Economic Performance Through Timet

American Economic Association Economic Performance Through Time Author(s): Douglass C. North Source: The American Economic Review, Vol. 84, No. 3 (Jun., 1994), pp. 359-368 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/2118057 Accessed: 28/05/2009 04:32 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with the scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that promotes the discovery and use of these resources. For more information about JSTOR, please contact [email protected]. American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org Economic PerformanceThroughTimet By DOUGLASSC. NORTH* I Economic history is about the performance of economies throughtime. The objective of researchin the field is not only to shed new light on the economic past, but also to contribute to economic theory by providingan analyticalframeworkthat will enable us to understandeconomic change. A theoryof economicdynamicscomparable in precision to general equilibriumtheory would be the ideal tool of analysis. In the absence of such a theory we can describe the characteristicsof past economies, examine the performanceof economies at various times, and engage in comparativestatic analysis;but missing is an analyticalunderstanding of the way economies evolve throughtime. A theory of economic dynamics is also crucial for the field of economic development. There is no mysterywhy the field of development has failed to develop during the five decades since the end of WorldWar II. Neoclassicaltheory is simplyan inappropriate tool to analyzeand prescribepolicies that will induce development. It is concerned with the operation of markets, not with how markets develop. How can one prescribepolicies when one doesn't under- tThis articleis the lecture DouglassC. North delivered in Stockholm,Sweden, December 9, 1993, when he receivedthe Alfred Nobel MemorialPrize in Economic Sciences.The article is copyright? The Nobel Foundation1993 and is publishedhere with the permissionof the Nobel Foundation. * Departmentof Economics,WashingtonUniversity, St. Louis, MO 63130-4899.I am indebted to Robert Bates, Lee and AlexandraBenham,Avner Greif, Margaret Levi, Randy Nielsen, John Nye, Jean-Laurent Rosenthal,NormanSchofield,and BarryWeingastfor their commentson an earlier draft and to Elisabeth Case for editingthis essay. 359 stand how economies develop? The very methods employed by neoclassical economists have dictated the subject matter and militated against such a development.That theoryin the pristineformthat gave it mathematical precision and elegance modeled a frictionlessand static world. When applied to economic historyand developmentit focused on technological development and more recentlyhuman-capitalinvestmentbut ignoredthe incentivestructureembodiedin institutions that determined the extent of societal investmentin those factors. In the analysis of economic performancethrough time it contained two erroneous assumptions: (i) that institutionsdo not matter and (ii) that time does not matter. This essay is about institutionsand time. It does not provide a theory of economic dynamics comparable to general equilibriumtheory.We do not have such a theory.' Rather it providesthe initial scaffoldingof an analyticalframeworkcapable of increasing our understandingof the historicalevolution of economies and a necessarilycrude guide to policy in the ongoing task of improving the economic performance of economies. The analytical frameworkis a modificationof neoclassicaltheory. What it retains is the fundamental assumption of scarcityand hence competitionand the analytical tools of microeconomictheory.What it modifies is the rationality assumption. What it adds is the dimensionof time. Institutionsform the incentive structure of a society, and the political and economic institutions,in consequence, are the underlying determinants of economic performance. Time as it relates to economic and IIn fact such a theoryis unlikely.I refer the reader to Frank Hahn's predictionabout the future of economic theory(Hahn, 1991). 360 THE AMERICAN ECONOMIC REVIEW societal change is the dimension in which the learningprocessof humanbeings shapes the way institutionsevolve. That is, the beliefs that individuals,groups, and societies hold which determine choices are a consequence of learning through time-not just the span of an individual'slife or of a generation of a society, but the learning embodied in individuals,groups,and societies that is cumulativethrough time and passed on intergenerationallyby the culture of a society. The next two sections of this essay summarizethe work I, and others, have done on the nature of institutionsand the way they affect economic performance (Section II) and then characterizethe nature of institutional change (Section 111).2 The remaining four sections describe a cognitive-science approach to human learning (Section IV); provide an institutional/cognitiveapproach to economic history (Section V); indicate the implications of this approach for improvingour understandingof the past (Section VI); and finallysuggestimplicationsfor currentdevelopmentpolicies (Section VII). II Institutionsare the humanlydevised constraints that structure human interaction. They are made up of formal constraints (e.g., rules, laws, constitutions), informal constraints(e.g., normsof behavior,conventions, self-imposed codes of conduct), and their enforcementcharacteristics.Together they