Cts report - pavel pelikán

CHOICE, CHANCE, AND NECESSITY
IN THE EVOLUTION OF FORMS OF ECONOMIES
Department of Industrial Economics and Management Forthcoming in Change, Transformation and Development, U. Cantner and J.S. Metcalfe, eds.,Springer-Verlag.
Abstract: Whereas ants have the constitution of their anthills prescribed by their genes, humansappear free to choose the form of their societies themselves. Ex post, however, this freedomturns out strongly limited by severe performance tests that human societies, to avoid crises anddisintegration, must be able to pass. As humans knew nothing and still know only little aboutwhich forms of their society have this ability, they have been forced to search for such forms byimperfectly informed trials and possibly costly errors, and thus run, without fully realizing it, akind of higher-level Darwinian evolution. Narrowing attention from the forms of humansocieties to the forms of their economies, this essay searches for principles and regularities ofthis evolution the knowledge of which, if understood and applied, could avoid at least someotherwise likely errors in the future.
Acknowledgements: I thank Luciano Andreozzi, Leonard Dudley, Dan Johansson, GeoffreyHodgson, J.S. Metcalfe, Bedrich Velicky, and participants of a seminar at the Center forTheoretical Study, Charles University, Prague, for valuable comments on earlier drafts. Theusual caveat applies. The work on this paper was partly supported by CTS Research ProjectMSM 110000001.
1 Introduction
Like ants, humans need to live in societies, but unlike ants, they are not told by nature which ones. Whereas each ant is given the constitution of its anthill as part of its genetic endowment, humans appear free to choose the form of their societies themselves. The much greater richness of their genetic endowment includes indeed the abilities to create and to adapt to a great variety of societies. Although one may speculate that this variety may be genetically constrained — much like the variety of human languages is seen constrained, following Chomsky (1967), by a genetically determined universal grammar — historical evidence demonstrates that, at least for limited periods of time, it is enormous.
In the long run, however, much of this freedom turns out not to be real, as many of the forms of societies which humans could create and live in for more or less long periods in the past have proved unable to last. More than by genetic constraints ex ante, nature thus limits the variety of forms of human societies ex post, by various performance tests, which each society, to avoid crises and disintegration, must be able to pass. A decisive role is played by the tests of economic performance, which the current demographic growth, globalization, and increasing scarcity of basic resources in general make increasingly severe, and thus the freedom For a long time, however, humans knew nothing, and even now they know only little, about which forms of their societies may, and which ones cannot, lastingly succeed. They have therefore been forced to search by poorly informed trials and often costly errors for the scarce forms able to so. They have thus extended, without fully realizing it, the Darwinian evolution of forms of life to the forms of their economies and societies. It is, in other words, as if nature had in mind a rather narrow range of forms of human society, but instead of informing us directly (as it does with ants), it forces us to guess, and hits us with crises and misery if we guess While nothing can yet be considered certain, some societies now clearly appear much closer to guessing right — at least as far as the form of their economy is concerned — than others. The wrong guesses, many of which can still be found at work in Third World economies, also turned out to include several ingredients of the First and Second Worlds economies that many people, including many theoretical economists, used to believe promising — in particular national planning, extensive welfare states, and selective industrial policies. What now appear to be the main ingredients of the right guesses — as indicated by the long period of growing prosperity of those economies which have used them most — are private enterprise and market competition, including competition in financial markets. But much uncertainty still remains about other ingredients — in particular about the extent and the contents of the role of government, if it is to solve those problems that markets cannot solve, without hindering markets in solving all the problems which they can solve.
In several earlier papers I used a simple evolutionary analysis to try to foresee, at least roughly, which forms of economy may be successful, and which ones cannot. In this paper I wish to examine, by similarly simple means, how such forms evolve over time. This evolution can be seen to depend upon three main factors: (i) human cognitive abilities, including abilities to create and to learn; (ii) the cultural heritage of different societies; and (iii) the ultimate sanctions of nature in the broadest sense, which also includes human nature and all the actually evolved and currently competing human societies. The first two factors supply the inputs for the guessing, while the third is an ex post feedback through which the actually implemented guesses are tested, and either more or less temporarily accepted — which allows the guessing to take a pause — or rejected — which causes a crisis and makes a new guess (reform, transition) necessary. While not all new guessing need be enforced by crises — people often try to improve even upon economies which work reasonably well — the feedback is always there, ready to hit whenever a guess, be it enforced or voluntary, proves to cause serious malfunctions.
In existing theories of societal change, the three factors appear to attract unequal attention. While the first two are increasingly discussed, the ultimate sanctions of nature are often underestimated or neglected. One reason may be that most authors of these theories come from prosperous capitalist economies which have not been hit by serious sanctions of this type for a long time, so that they may tend to forget how devastating these sanctions can be. In this 1See, e.g., Pelikan (1988, 1989, 1992, 1993). My results were only verbal, and thus not very precise (a morerecent attempt to increase their precision is in Pelikan, 1999). Nevertheless, they proved well centered on whatturned out later, after the collapse of real socialism and the Japanese financial crisis, to be the right answers. Thesimple evolutionary comparison of alternative economic institutions for the scope of entrepreneurial trials that theyallow and encourage, and for the rigor and speed of the correction of errors that they enforce, foresaw quite wellwhat now empirically turn out to be the main difference between the right and the wrong guesses, mentioned in theprevious paragraph. Let me add that little of this difference was seen by the much more precise standard analysis ofthat time; many of its mathematical models were on the contrary proving the optimality of the wrong guesses.
