Institutions and Economic Growth: A Historical Introduction By Douglass North

In this essay, Douglass North underlines the importance that institutions have had in the economic development of the west. The classical economic model that do not consider the cost of transaction, or that take this cost as fixed, ignores a central element of a decisive element in the functioning of our economic system.

To understand the importance of institutions, one has to understand the two historical and structural extremes in trade. In primitive societies and in order to avoid cheating, shirking or opportunism the individual engaged only in trade with those who he knew well. The transactions were limited in both space and time because the number of people an individual knew was very small. This reduced the size of the market, forced him to produce most of the things he needed and impeded him to specialize.

The opposite of personal exchange is specialized interdependence. An ideal model of specialized interdependence is one in which an individual can have trade with someone at the other side of the world without fear of being cheated. The personal knowledge of those who one trades with is no longer necessary, and in consequence the markets available to fulfill one’s necessities and to sell one’s products are much larger. This creates the kind of specialized economy in which both, North and the classical economist, think lays the welfare of societies.

But for the creation of this specialized interdependence it is vital the creation of a third party that can guarantee contracts and enforce property rights. This third party can be called government but in the essay North simply calls it “institution”. Presumably, North avoids using the word “government” because he takes into account the fact that there are several international organizations and norms that also facilitate trade.

The essay finishes with an application of the theory using the historical examples of England and Spain during the 16th and 17th centuries. With the introduction of new weapons and war tactics, war became more expensive and both kingdoms were forced to raise taxes. The English collected taxes from the population in the island, this ignited social demands and ultimately the creation of the Parliament. The Parliament being the representation of merchants increased the governmental protection of property rights. On the other hand, Spain relied on the money that was raised in the colonies, not taxing the Spanish population. This allowed the king to reduce the Cortes and the protection of property rights never took off.