Winds of fortune

In Part I of the article we had discussed the economic/financial, political and judicial institutions in England, France and Holland. We had also found that while Holland had receded from the race for global leadership, England and France were still locked in a fierce battle across the globe in the 18th century. In Part II of the article, we will examine how New Institutional Economics (NIE) helps us explain the success of England vis-à-vis France in the 17th-19th century.

NIE: Salient features

We have discussed earlier that the traditional neoclassical model is inadequate to study public policy and social policy problems since it assumes that there are no institutions, transactions are costless and there is perfect information (everyone knows everything). It is also a static analysis. For these reasons, the neoclassical framework is also inadequate to study economic history and does not provide satisfactory answers to the question that we want to answer in this two-part article, namely 'Why some nations succeed and some fail?'. I believe that the NIE framework provides a far better way to find an answer to this question. Mancur Olson, the Nobel Laureate in an article Big Bills Left on the Sidewalk in 2001 had this to say: '……the great differences in the wealth of nations are due mainly to differences in the quality of their institutions and economic policies.'

Olson had considered various other factors such as knowledge, culture, human capital, land or natural resources and found that these don't really explain the levels of development across nations.

Another Nobel laureate, Oliver Williamson had also considered the role of institutions in the economic development of countries. He had divided the operation of the NIE framework at two levels: the macro-level, which is the institutional environment. According to Douglass North, the institutional environment is the 'humanly devised constraints that structure political, economic and social interactions. They consist of both informal constraints (sanctions, taboos, customs, traditions and codes of conduct) and formal rules (constitutions, laws, property rights).' The micro-level deals with institutions of governance such as contracting and managing transactions.

North also makes a distinction between institutions and organisations. Institutions, as we have seen above are formal and informal constraints on human behaviour and create opportunities in society and provide an incentive structure. Organisations are structures that are created to take advantage of these opportunities. The interplay between institutions and organisations determine the path of institutional change.

We can see that the NIE framework with its macro and micro-levels are responsible for the way economic development unfolds in a country. We have discussed the features of New Institutional Economics in some detail in these columns in earlier articles. We will touch upon the salient features for the purposes of this article:

n Transaction costs: These are the costs of planning and contracting 'ex-ante' and those of implementing and enforcing these plans and contracts 'ex-post'. Recall that transaction costs are zero in the neoclassical model, i.e., there are no costs of drawing up of contracts and enforcing them. In the NIE world, this assumption of neoclassical economics is relaxed and transaction costs are weaved into the analysis. We may recall that the Nobel laureate Coase had suggested that if transaction costs are low, bargaining between parties can lead to an efficient outcome (externalities are internalised), whatever the initial distribution of property rights between the parties.

n Asymmetric information: In the neoclassical world, everyone knows everything and there is a free flow of information. However, in the real world, this is not true and this is reflected in the NIE analysis by recognising that parties to a transaction may not know everything about each other or the good being transacted. This leads to principal-agent problems and the problems of adverse selection and moral hazard.

n Institutions as constraints: Institutions are assumed away in the neoclassical world and there is no place for the government, public bureaucracies or political parties. This assumption is relaxed in the NIE world. Here, institutions reduce uncertainties and unpredictability thereby lowering transaction and information costs.

n Bounded rationality: All individuals are not the 'supercomputer' of neoclassical economics but have limits on rationality as Herbert Simon, a Nobel laureate had propounded. The implication is that all contracts are always incomplete since individuals can't possibly comprehend all possible outcomes and then rank them in order of preference.

Institutional evolution and path dependence

Another concept, which is critical to the study of economic history is that of 'path dependence' proposed by the Nobel laureate Douglass North. Once a policy or development path is chosen, countries or societies get locked into the path for the following reasons:

Large initial fixed costs involved in that path

Learning effects associated with that path

Coordination effects, which push economic/political agents to form coalitions

Adaptive expectations where increased prevalence further enhances beliefs of further prevalence

Hence, if there is a change in relative prices, it would affect two systems differently. The change results in adaptations at the margins, which in turn will depend on existing institutional arrangements. The final outcome would, of course, depend on the bargaining power of the parties involved. A development path would get reinforced by the network externalities, learning effects and coordination effects set forth by such a path. Again, if political and economic actors were efficient (zero transaction costs) and information flow was perfect (no asymmetric information), choices made would always be efficient and inefficient institutions would be driven out by efficient ones.

But, we all know that this rarely happens. Actors have to make choices based on incomplete information and positive transaction costs.

Why England?

In the 17th century, if one were to place a bet on who would emerge as the largest colonial empire and lead the industrial revolution, England would be low on this list. England was not only a backward country, but it also failed in its attempt to find its 'El Dorado', much like Spain had discovered silver and gold deposits in Peru and Mexico. Since England was unable to beat the Spanish and the Portuguese in international trade, it took to piracy.