2See, e.g., North (1990, 1999, 2000), Grief (1994), Denzau and North (1994), Vanberg (1994), and Knight andNorth (1997).
paper, I wish to decrease this inequality by putting these sanctions in the center and showing that, in the evolution of human societies, the last word is always theirs.
This will have interesting implications for the other two factors. When the importance of sanctions of nature is correctly appreciated, our cognitive abilities will turn out to have limits which, in the evolution of forms of economies, make them often comparable to the sources of random (uninformed) mutations in the evolution of life — however informed and rational we might believe them ourselves. Although cultures will still be recognized to constrain both the actual form and the possible reforms of economies, and thus make the evolution of each economy path-dependent, this path-dependency will turn out to be weaker and less irrevocable than usually believed. Namely, many cases of path-dependency will be found inevitably and often brutally interrupted by requirements of nature's performance tests: a culture which prevents its economy from evolving into and preserving a reasonably efficient form, able to cope with both scarcity of resources and competing economies, will itself prove unable to last — unless subsidized and thus artificially kept alive by more efficient friends, at their risk and The ultimate sanctions of nature will thus be found to imply severe objective constraints upon the evolution of forms of economies, which, in the long run, decrease the importance of chance and of culturally conditioned subjective interests and beliefs. In other words, the process of societal change will be found to be based on objective fundamentals, which determine a more or less rich, but nevertheless limited, variety of sustainable forms of economies. That what will be determined is a variety, and not a single form, deserves emphasis, to make it clear that historical determinism will not be advocated.
The unpleasant problem is that there are no corresponding ex ante constraints to prevent policies driven by culturally conditioned subjective interests and/or false beliefs from implementing forms from outside this variety. Although such forms cannot last — the constraints of nature (in the present broad sense) will sooner or later force humans to change them — the social costs of such changes may be very high. This raises the important but so far 3Note that the argument that the future of societies depends upon the performance of their economies is indeedalso the basis of the Marxist historical determinism. But, while Karl Marx deserves credit for being one of the firststudents of the evolution of economies and societies, he was grossly mistaken in at least two respects: (i) the claimthat this evolution is a deterministic process with a unique outcome, and (ii) the prediction, based on a distorted anddistorting labor theory of value, that capitalism will perish and the outcome will inevitably be a form of socialism orcommunism — which now turns out to be the least likely thing to happen. For a brief assessment of Marx's story,fully compatible with the present view, see North (1990: 132-133).
little examined questions of what the constraints of nature are, and how they can best be understood by theory and respected by policy, to avoid or minimize experiments with unsustainable forms of economies. Without aspiring to answer these questions in any detailed and definite way, the main purpose of the following pages is to call attention to them and consider how they might fruitfully be addressed.
The paper is organized as follows. Section 2 clarifies the main concepts used and finds good reasons why, in an evolutionary perspective, the form of economies is best characterized by their institutions. Section 3 outlines how these concepts relate to each other. Section 4 discusses the conditions of sustainability of institutions, considering both their objective evaluation by nature, according to the real economic performance to which they may lead, and their subjective evaluation by the human agents concerned, expressed by the political support they may obtain. As nature is found to put a growing premium on adaptability, Section 5 examines which parts of an economy may have to be adaptable, and finds out that they need not include its institutions, provided that these have a sufficiently high adaptation potential, in the sense that they provide for sufficient adaptability of organizations and outputs. Section 6 shows that the institutions with the highest adaptation potential, which in severe and variable environments are also the only sustainable ones, belong to the category that can globally be denoted as 'modern capitalism.' Section 7 considers the cultural prerequisites for the forming and maintaining of such institutions, and draws from it conclusions about the limits of cultural relativism and the first task of development policies.
2 Concepts
The present argument is built around three main concepts: culture, institutions, and organizations. All are parameters which condition and constrain human actions in the short run, but may themselves change as a result of some of these actions in a longer run. In agreement with North (1990) and following my earlier uses of these terms (Pelikan, 1987, 1992, 1995), Institutions are humanly devised rules that constrain human decisions sets. They can be said to shape human actions and interactions, and can be compared to 'the rules of a game.' In addition to rules that concern all agents, such as property rights, the institutions of an economy also define the instruments of economic policy that government is allowed or required to use.
According to their origins, institutions can be divided into two types: formal, consisting of politically determined written laws; and informal, consisting of culturally evolved and often unwritten custom, such as moral norms or religious taboos. An important difference between the two is in the speed at which they can change: while a determined policy-maker (legislator, reformer) can change formal institutions overnight, informal ones cannot but evolve relatively slowly. In consequence, they often constitute a binding constraint on how fast effective A culture includes, in addition to its specific informal institutions, specific values and beliefs. It thus not only determines an important part of the rules of the game, but moreover strongly influences how the game is actually played: its values influence which objectives (preferences) the players pursue, and its beliefs influence which part of the information available they are able and willing to employ.
