North (2003) attempted to solve the puzzle of economic change. According to North, the structure we impose on our lives to reduce uncertainty accumulates from prescriptions and proscriptions, which produce a complex mix of formal and informal constraints embedded in language, physical artifacts, and beliefs. It is beliefs that connect “reality” to the institutions. The dominant beliefs, that is, of those political and economic entrepreneurs in a position to make policies, over time result in the accretion of an elaborate structure of institutions. These formal and informal institutions together determine economic and political performance. Entrepreneurs enact policies to improve their competitive positions, resulting in alterations of the institutional matrix. What follows are revised perceptions of reality, and therefore new efforts by entrepreneurs to improve their position in a never-ending process of change.
Institutions (Why Daron Acemoglu is famous)
The main purpose of institutions is to reduce uncertainty and put order to the natural chaos. Two kinds of uncertainties: one stemming from the environment and one from the human social structure. In the past, human dependence on nature resulted in the primacy of the former. Having largely controlled nature, we are now facing increasing uncertainty resulting from the ever more convoluted social construct. For example, the level of complexity in social transactions in a rural village in medieval England is vastly simpler than that of 21st century London. According to North, people cooperate productively when engaging in repeated transactions, when there is a theoretically infinite horizon for these transactions, when they are familiar with each other, and when there are small numbers of players in the cooperation game. Hence, we need appropriate economic and political institutions that keep the payoff of cooperation high or, in simple words, rules that motivate people to be nice to each other.
Beliefs (what happens in our heads actually matters)
The way in which the mind works is based on pattern-based reasoning. The neural networks of the mind gradually establish patterns by which they interpret the world, and the patterns become quite complex and elegant, as indeed many belief systems and ideologies are. Beliefs are also devised as a means of controlling uncertainty. Human beings theorize about the world of uncertainty all the time. We make decisions in the face of pure uncertainty, based on religion, beliefs, or ideologies.
It is quite clear that our ability to make radical change depends on the way in which beliefs have evolved in society, and the degree to which that set of beliefs is amenable to the kind of changes that we think are essential.
Another relative concept is what we broadly define as culture. Culture is a cumulative (due to the pattern-based reasoning of the mind) structure of rules, norms, and beliefs, that we inherit from the past, that shape our present, and that influence our future.
Example:
Soviet Union: This is a story of perceived reality, inducing a set of beliefs, which in turn induced a set of institutions to shape the society, which in turn introduced at the margin incremental policies, which in turn altered reality, which in turn, went back to revising beliefs.
Figure 1: Illustration of how our perception of reality and policies are interlinked
Data: Bonsai Economics, North (2003).
Conclusion
Economic change is defined by the interplay between institutions, beliefs, and norms. We can conceive of the process as a circular flow, in which we have initial perceptions of what reality constitutes. Those perceptions in turn lead to the construction of a set of beliefs, ideologies to explain that reality and to explain the way that we should behave. That in turn leads to the creation of an institutional structure, or an institutional matrix, which then shapes our “world”. And as our beliefs about that reality incrementally change, we enact policies that incrementally modify that institutional structure. An incremental change is always constrained by path dependence. That is, the existing institutions constrain our choices. As we make those choices that are incrementally altering policy, we are changing reality. And in changing reality, we are changing, in turn, the belief system we have. That circular flow has gone on ever since human beings began to try to shape their destiny.
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