Even geographically, England was not favourably placed to be a mercantile power. Niall Ferguson has pointed out in Empire that the clockwise pattern of winds and currents in the Atlantic gave an easier passage to the Spanish and Portuguese ships from the Iberian peninsula to Central and Latin America (the Canary and the North Equatorial currents would ease the ships' path with helpful tailwinds). This was in contrast to the headwinds that the British ships had to face in the North Atlantic while heading to North America (British ships would head into the Gulf and the North Atlantic drift currents).

England was also a laggard in naval technology as compared to Spain and Portugal and even to the Dutch.

Given the factors ranged against England, how did it manage to overcome the handicaps and become a leader? The answer is that England was blessed with the right institutions early in its development trajectory. Let us discuss this further.

The case of England

Applying the framework of institutional evolution to England, we see that the Crown and the Parliament were in constant conflict over control of revenues and directing expenditure in the 17th century. This led to a coalition against the Crown, which comprised the Parliament, the common law courts and the nobles who were highly taxed. This, in turn, was followed by more checks on the power of the Crown to raise revenues and undertake expenditure. All taxes to be imposed and expenditure to be undertaken had to be cleared by the Parliament. After the Glorious Revolution in 1688, when a Dutch prince known as William of Orange defeated the English King James II, ostensibly on religious grounds (Dutch Protestant drove out the Catholic James II), parliamentary supremacy was firmly established with more restrictions on the Crown. This was followed by a more orderly and rational tax administration, which raised the predictability and the credibility of the government.

The Dutch expertise coupled with the setting up of organisations such as the Bank of England in 1694, spawned more network externalities such as the significant rise of the public debt and the development of private capital markets. The common law system also ensured fair and quick arbitration of disputes. These developments ensured that England was never short of funds in its war efforts to spread the Empire. Hence, once England was on the path which bestowed more powers on the Parliament, this led to network externalities, learning effects and coordination effects, which were carried well into the 19th century giving England a perfect launchpad for the industrial revolution. This path-dependence ensured lower transaction costs and information costs of governing and created a virtuous cycle of the growing power of England vis-à-vis its competitors such as France.

Hence, to interpret this in the framework propose by Douglass North above: the change in the balance of power established the supremacy of the Parliament and the institutions or rules that emerged ensured that the loans raised would be paid back. In other words, a new incentive structure took shape.

Consequently, organisations such as the Bank of England, commercial banks and later private capital markets and public debt instruments took advantage of these institutions and ensured that there was no shortage of funds for England's war efforts or other development purposes.

The case of France

On the other hand, in France, the path of development was very different. We saw in the previous article that economic, political and judicial institutions that evolved were more a result of the Monarch's will rather than an outcome of bargaining between a wider section of the polity. In 17th century France, the monarch was all-powerful, with no countervailing power residing in the Parliament. In fact, there was no standing Parliament in France. This led to the Monarch driving all economic and financial initiatives such as tax reforms and administrative reforms, rather than coming from an institutional matrix. While Louis XIV did manage to consolidate the finances through efficient taxation in the 17th-18th century, they couldn't last long. At the end of the 18th century, France was almost bankrupt because of the constant wars with England. One reason for this was that the capital markets were more comfortable backing an institutional-based England rather than a monarch-driven France to lend money. The institutions of France, mainly the monarch and the civil law system actually raised the transaction costs of governing.

As there was no incentive to increase the tax base by including the nobles as payees, there were large revenue shortfalls. France never really emerged from this increasing returns set of institutions and continuously lost to the British in the many wars until the Battle of Waterloo in 1815 where Napoleon was bested. This was also the reason that France lost its colonies across the globe from Louisiana and Quebec in North America to Martinique and Guadeloupe in the Caribbean.

Interpreting the developments in France with North's framework, we see that the institutions that were in place at the end of the 17th century were largely crown-centric. Accordingly, the incentive structure did not allow for the development of durable organisations which could expand the tax base (the rich and nobles were generally kept out of the tax net) and raise resources for the war effort and other development works in France.

Conclusion

The NIE framework offers a useful method to analyse and explain the varied development pathways that countries take. In the above articles, we have attempted to explain the different paths taken by the big European powers, namely, Spain, Portugal, England, France and Holland from 17th-19th century through the prism of the NIE framework. We found that the institutions and organisations in these countries were largely responsible for the varied paths.

To recall the interesting dichotomy of a 'stationary bandit' and a 'roving bandit' proposed by Olson, we find that the 'stationary bandit' creates an incentive structure for the citizens to produce and regularly pay the bandit a 'tax'. The 'roving bandit' governance structure, on the other hand, provides no incentive for production or accumulation.

In our case, England proved to have 'stationary bandit' type institutions which allowed it to defeat its competitors. France, on the other hand, had a 'roving bandit' type institutions, which did not allow the development of an incentive structure which favoured growth.