A set of interconnected beliefs — possibly expressed in terms of mental models, religious dogma, or theories — can be referred to as an ideology (cf. North 1990:23). Ideologies can thus be seen as substitutes for, or competitors with, knowledge, providing answers to questions that science cannot answer, or has not yet answered. They may be flexible (open) or rigid (closed), depending on whether or not they allow beliefs to be qualified or replaced by newly gained knowledge. A culture may be tolerant or intolerant, depending on whether it admits several parallel ideologies, or only one. A tolerant culture is a prerequisite for political democracy, which includes the task of organizing a civilized competition among different All these concepts can be seen at work in organizations. An organization is defined as a set of interacting agents, whose actions are constrained (shaped) by its institutions, and whose choices of the specific actions actually taken depend on their preferences and cognitive abilities, conditioned by the values and beliefs (ideologies) of its culture. In other words, if institutions are seen as the rules of a game, an organization is an interrelated collection of the players As noted, the present focus is on economic organizations, defined, as usual, to consist of economic agents — such as producers, consumers, investors, and savers — engaged in 4To make such a sharp difference between institutions and organizations is the first necessary step to makinginstitutional analysis operationally clear. In most common languages and older institutional economics, 'institutions'may mean both 'rules' and certain lasting 'organizations' - such as central banks, ministries, or universities — whichcannot but lead to analytical confusion.
production, allocation, and the use of scarce resources. But, and this is perhaps less usual, economic organizations are understood here broadly to include not only relatively tightly and deliberately organized firms and government agencies (economic organizations in the narrow sense), but also less tightly and more spontaneously organized markets and entire economies.
This means that a national economy is seen as an economic organization the agents of which are constrained by national institutions, and which contains a number of smaller economic organizations — such as firms, markets, and government agencies. Each of these organizations has internal institutions of its own, but is constrained, both in its actions and in the choice of its institutions, by certain national institutions — such as the corporate law which constrains the choice of the rules of corporate governance within a firm.
All the (smaller) organizations that an economy actually contains, together with their internal institutions and their market and/or non-market interrelationships, will be referred to as the economy's organizational structure. Intuitively, this structure can be visualized as the 'working body' of the economy. While in standard analysis, organizational structures are usually assumed constant — e.g., all the markets and firms studied are assumed once for all given — in the study of societal change they are important variables. It is the actual state of this variable — in particular the quality and the quantity of the actually existing firms, the extent and the transaction costs of the actually existing markets, and the abilities of the actual government agencies — that determines the range of possible outputs, or in other words, implies the In the study of the evolution of forms of economies, the first question is, which concept can best characterize such forms. To concentrate on the most important evolutionary changes, without being distracted by less important short-term fluctuations, we need a concept that does not change very often, and may thus remain stable for relatively long periods, during which other economic variables may keep changing. In static analysis, in which organizational structures are assumed constant, the form of an economy is usually characterized by this structure, often called an 'economic system' — such as a given set of firms and households interconnected by a given set of markets, or by a given mechanism of planning. But evolutionary analysis, in which organizational structures turn out often to change — e.g., by 5In many economic problems, of course, distinguishing firms, government agencies, and markets from each otheris of prime importance. Here, however, we need to begin with a more elementary distinction between the level ofactors, where things actually happen, and where all the three can be seen to belong, from the level of rules whichconstrain, and thus shape, this happening. entry and exit of firms, rise and decline of industries, and opening, enlarging, or closing of markets — needs another concept, for which the institutions of economies appear to be the best candidate. By determining the forms of property rights and the instruments of economic policy, institutions indeed determine all the features by which forms of economies are usually characterized — such as 'liberal capitalism' with a minimum of government intervention, or various forms of 'mixed economies' with different types and degrees of government control, and industrial and/or welfare policies. They may also remain stable for relatively long periods of time, while the organizational structure under them, within the more or less broad limits implied by their rules, may keep changing and developing, and thus more or less successfully adapting to changes in technologies and/or in relative prices. Although institutions also may, and from time to time indeed do, change, these changes, beside being in average slower that those of organizational structures, also appear to contain principles and regularities which can be more easily extracted and comprehended by theoretical analysis. The evolution of the forms of economies is thus understood to be the story of their changes.
3 Interrelations
An economy's culture, institutions, and organizational structure are interrelated in multiple ways. As noted, the culture directly determines all the informal institutions, and strongly influences, by its values and beliefs, the preferences and the cognition (rationality) of human individuals, and thereby the actual behavior of the economy's agents under both the formal and informal institutions. The culture thus determines an important part of the rules of the economic game, and strongly influences the ways in which the rules are actually exploited and the game is In addition to the roles of economic agents, human individuals may, and usually do, assume the roles of political and cultural agents. Among the actions they may take in these roles, the present focus is on the innovations by which they contribute to changing the institutions and/or the culture. Legislating changes of formal institutions is an example of political innovation, while introducing or imitating new informal rules of conduct, and 6To characterize the form of an economy by its institutions is in agreement with North (1990) and Hayek (1967,1973), who refers to what is called here 'institutions' by the terms 'general rules' and 'the order of rules' (cf. alsoNorth, 1999). I advocated this characterization in Pelikan (1988, 1992), where I also showed that characterizing theform of economies by their institutions instead of organizational structures formally corresponds to characterizingliving organisms by their genotypes instead of the more variable phenotypes, as modern biology is indeed doing.
modifying or refuting received beliefs are examples of cultural innovations. Such innovations are the micro-causes of societal change; it is by them that societal change is driven.