define the incentive structureof societies and specificallyeconomies. Institutionsand the technologyemployed determine the transactionand transformation costs that add up to the costs of production. It was Ronald Coase (1960) who made the crucial connection between institutions, transactioncosts, and neoclassical theory. The neoclassical result of efficient markets only obtains when it is costless to 2These two sectionsbrieflysummarizematerialcontained in North (1990a). JUNE 1994 transact.Only under the conditionsof costless bargaining will the actors reach the solution that maximizes aggregate income regardlessof the institutionalarrangements. When it is costly to transact, then institutions matter. And it is costly to transact. John J. Wallis and North (1986) demonstratedin an empiricalstudythat 45 percent of U.S. GNP was devoted to the transaction sector in 1970.Efficientmarketsare created in the real worldwhen competitionis strong enough via arbitrageand efficient information feedback to approximate the Coase zero-transaction-cost conditions and the parties can realize the gains from trade inherent in the neoclassicalargument. But the informational and institutional requirementsnecessaryto achieve such efficient markets are stringent. Players must not only have objectives,but know the correct way to achieve them. But how do the players know the correct way to achieve their objectives?The instrumentalrationality answer is that, even though the actors may initially have diverse and erroneous models, the informationalfeedback process and arbitragingactors will correct initially incorrect models, punish deviant behavior, and lead survivingplayers to correct models. An even more stringentimplicit requirement of the discipline-of-the-competitivemarket model is that, when there are significant transaction costs, the consequent institutionsof the market will be designed to induce the actors to acquirethe essential informationthat will lead them to correct their models. The implication is not only that institutionsare designed to achieve efficient outcomes, but that they can be ignored in economic analysis because they play no independent role in economic performance. These are stringentrequirementsthat are realized only very exceptionally.Individuals typicallyact on incompleteinformationand with subjectivelyderived models that are frequentlyerroneous;the informationfeedback is typicallyinsufficientto correctthese subjectivemodels. Institutionsare not necessarily or even usually created to be socially efficient; rather they, or at least the VOL.84 NO. 3 NORTH:ECONOMICPERFORMANCE THROUGHTIME formalrules, are created to serve the interests of those with the bargainingpower to create new rules. In a worldof zero transaction costs, bargainingstrength does not affect the efficiency of outcomes; but in a world of positive transactioncosts it does. It is exceptionalto find economicmarkets that approximatethe conditions necessary for efficiency.It is impossibleto find political marketsthat do. The reason is straightforward.Transactioncosts are the costs of specifyingwhat is being exchanged and of enforcing the consequent agreements. In economic markets what is being specified (measured) is the valuable attributes-the physicaland property-rightsdimensions-of goods and services or the performanceof agents. While measurementcan frequently be costly, there are some standardcriteria: the physicaldimensionshave objectivecharacteristics(size, weight, color, etc.), and the property-rightsdimensions are defined in legal terms. Competitionalso plays a critical role in reducingenforcementcosts. The judicial system provides coercive enforcement. Still, economic markets in the past and present are typicallyimperfect and beset by high transactioncosts. Measuring and enforcing agreements in political marketsis far more difficult.What is being exchanged (between constituents and legislatorsin a democracy)is promises for votes. The voter has little incentive to becomeinformedbecausethe likelihoodthat one's vote matters is infinitesimal;further, the complexityof the issues produces genuine uncertainty.Enforcement of political agreementsis beset by difficulties.Competition is far less effective than in economic markets. For a variety of simple, easy-tomeasure, and important-to-constituentwell-beingpolicies, constituentsmay be well informed,but beyond such straightforward policy issues ideological stereotypingtakes over and (as I shall argue below in Section IV) shapes the consequent performanceof economies.3It is the polity that defines and 3See the author's"A TransactionCost Theory of Politics"for a transaction-costapproachto the relative inefficiencyof politicalmarkets(North, 1990b). 