2

China’s Institutional Challenge

HONG KONG – Last month, the Nobel laureate economist Douglass North, who applied economic theory to history to gain insight into institutional and social change, died at his home in Michigan. But his ideas will live on, particularly in China. Though North never focused explicitly on China’s institutional development, his theoretical framework could prove invaluable to the country’s leaders as they navigate the next phase of institutional change.

In his Nobel lecture in 1993, North identified three lessons that policymakers should draw from his research. First, what determines economic performance is the mix of “formal rules, informal norms, and enforcement characteristics.” Second, polities have a major impact on economic performance, because they “define and enforce the economic rules.” And, finally, adaptive efficiency (how the rules are changed), not allocative efficiency (the most effective rules right now), is the key to long-term growth.

These lessons are reflected in North’s assessment of Western Europe’s institutional and economic development, in which he attributed the Industrial Revolution to two key factors: varying belief systems and intense competition between and within the emerging sovereign powers. Specifically, the English and the Dutch created diverse political/economic units that evolved institutions nurturing specialization and division of labor. These institutions delivered superior economic and political outcomes through lower transaction costs, clear and enforceable property rights, and other shared rules and norms.

North observed that institutional change is extremely difficult, as it requires overcoming not only vested interests, but also outdated belief systems and mental models. The breakthrough, he noted, comes when institutions go beyond trade within local communities to permit anonymous and impersonal exchange across time and space. Sustainable institutions are those that learn and adapt, overcoming their own biases and limitations.