Although the three roles are often considered separately, each by its specialized social scientists, they must be recognized as being linked by the prevailing culture, which conditions the preferences and the cognitive abilities of every individual in all these roles. This means that in addition to influencing how people as economic agents play the economic game, the culture also influences both how they as political agents try to change formal institutions and how they as cultural agents try to change the culture itself.
It is instructive to regard culture, institutions, and organizational structure as a chain of successively hardening constraints. This may perhaps best be seen by starting from the end of the chain, with the economy's output. As noted, this is directly constrained by the economy's organizational structure: each specific structure implies a certain limited range of feasible outputs. To obtain more or better outputs, the structure must first itself be changed — e.g., by the entry of new firms and the reorganization or exit of some of the incumbent ones.
The ways in which the structure can change, and thus develop or decay, are in turn constrained by the prevailing institutions — such as the institutional conditions for entrepreneurship, which include corporate, labor and competition laws, and the extent of allowed or required industrial subsidies. While some institutions allow or even encourage extensive structural changes, others make many such changes difficult or impossible. If the performance cannot be improved without a substantial structural change, and if this is prohibited by the prevailing institutions, the performance cannot be improved without first In the next link of the chain, the variety of institutions with which an economy can be endowed is constrained by the prevailing culture; for instance, this can exclude certain forms of property rights or economic competition for religious or ideological reasons. Cultures also differ in the severity of these constraints: some allow a wide variety of alternative institutions, while others are tightly linked to institutions of a specific type.
The final link is self-enclosed: the variety of feasible changes of a culture is constrained by the culture itself. More precisely, each culture, to preserve itself over time, must contain an essential core which it must effectively protect — otherwise it could not last long as an identifiable entity. Usually one of its core beliefs is that all of its core beliefs are eternal truths which must never be put in doubt. In consequence, cultures may differ not only in their actual contents, but also in how these contents are partitioned between the protected core and the modifiable parts. Depending on how tolerant a culture is — in other words, how many different ideologies and types of scientific knowledge it may accommodate and allow to compete — its protected core may be relatively small and many of its parts may therefore be modifiable by learning, or the core may be large, and most of it may thus be dogmatically kept unchanged.
In addition to this chain of influences leading from culture through institutions and individual behavior to the economy's organizational structure and performance, there are also important feedback influences leading in the opposite direction. The main feedback is the impact of the economy's performance upon the psychical and physical health and well-being of the members of the society. It is this feedback which is seen to constitute the 'ultimate sanctions This real-term feedback is accompanied by several informational feedbacks, through which its actual and future states are more or less incompletely signalled, and whose signals are interpreted and acted upon by the agents — again depending on their culturally conditioned values and beliefs. The signalling is often based on different conventional, more or less aggregated performance criteria or indicators — such as the growth of national product, the income per capita, the level of literacy, or the expected length of life — which usually represent a compromise between what is valued and what is possible to measure.
Many innovative actions can indeed be understood as deliberate responses to such signals — such as policies or economic reforms trying to cure an actual crisis or to prevent a threatening one. But societal change may also be driven by innovative actions based on arbitrary fantasies — such as beliefs in various utopias — and the difference between the two may not be very sharp. If, as is usually the case, the signalling is incomplete and/or the innovators' cognitive abilities are limited or culturally biased, what the innovators may subjectively believe to be deliberate rational responses may objectively be close to arbitrary fantasies, whose role in the evolution of economies is not very different from the role of random mutations in the evolution of species — i.e., they are necessary to keep the evolution going, but most of them turn out to lead in the wrong direction.
There is a subtle relationship between the subjective, socially chosen performance criteria, which are part of the information feedback and thus guide the members of society in their endeavors, and the objective criteria of nature, which determine the ultimate sanctions. The basic point is that the former criteria must be reasonably close proxies of the latter, if the economy is not to be hit surprisingly by sanctions of the latter while apparently performing well according to the former. For instance, while its national product and the income per capita may be growing, a large part of its population may fall sick or start dying, because of stress, lack of exercise, or an unhealthy diet. This point is important to realize, to avoid the widespread fallacy that socially chosen performance criteria are the only ones that matter, and that the valuation of performance of economies is therefore purely a matter of culturally conditioned social A qualification is in order. To the extent that socially chosen performance criteria may become internalized in human minds, they may also influence real feelings of satisfaction, and thereby also the objective criteria of nature: as is well known from elementary psychology, if some subjective criteria are believed important, the failure to meet them can objectively affect people's physical and mental health. But these influences have strict limits: nature imposes many criteria which no cultural conditioning can change. Thus, most people cannot be convinced to abstain from demanding food, shelter, medical care, and probably also a minimum of personal freedom; the few deviants who might be convinced to do so would be unlikely to survive for long and could definitely not provide the basis for a successful human economy.