361 enforces property rights, and in consequence it is not surprisingthat efficienteconomic marketsare so exceptional. III It is the interactionbetween institutions and organizationsthat shapes the institutional evolution of an economy. If institutions are the rules of the game, organizations and their entrepreneurs are the players. Organizationsare made up of groups of individualsbound together by some common purpose to achieve certain objectives. Organizationsinclude political bodies (e.g., political parties, the Senate, a city council, regulatorybodies), economic bodies (e.g., firms, trade unions, family farms, cooperatives) social bodies (e.g., churches, clubs, athletic associations),and educationalbodies (e.g., schools, universities, vocational trainingcenters). The organizationsthat come into existence will reflect the opportunitiesprovided by the institutionalmatrix. That is, if the institutionalframeworkrewardspiracythen piratical organizationswill come into existence; and if the institutional framework rewardsproductiveactivitiesthen organizations-firms-will come into existence to engage in productiveactivities. Economic change is a ubiquitous,ongoing, incremental process that is a consequence of the choices individualactors and entrepreneursof organizationsare making every day. While the vast majorityof these decisions are routine (Richard Nelson and SidneyG. Winter,1982),some involvealtering existing"contracts"between individuals and organizations.Sometimes that recontractingcan be accomplishedwithin the existing structureof propertyrightsand political rules; but sometimes new contracting forms require an alteration in the rules. Equally, norms of behavior that guide exchangeswill graduallybe modifiedor wither away.In both instances,institutionsare being altered. Modificationsoccur because individuals perceive that they could do better by restructuring exchanges (political or eco- 362 THE AMERICAN ECONOMIC REVIEW nomic). The source of the changed perceptions may be exogenous to the economyfor instance a change in the price or quality of a competitive product in another economy that alters perceptions of entrepreneurs in the given economy about profitableopportunities.But the most fundamental long-run source of change is learningby individualsand entrepreneursof organizations. While idle curiositywill result in learning, the rate of learningwill reflect the intensity of competition among organizations.Competition, reflecting ubiquitous scarcity, induces organizationsto engage in learningto survive.The degree of competitioncan and does vary. The greater the degree of monopolypower, the lower is the incentive to learn. The speed of economic change is a function of the rate of learning, but the direction of that change is a function of the expectedpayoffsto acquiringdifferentkinds of knowledge.The mental models that the playersdevelop shape perceptionsabout the payoffs. JUNE 1994 that have characterized the political and economicchoices that shaped (and continue to shape) historicalchange. Herbert Simon (1986 pp. S210-11) has stated the issues succinctly: If... we accept the proposition-that both the knowledgeand the computational power of the decisionmakerare severely limited, then we must distinguish between the real world and the actor's perceptionof it and reasoning about it. That is to say we must constructa theory(and test it empirically) of the process of decision. Our theory must include not only the reasoning processes but also the processes that generatedthe actor'ssubjectiverepresentation of the decision problem,his or her frame. It is necessaryto dismantlethe rationality assumptionunderlyingeconomic theory in order to approachconstructivelythe nature of human learning. History demonstrates that ideas, ideologies, myths, dogmas, and prejudicesmatter;and an understandingof the way they evolve is necessaryfor further progress in developing a frameworkto understand societal change. The rationalchoice frameworkassumes that individuals know what is in their self-interest and act accordingly.That may be correct for individuals makingchoices in the highly developed marketsof modern economies,4but it is patently false in making choices under conditions of uncertainty-the conditions The analyticalframeworkwe must build must originate in an understandingof how humanlearningtakes place. We have a way to go before we can constructsuch a theory, but cognitive science has made immense strides in recent years-enough strides to suggest a tentative approachthat can help us understand decision-makingunder uncertainty.5 Learningentails developinga structureby which to interpret the varied signals received by the senses. The initialarchitecture of the structure is genetic, but the subsequent scaffoldingis a result of the experiences of the individual.The experiencescan be classifiedinto two kinds-those from the physical environment and those from the socio-cultural linguistic environment. The structuresconsist of categories-classifications that gradually evolve from earliest childhood to organize our perceptions and keep trackof our memoryof analyticresults and experiences.Buildingon these classifications, we form mental models to explain and interpretthe environment-typically in 4However,see the anomalieseven here in the studies by Amos Tverskyand Daniel Kahneman(1986)and others(RobinM. Hogarthand MelvinW. Reder, 1986). 