, such that no party would have any reason to deviate from his or her course of actions if all other parties were to pursue their courses of actions. As a general rule, societies harbour more than one Nash equilibrium. Some yield desirable outcomes, others do not. The fundamental problem every society faces is to create institutions where conditions (1) and (2) apply to engagements that protect and promote its members’ interests. When we come to study what economics has to say about the ideal role of the state, we will have much to add about those interests.
Conditions (1) and (2), taken together, require an awful lot of coordination among the parties. In order to probe the question of which Nash equilibrium can be expected to be reached – if a Nash equilibrium is expected to be reached at all – economists study human behaviour that is not Nash equilibria. The idea is to model the way people form beliefs about the way the world works, the way people behave, and the way they revise their beliefs on the basis of what they observe. The idea is to track the consequences of those patterns of belief formation so as to check whether the model moves toward a Nash equilibrium over time, or whether it moves about in some fashion or other but not toward an equilibrium.
This research enterprise has yielded a general conclusion. Suppose the economic environment in a certain place harbours more than one Nash equilibrium. Which equilibrium should be expected to be approached – if the economy approaches an equilibrium at all – will depend on the beliefs that people held at some point in the past. It also depends on the way people have revised their beliefs on the basis of observations since that past date. But this is another way of saying that history matters. The narrative style of empirical economics that I spoke of earlier becomes necessary at this point. Model-building, statistical tests on data relating to the models, and historical narratives have to work together synergistically if we are to make progress in understanding our social world. Unfortunately, the study of disequilibrium behaviour would lengthen this monograph greatly. So I shall only allude to it from time to time. We will discover that, fortunately, a study of equilibrium behaviour takes us a long way. We started this chapter by observing that mutual trust is the basis of cooperation. In view of what we have learned about the multiplicity of Nash equilibria, we are now led to ask what kinds of the institution are capable of supporting cooperation. To answer that, it will prove useful to classify the contexts in which the promises people make to one another are credible.