Unfortunately, however, nature declines to inform us not only about the form of a successful human society, but even about the success criteria that it requires such a society to meet. Our situation is thus very much like the one of a student who has to pass an examination without fully knowing what it may be about. Our quest for a successful form of economy cannot be only about the means, but much of it must also concern the ends.
4 The double feedback in the selection of human institutions
To understand the evolution of institutions, we need to know when an economy's institutions may remain stable, and when a more or less radical institutional change (reform, transition) The answer involves a double feedback: (i) economic, or external, which consists of the real-term economic performance to which the institutions lead; and (ii) political, or internal, which transmits the approval or disapproval of the institutions by the members of the society. Thus, to be sustainable, an economy's institutions must both provide for a minimum objective economic performance, which would allow the members of the society to keep in reasonably good physical and mental health, and satisfy the members' subjective, culturally conditioned values and preferences, so that they will not feel frustrated and consequently try to reject the It is again instructive to recall the example of anthills and note that the sustainability of their institutions depends only on feedback (i): as the institutions of anthills are genetically given, ants cannot reject them and not even put them in doubt. In contrast, the strong dependence of human institutions upon feedback (ii) substantially complicates their evolution, opening it to the risk of repeated conflicts and crises.
One reason is that feedback (ii) alone is complex. Depending on their culturally conditioned values and cognitive abilities, people may judge, and possibly feel dissatisfied with, the performance of their economy, or its institutions, or both. As the ignorance of the links between the two is still widespread, even among theoretical economists, the two judgements may clash: desired institutions may lead to undesired outcomes and vice versa. Moreover, because of the above-mentioned imperfect knowledge of nature's ultimate criteria of economic performance, feedback (ii) may clash with feedback (i): not only may desired institutions fail to deliver desired performance, but even if delivered, such performance may not be very wise from the point of view of feedback (i) — for instance, it may turn out to harm individual health and/or undermine the economy's future performance.
The possibility of such clashes can be illustrated by Schumpeter's (1942/1976) argument that capitalism will fall not because of an economic crisis, as Marx claimed, but because it will be increasingly disliked, in particular by influential intellectuals, and therefore, sooner or later, politically rejected. But now when all forms of socialist economies have proved, contrary to what Marx believed and Schumpeter argued, prohibitively inefficient, and their transition to forms of capitalism appears to be the only effective remedy, it must be concluded that new socially disastrous clashes of the two feedbacks can be prevented only if Schumpeter could be proven wrong also about capitalism's unpopularity, and some of its economically successful forms could gain sufficient intellectual and political support.
7Another argument of Schumpter's was that capitalism would erode the moral norms (informal institutions) onwhich it is based. But even this argument may be considered disproved: in the light of the strongly negativeinfluences of socialism and extensive welfare states on working morale and civic honesty, capitalism provessuperior even in this respect.
Another illustration is Hayek's (1976) argument that the social justice that should be valued is the 'procedural' one of rules, and not the 'substantial' one of outcomes. This argument implies that societies can succeed economically only if their institutions offer efficient incentives and just rewards for contributions to production and productivity increases. Such institutions should therefore be positively valued, even if they turn out to lead — because individuals in all societies inevitably differ in their abilities and effort — to a highly unequal income and wealth distribution. But socially damaging clashes of the two feedbacks are again likely, for large wealth inequalities are more or less negatively valued in all known human cultures. The justice of outcomes can thus hardly escape valuation and, if this is sufficiently negative, the institutions that lead to it — even if they were the only ones able to save the society from economic collapse — can hardly resist political rejection.
In feedback (i), the main ingredients are efficiency and adaptability. With a slight extension of the usual meaning, the former refers to the ability of an economy to obtain all the private and public goods needed for keeping its members in reasonably good physical and mental health by exploiting its current environments — in particular the available natural resources and the terms of trade with other economies. The latter means the ability to maintain the former ability when the environments change.
The working of this feedback depends on both properties of an economy and properties of its environments. How efficient and adaptable an economy must be, in order to avoid being forced by crises and threats of disintegration into a radical institutional change, depends on two properties of its environments: their severity, meaning the costs of obtaining the needed goods, and their variability, which can be expressed in terms of the frequency, the amplitude, and the regularities (or irregularities) with which these costs may keep changing. The severity puts demands on the economy's efficiency: the higher the costs, the less inefficiency feedback (i) admits. The variability puts demands on the economy's adaptability: the more the environments change, and the more they do so in irregular and thus unpredictable ways, the more adaptability While economists have mostly been concerned with an economy's efficiency in assumedly constant environments, the present argument is that, in the long run, the main 8When arguing in favor of procedural justice and against substantive justice, Hayek can be said to haveabandoned the position of a positive scientist, who must recognize that people of all cultures value the distributionof outcomes, to turn into a social reformer trying to convince them not to do so.