5See John H. Hollandet al. (1986) for an excellent introductionto the cognitive-scienceliterature. IV VOL.84 NO. 3 THROUGHTIME NORTH:ECONOMICPERFORMANCE ways relevant to some goal. Both the categories and the mental models will evolve, reflecting the feedback derived from new experiences: feedback that sometimes strengthensour initial categories and models or may lead-to modifications-in short, learning. Thus the mental models may be continuallyredefinedwith new experiences, includingcontact with others' ideas. At this juncture the learning process of human beings diverges from that of other animals (such as the sea slug-a favorite researchsubject of cognitive scientists) and particularly diverges from the computer analogythat dominatedearlystudies of artificial intelligence.The mind appears to order and reorder the mental models from their special-purposeorigins to successively more abstract forms so that they become availableto process other information.The term used by Andy Clark and Annette Karmiloff-Smith(1993) is "representational redescription."The capacity to generalize from the particularto the general and to use analogy is a part of this redescription process. It is this capacitythat is the source not only of creativethinking,but also of the ideologies and belief systems that underlie the choices humansmake.6 A common cultural heritage provides a means of reducing the divergence in the mental models that people in a society have and constitutesthe means for the intergenerational transfer of unifying perceptions. In pre-modern societies cultural learning provided a means of internal communication; it also provided shared explanations for phenomenaoutside the immediateexperiences of the members of society in the form of religions,myths, and dogmas. Such belief structuresare not, however,confined to primitive societies, but are an essential part of modern societies as well. Belief structuresget transformedinto societal and economic structures by institutions-both formal rules and informal 6Ideologies are sharedframeworksof mental mod- els that groupsof individualspossess that provideboth an interpretationof the environmentand a prescription as to how that environmentshouldbe ordered. 363 norms of behavior. The relationship between mental models and institutionsis an intimate one. Mental models are the internal representationsthat individualcognitive systemscreate to interpretthe environment; institutions are the external (to the mind) mechanismsindividualscreate to structureand order the environment. V There is no guaranteethat the beliefs and institutions that evolve through time will produce economic growth. Let me pose the issue that time presents us by a brief institutional/cognitive story of long-run economic/political change. As tribes evolved in differentphysicalenvironments, they developed different languages and, with differentexperiences,different mental models to explain the world around them. The languages and mental models formedthe informalconstraintsthat defined the institutionalframeworkof the tribe and were passed down intergenerationally as customs, taboos, and myths that providedculturalcontinuity.7 With growingspecializationand division of labor, the tribes evolvedinto polities and economies; the diversityof experience and learningproducedincreasinglydifferentsocieties and civilizationswith different degrees of success in solvingthe fundamental economic problems of scarcity.The reason is that as the complexityof the environment increasedas humanbeings became increasingly interdependent,more complexinstitutional structureswere necessaryto capture the potential gains from trade. Such evolution requiresthat the society develop institutions that will permit anonymous,impersonal exchange across time and space. To the extent that the culture and local experiences had produceddiverseinstitutionsand belief systemswith respect to the gainsfrom 7RonaldHeiner (1983), in a path-breakingarticle, not only made the connection between the mental capacities of humans and the external environment, but suggestedthe implicationsfor arrestingeconomic progress. 364 THE AMERICAN ECONOMIC REVIEW such cooperation,the likelihoodof creating the necessary institutions to capture the gains from trade of more complexcontracting varied. In fact, most societies throughout history got "stuck" in an institutional matrix that did not evolve into the impersonal exchange essential to capturing the productivitygains that came from the specialization and division of labor that have producedthe Wealth of Nations. The key to the foregoingstoryis the kind of learningthat the individualsin a society acquiredthroughtime. Time in this context entails not only current experiences and learning,but also the cumulativeexperience of past generationsthat is embodiedin culture. Collective learning-a term used by FriedrichA. Hayek-consists of those experiences that have passed the slow test of time and are embodied in our language, institutions,technology, and ways of doing things.It is "the transmissionin time of our accumulatedstock of knowledge" (Hayek, 1960 p. 27). It is culture that provides the key to path dependence-a term used to describe the powerfulinfluence of the past on the present and future. The current learningof anygenerationtakesplace within the context of the perceptionsderivedfrom collective learning. Learningthen is an incrementalprocess filtered by the culture of a society which determines the perceived payoffs,but there is no guaranteethat the cumulativepast experienceof a society will necessarilyfit them to solve new problems. Societies that get "stuck" embody belief systemsand institutionsthat fail to confront and solve new problemsof societal complexity. We need to understanda great deal more about the cumulativelearning of a society. The learningprocess appearsto be a function of (i) the way in which a given belief structure filters the information derived from experiencesand (ii) the differentexperiences confrontingindividualsand societies at different times. The perceived rate of return (private) may be high to military technology (in medieval Europe), to the pursuit and refinement of religious dogma (Rome duringand after Constantine),or to the researchfor an