New Institutional Economics: The rules of the game of life.

In brief:

The game of life has rules. Things like laws, culture, and political systems all create environments under which we all act. Some lead to poverty and violence, others to peace and prosperity. Different institutions guide our lives in drastically different ways — we have to get them right.

What is it?

New Institutional Economics (NIE) is a well-established field which studies the role that culture, legal systems, and political institutions have on economic development. Today it seems obvious that a corrupt legislature, a lack of property rights, or a culture of entrepreneurship would change the ways economies evolve. But for many years, economists focused on simplified models which held ‘institutions’ in the background with little thought.

The word ‘institutions’ sounds more abstract than it is. Institutions are the ‘rules of the game’ in a society. A social norm for driving on the right side of the street is an cultural institution. So is the distrust of outsiders or strong family loyalty. Democracy and dictatorship are political institutions and French civil law or British common law are different legal institutions.

In the words of Nobel Laureate economist Douglass North, institutions are “informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal rules (constitutions, laws, property rights)”.

Before NIE, many experts would recommend policies and models which looked elegant on paper, but failed in reality. A given nation’s institutions would swallow the gains from a foreign-aid project, or an investment would miss crucial legal or cultural support structures that allowed them to succeed previously in other countries.

Institutions matter because they create the overall structure of ‘payoffs’ in a society. We’re all trying to get ahead – we’re looking for a ‘payoff’. A society will grow slowly and stagnate if it offers many opportunities to get ahead by special-interest lobbying, corruption, stealing, bribery, violence and other activities that harm others or gain at their expense.

A society that has institutions that reward activities like charity, trust, education, long-term thinking, entrepreneurship and wealth-creation will be dynamic and grow quickly.

Exhaustive studies of economic development have whittled away at other explanations for why some countries are poor and others are rich. Access to capital, to natural resources, to education – all of these things certainly help, but they can’t awaken a dynamic, entrepreneurial society without good rules. A family who stumbled upon on a diamond mine needs strong legal tools to protect their claim. A well-educated populace unable to form a legal business with others can’t put their brains to good use.

Economic growth needs entrepreneurs, and entrepreneurs need good institutions.

What does New Institutional Economics mean for radical social entrepreneurs?

NIE brings good and bad news. The bad news is that many years of attempts to alleviate poverty have failed by ignoring a rather obvious complication – institutions. NIE seriously undermines the possibility of simple, ‘one-shot’ plans to fight poverty, especially those that are centrally planned.

“If only Kenya would grow corn!” or “if only the U.S. would send machines to Indonesia!” – these attractive schemes unfortunately founder on institutional troubles. Without the right ‘rules of the game’, the corn may rot, the machines may rust, or both may simply be stolen.

The good news is that institutional reform and social entrepreneurship in legal systems can have massive benefits to a nation. Good rules awaken entrepreneurs, attract prudent investment, and spur innovation.

Once in place, the right rules create positive feedback loops that encourage growth, opportunity and peace – just the environment which social entrepreneurs (and everyone else!) need to thrive.

Douglass North writes, “an essential part of development policy is the creation of polities that will create and enforce efficient property rights.” Dynamic, efficient legal systems that contain ‘external damage’ like environmental harm, while allowing for the speedy and peaceful resolution of disputes is a cornerstone of good growth.

Sadly, reform of ‘the rules’ can be a long-term political struggle, because changing institutions often takes away payoffs from special interests who rely on bad institutions to exploit others.

Free Cities
and entrepreneurship in legal systems offer one innovative avenue to spur reform. We ignore institutions at our peril. Radical social entrepreneurs take note.