criterion of feedback (i) is the requirement of adaptability. At first sight, there may seem to be both historical and logical reasons to doubt this argument. Historically, several highly rigid economies proved able to exist for millennia. Logically, adaptability is only required in one of four types of environments: those that are both severe and variable. If the environments are generous, inefficiency due to poor adaptation is only weakly penalized, and if they are severe but stable, it suffices to obtain the required efficiency only once, after which it can be routinely repeated without further changes. But both doubts have a simple answer: the growing world population, the increasing scarcity of vital resources, and the consequent need to keep producing and adapting to technological innovations make the other three types of environments increasingly unlikely to be encountered, which makes rigid economies increasingly unlikely to 5 Conditions of adaptability of economies
The requirement of adaptability of an economy leads to the question of what exactly must keep adapting when environments are changing. As opposed to the popular view that changing environments require changing institutions (see, e.g., North 1990, 2000), I shall argue that the economy's institutions may remain stable, and thus spare the economy the high costs and risks of forced institutional changes, provided that they have certain suitable properties. My starting point is the elementary but often forgotten principle that can roughly be put as follows: if something is regularly changing, there must be something else which realizes the regularity and More precisely, the ability of a variable or a parameter suitably to change in response to changes of another variable or parameter requires at least temporary stability of yet another parameter, namely the one realizing the response relationship (function, routine, regularity) which makes such suitable changes feasible. If furthermore this relationship is to change and adapt, there must again be another, higher level parameter which must remain relatively stable, to make such a higher level adaptability feasible. Formally: if y is suitably to change in response 9In slightly different words, this principle is discussed by Hofstadter (1979: 686), who speaks of 'modifiablesoftware' which must always be based on 'inviolate hardware.' A clear empirical example is the human brain, whosehigh and multilevel flexibility and adaptability — such as the ability to learn to learn — is ultimately due to thegenetic recipes for building it, contained in the genetic endowment of homo sapiens (the brain of apes issubstantially less adaptable!), which have remained quite stable during several tens of thousands of years, and whichremain constant for each individual during his entire life.
to changes of x, say y = f(x), the suitable f(.) must remain relatively stable; and if, in a longer run, f(.) is suitably to change in response to changes of z, say f(.) = G(z), the suitable G(.) must This calls for a sharp distinction between the ability of a parameter suitably to change its own state, and its ability to provide for suitable changes of other variable(s) or parameter(s). Let me reserve the term 'adaptability' for the former ability, and denote the latter as 'adaptation potential.' Thus, adaptability is the ability of variable parameters to vary themselves, while adaptation potential is the ability of actually stable parameters to provide for adaptability of The case of an economy's institutions is both important and instructive. While considered in more detail below, to see clearly the difference between the two abilities, it may be helpful to realize already now that the higher the institutions' adaptation potential, the less More generally, the present framework distinguishes four levels of parameters or variables within an economy that, to allow it to cope with changing environments, may need to be adaptable, or have a high adaptation potential, or both: (1) the qualities and quantities of the economy's output; (2) the organizational structure producing the output; (3) the institutions, which shape both the working and the forming of the structure; (4) the culture, which includes the informal part of the institutions and the values and beliefs that guide individuals in their economic and non-economic behaviors.
The main relationships can be summarized as follows: the adaptability of the output depends on the adaptation potential of the organizational structure, the adaptability of the structure depends on the adaptation potential of the institutions, and the adaptability of the institutions depends on the adaptation potential of the culture. As the constraints upon the 10It is this difference that appears overlooked in North (2000). He correctly notes that the changes of aneconomy's environments may be both important and unpredictable ('non-ergotic'), but appears to believe that, toavoid a crisis, such changes require correspondingly important changes of the economy's institutions. Althoughsome environmental changes may indeed be so important that even previously successful institutions must bechanged, the link between environmental changes and institutional changes is less direct. The present point is thatmuch depends on the institutions' adaptivity: highly adaptive institutions, such as the US ones, allow their economyto adapt to a broad range of environmental changes, within which they may thus themselves remain stable, whereaslittle adaptive institutions, such as those of many less developed economies, prevent adaptations to much morelimited environmental changes. Such institution must indeed be adapted (reformed, transformed) if a crisis is to beavoided, as soon as an actual environmental change exceeds these narrow limits.
adaptability of a culture are also features of this culture, the adaptability of a culture depends on its adaptation potential vis-a-vis itself.
What an economy always needs to keep adapting is its output. Whether it also needs to adapt its organizational structure depends on how much the outputs are required to vary compared to the adaptation potential of the structure. If the required output changes stay within the limits of the structure's adaptation potential, the structure need not be adaptable. This case, however, appears increasingly rare. Because of the limited flexibility of many firms to change their products and methods of production, it is unlikely that all the changes of outputs required by rapid technological progress and important changes in relative prices could be achieved without some changes of the structure, including continuous entry and exit of firms ('creative destruction'). In other words, the required adaptability of outputs often exceeds the adaptation potential of existing organizational structures — including the Japanese one, which many economists for a long time believed to be the miraculous exception — so that some structural This requirement, in turn, raises the question of whether the economy's institutions need to be adaptable. Much as in the previous case, this answer again depends on how the adaptability required compares to the adaptation potential providing for it. But the result appears less universal. In contrast to all the known organizational structures, of which none appears to have a sufficiently high adaptation potential to provide for sufficient output adaptability, institutions appear more promising, in the sense that the adaptation potential of some of their forms may provide for sufficient structural adaptability even in widely and irregularly (non-ergotically) changing environments. The problem is that such institutions are still far from widespread, but remain limited to advanced capitalist economies. For example, the adaptation potential of US institutions has been so high that they have allowed the structure of US economy to keep adapting successfully to widely changing terms of trade, while themselves remaining basically stable for over a century (counting from what may be considered the last substantial changes: income tax and antitrust law). By contrast, the institutions of less developed economies have a much lower adaptation potential, which causes structural rigidities and, as argued below, is indeed the main obstacle to their development.