accuratechronometerto JUNE 1994 determine longitude at sea (for which a substantial reward was offered during the Age of Exploration). The incentives to acquire pure knowledge, the essential underpinningof modern economic growth,are affected by monetary rewardsand punishments;they are also fundamentallyinfluenced by a society's tolerance of creativedevelopments,as a long list of creativeindividualsfrom Galileo to Darwin could attest.While there is a substantial literatureon the originsand developmentof science, very little of it deals with the links between institutional structure, belief systems, and the incentives and disincentives to acquirepure knowledge.A major factor in the developmentof WesternEurope was the gradualperception of the utility of research in pure science. Incentives embodied in belief systems as expressed in institutions determine economic performancethroughtime, and however we wish to define economic performance the historical record is clear. Throughoutmost of history and for most societies in the past and present, economic performancehas been anythingbut satisfactory. Humanbeings have, by trial and error, learned how to make economies perform better; but not only has this learningtaken ten millenia (since the first economic revolution), it has still escaped the grasp of almosthalf of the world'spopulation.Moreover the radical improvementin economic performance,even when narrowlydefined as material well-being, is a modem phenomenon of the last few centuriesand confined until the last few decades to a small part of the world. Explainingthe pace and direction of economic change throughout historypresents a majorpuzzle. Let us representthe humanexperienceto date as a 24-hourclock in which the beginning consists of the time (apparently in Africa between 4 and 5 million years ago) when humans became separate from other primates. Then the beginning of so-called civilizationoccurs with the developmentof agriculture and permanent settlement in about 8000 B.C. in the Fertile Crescent-in the last three or four minutes of the clock. For the other 23 hours and 56 or 57 min- VOL.84 NO. 3 THROUGHTIME NORTH:ECONOMICPERFORMANCE utes, humansremainedhuntersand gatherers, and while populationgrew, it did so at a very slow pace. Now if we make a new 24-hourclock for the time of civilization-the 10,000 years from developmentof agricultureto the present-the pace of change appears to be very slow for the first 12 hours,althoughour archeological knowledge is very limited. Historicaldemographersspeculate that the rate of population growth may have doubled as compared to the previous era but still was very slow. The pace of change acceleratesin the past 5,000 years with the rise and then decline of economies and civilizations. Populationmay have grown from about 300 million at the time of Christ to about 800 million by 1750-a substantial accelerationas comparedto earlier rates of growth.The last 250 years-just 35 minutes on our new 24-hour clock-are the era of modern economic growth, accompaniedby a populationexplosionthat now puts world populationin excess of 5 billion. If we focus now on the last 250 years, we see that growth was largely restricted to Western Europe and the overseas extensions of Britainfor 200 of those 250 years. Not only has the pace varied over the ages; the change has not been unidirectional. That is not simply a consequence of the decline of individualcivilizations;there have been periods of apparentsecular stagnation-the most recent being the long hiatus between the end of the Roman Empire in the West and the revival of Western Europe approximately500 years later. VI What can an institutional/cognitive approach contributeto improvingour understandingof the economicpast? First of all it should make sense out of the very uneven patternof economic performancedescribed in the previous section. There is nothing automaticabout the evolving of conditions that will permit low-cost transactingin the impersonal markets that are essential to productiveeconomies. Game theorycharacterizes the issue. Individualswill usuallyfind it worthwhilecooperatingwith others in ex- 365 change when the play is repeated, when they possess completeinformationaboutthe other players'past performance,and when there are small numbersof players.Cooperation is difficultto sustainwhen the game is not repeated(or there is an endgame),when informationabout the other playersis lack-ing, and when there are large numbers of players. Creating the institutions that will alter the benefit/cost ratios in favor of cooperationin impersonalexchangeis a complex process, because it not only entails the creation of economic institutions, but requires that they be undergirdedby appropriate political institutions. We are just beginningto explore the nature of this historicalprocess. The remarkable developmentof Western Europe from relativebackwardnessin the 10th centuryto world economic hegemonyby the 18th century is a story of a graduallyevolvingbelief system in the context of competitionamong fragmented political/economic units producing economic institutions and political structure that produced modern economic growth.8And even within Western Europe there were successes (the Netherlands and England) and failures (Spain and Portugal) reflecting diverse external environmental experiences.' Second, institutional/cognitive analysis should explainpath dependence, one of the remarkableregularitiesof history. Why do economies once on a path of growth or stagnationtend to persist? Pioneeringwork on this subject is beginning to give us insights into the sources of path dependence (BrianArthur, 1989;Paul David, 1985).But there is much that we still do not know.The rationalityassumptionof neoclassicaltheory would suggest that political entrepreneurs of stagnatingeconomies could simply alter the rules and change the directionof failed economies. It is not that rulers have been 8See North and Robert P. Thomas (1973), E. L. Jones(1981),and NathanRosenbergand L. E. Birdzell (1986)for accountsof this growth. 