The requirement of adaptability of institutions is thus selective, limited to those with an insufficient adaptation potential. For them, the inquiry continues to the prevailing culture, raising the question of whether its adaptation potential is high enough to allow them to increase this potential by a suitable change. If yes, the culture may be maintained, if not, it must itself change, and is therefore itself required to be adaptable. But here the story comes to its end: as a culture is defined to include the constraints on its own adaptability, if it is to be adaptable, it must have a sufficiently high self-adaptation potential. This means that those of its parts that are required to adapt must belong to its periphery modifiable by learning, and not to its stubbornly self-protected core. Otherwise the culture cannot adapt, and neither can, in consequence, the economy's institutions, structure, and outputs. It then helps little to complain that the environments are no longer what they used to be.
To recapitulate, the requirement of adaptability, which stems from properties of an economy's environment and begins with its outputs, may be relayed, through a domino-like chain of required changes, through the economy's organizational structure and institutions, all the way up to its culture. How high the relaying must actually reach — in other words, how many of these parameters need to change and therefore need to be adaptable — depends in part on the importance of the environmental changes and in part on the adaptation potential of the parameters. A parameter with a sufficiently high adaptation potential, which allows the variable(s)-parameters(s) under its influence to be sufficiently adaptable, can remain stable and An important property of this chain is that both the difficulties and the social and individual costs of adaptations appear to increase steeply with the level of the required changes — from adaptations of quantities and/or qualities of outputs which, if they can be realized within a stable structure, are often easy and cheap through the more difficult and more expensive structural and institutional adaptations, to the cultural ones which appear to be the One reason for these rising costs is subjective: be it due to genetically given instincts or cultural conditioning, people often tend to value changes negatively. The more fundamental the changes are and the more uncertain their consequences, the more painful they are usually perceived. Another reason is the lack of knowledge about what specific adaptations are required, which usually also increases with the levels. The less knowledge is available, the 11It may be instructive to think of our genetic endowment as so highly adaptive, and thus providing for such ahigh adaptation potential (learning abilities) of human brains, that it could itself remain basically constant for tens ofthousands of years, while the environments to which humans kept successfully adapting varied widely in bothergotic and non-ergotic fashions.
higher the expected costs of the errors in the inevitable trial-and-error search for a suitable The need for cultural adaptation and the social costs of searching for it are strikingly illustrated by some of the least advanced post-socialist economies, where the incumbent values and beliefs, culturally evolved through a mixture of feudal and socialist conditioning, are among the main reasons why the economically needed institutional and structural changes cannot find sufficient political initiative and support. This situation may also be understood as a particularly severe clash of feedback (ii) with feedback (i).
6 Which economic institutions can be sustainable?
Until now, our attention has mostly been limited to general conditions that sustainable institutions of economies must meet. Now it is time to identify these conditions in more detail and ask which specific institutions can effectively meet them. Let me start broadly by considering an entire politically organized society (such as a nation) with the two basic conditions that it must meet to avoid misery and crises: (1) its economy must be sufficiently efficient (non-wasteful) in terms of its socially chosen performance criteria and in relation to the severity and variability of its environments; (2) the criteria must be sufficiently wise not to deviate too much from the objective criteria of nature (in the broad sense). This leads to the following series of questions: What can the members of the society do to meet these conditions? What role must be played by the economy's institutions? Which specific institutions can play this role best, or at least sufficiently well.
To meet Condition (2), the members must overcome the above-mentioned difficulties with nature which does not inform them in advance of its objective criteria (cf. the end of Section 3). Thus, if they want to minimize the probability of unpleasant surprises, they must search for knowledge about these criteria themselves, including learning from past mistakes, and then wisely use whatever knowledge they may acquire in the choice of their social criteria. This is certainly a difficult and risky task: as the knowledge will hardly ever be complete, sound intuition and above all good luck are also necessary if the socially chosen criteria are not to be unwise, directing even the most efficient economy towards social misfortunes. A simple illustration is the current controversy about the effects of humanly caused CO2 emissions on global warming and resulting policy objectives. It is indeed still difficult to know how the causes of the currently observed global warming are divided between natural fluctuations and human industrial activities, and the risks include failing to avoid natural disasters at one extreme, and unnecessarily causing economic difficulties at the other.