9See part III of North (1990a)for a brief discussion of the contrastingpaths of the Netherlandsand England on the one hand and Spainon the other. 366 THE AMERICAN ECONOMIC REVWIEW unawareof poor performance.Rather, the difficultyof turning economies around is a function of the nature of political markets and, underlyingthat, the belief systems of the actors. The long decline of Spain, for example, from the glories of the Hapsburg Empireof the 16th centuryto its sorrystate under FranciscoFranco in the 20th century was characterizedby endless self appraisals and frequentlybizarreproposed solutions.'0 Third, this approach will contribute to our understandingof the complex interplay between institutions, technology, and demography in the overall process of economic change. A complete theory of economic performance would entail such an integrated approach to economic history. We certainly have not put all the pieces together yet. For example, Robert Fogel's path-breakingwork on demographic theory" and its historical implications for reevaluating past economic performance have yet to be integratedfully with institutional analysis.The same is true for technological change. The importantcontributions of NathanRosenberg(1976)and Joel Mokyr (1990) exploringthe impetusfor and consequences of technologicalchange have ongoing implicationswhich need to be integrated with institutional analysis. An essay by Wallis and North (1994) is a beginning at integrating technological and institutional analysis.But a major task of economic history is to integratethese separatestrandsof research. VII We cannot account for the rise and decline of the Soviet Union and world communismwith the tools of neoclassicalanalysis, but we should with an institutional/ cognitive approach to contemporaryproblems of development. To do so-and to provide an analyticalframeworkto understand economic change-we must take into 10DeVries (1976 p. 28) has a description of the bizarre remedies proposed by a royal commissionto reverseSpain'sdecline. "See Fogel's (1994)accompanyingNobel lecture. JUNE 1994 account the following implications of this approach: 1. It is the admixtureof formalrules, informal norms,and enforcementcharacteristics that shapes economic performance. While the rules may be changed overnight, the informalnormsusuallychange only gradually.Since it is the norms that provide "legitimacy"to a set of rules, revolutionarychange is never as revolutionaryas its supportersdesire, and performance will be different than anticipated. And economies that adopt the formalrulesof anothereconomywill have very different performance characteristics than the first economy because of different informal norms and enforcement. The implicationis that transferring the formal political and economic rules of successfulWestern marketeconomies to third-world and Eastern European economies is not a sufficient condition for good economic performance.Privatization is not a panacea for solving poor economicperformance. 2. Polities significantlyshape economicperformance because they define and enforce the economic rules. Therefore an essential part of development policy is the creation of polities that will create and enforce efficient property rights. However,we know very little about how to create such polities because the new political economy (the new institutional economics applied to politics) has been largelyfocused on the United States and developed polities. A pressing research need is to model third-worldand Eastern European polities. However the foregoing analysisdoes have some implications: (a) Politicalinstitutionswill be stable only if undergirdedby organizationswith a stake in their perpetuation.(b) Both institutionsand belief systemsmust change for successfulreformsince it is the mental models of the actors that will shape choices. (c) Developing norms of behavior that will support and legitimize new rules is a lengthy process, and in the absence of such reinforcingmechanisms politieswill tend to be unstable.(d) While VOL.84 NO. 3 NORTH:ECONOMICPERFORMANCE THROUGHTIME economic growth can occur in the short run with autocratic regimes, long-run economic growth entails the development of the rule of law. (e) Informal constraints (norms, conventions, and codes of conduct) favorable to growth can sometimesproduce economicgrowth even with unstable or adverse political rules. The key is the degree to which such adverserules are enforced. 3. It is adaptive rather than allocative efficiency which is the key to long-run growth. Successful political/economic systems have evolved flexible institutional structures that can survive the shocks and changes that are a part of successful evolution. But these systems have been a product of long gestation. We do not know how to create adaptive efficiencyin the short run. 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