Most of this, however, is not of a direct concern to economists. According to the standard division of labor among sciences, the search for knowledge about nature's criteria belongs to the natural sciences and, to the extent that these criteria also depend on human nature, to such social sciences as anthropology and social psychology. How the knowledge found can be used, under influences of the prevailing values and ideological beliefs, in the political choice of the social criteria of economic performance (policy objectives, social preferences) is mostly the subject for political scientists. Economists can certainly do a few things, such as checking these processes for logical consistency and warning about possible distortions due to imperfect incentives and insufficient competence of politicians and government officials. Basically, however, the politically chosen criteria belong to the givens In consequence, the role of economic institutions may be considered limited to helping the society to meet Condition (1). But this is not a simple task. In environments that are increasingly severe and variable, the society needs an economy which, as noted, is not only highly efficient in relation to their current state, but also sufficiently adaptable, to be able to regain and keep its efficiency even after the environments have possibly changed. The economy's institutions, in addition to allowing and inducing the economy to form an efficient organizational structure for current environmental conditions, must therefore also have a sufficient adaptation potential, to allow this structure to be adaptable over the whole range of This task, which is difficult by itself, is compounded by the need to make the required efficiency and adaptability compatible with the politically chosen performance criteria. This 12The welfare economists who take the postulate of consumer sovereignty for granted may claim that they havemuch more to say about these criteria. Libertarians may object against all kinds of political choice and claim thateach individual consumer must have the exclusive right to decide what is best for him. Two comments are in order.
First, the division of such rights between individual and political decisions must itself result from a politicaldecision: libertarians would have to gain political power to be able to abolish all political valuations of economicperformance. Second, regardless of our personal tastes for either consumer sovereignty or political paternalism,such tastes are only parts of our culturally evolved ideologies, which undoubtedly determine much of our currentlychosen performance criteria, but without any guarantee of compatibility with the ultimate criteria of nature. Whichspecific mixtures of consumer sovereignty and political paternalism may prove sustainable is thus less a matter ofsubjective tastes than another question for an objective evolutionary analysis — which, however, will not be enteredhere.
means that, to the extent that these criteria are more than market aggregations of individual consumers' preferences, the institutions must define policy instruments by which the economy could be steered to do well also according to the additional, politically chosen parts of these criteria. There are several reasons why also this task is difficult. First, the extent of these parts — which start with the traditional public goods and spillover effects — is likely to be quite large if Condition (2) is to be met in today's world, where spillovers among both individuals and economies appear to grow in both intensity and density. A second reason is the interference of most of feasible policy instruments with both efficiency and adaptability, which leads to difficult trade-offs — such as the well-known one between efficiency and equity. A third reason is the imperfection of real-world policy-makers, who cannot be expected to be either perfectly benevolent or perfectly competent (unboundedly rational). The needed policy instruments must thus not only have the intended positive effects — which is often difficult to achieve by itself — but these must not be overridden by their negative side-effects, including the possible social losses that they might cause in the hands of imperfectly benevolent and/or imperfectly competent policy-makers. In other words, the institutions must define only such policy instruments that are needed to avoid greater social losses than those that their use in non- idealized real-world conditions could be expected to cause.
The crucial question thus is: which specific features must an economy's institutions have to meet reasonably well all these requirements? While this question is of prime importance for both theory and policy, it appears to attract little attention of today's economists. Interesting parts of the answer can be found in the literature on law and economics, public choice, and new institutional economics, but they are mostly limited to the effects of institutions on efficiency, while leaving aside the in the long run much more important problem of adaptability.
To deal with this problem, I used a simple evolutionary analysis (cf. footnote 1), which can be summarized as follows. As it is never fully known in advance which structural change will be successful, structural adaptation cannot proceed without imperfectly informed 13The emphasis on 'feasible' is to warn against the old bad habit of theoretical economists of playing withunfeasible policy instruments — such as lump-sum taxes. To rank feasible policy instruments according to theefficiency losses caused, adaptive efficiency provides sharper criteria than the usually considered allocativeefficiency. Thus, as bases for taxation, final consumption appears relatively benign, whereas capital, reinvestedcapital gains, and financial market transactions prove by far the most harmful. As ways of responding to spillovereffects, policies building on market exchanges and competition of private enterprises — such as tax financedvouchers for boosting merit consumption and tradeable emission rights for limiting air and water pollution — proveadaptively less inefficient than direct government control (Pelikan 1993, 1999).
entrepreneurial trials, most of which may turn out to be errors. The adaptation potential of institutions therefore depends on how large the variety of such trials they allow and encourage, and how fast and rigorous the correction or elimination of errors they enforce. This makes it possible to conclude that the institutions with the highest adaptation potential must be variants of what can be denoted as 'modern capitalism,' the basic property of which is to provide for the formation, development and preservation of competitive markets, including financial markets, and for private and tradable ownership of firms, including commercial and investment banks. In contrast, institutions which allow or prescribe national planning, and/or government ownership of firms and/or industrial subsidies and/or government controlled allocation of productive investment, can be shown to reduce the variety of trials, or the speed and the rigor of the elimination of errors, or both, which causes their adaptation potential to be significantly That the main comparative advantage of capitalism is in its adaptability, and not in the usually studied static efficiency, and that it was necessary to employ evolutionary analysis to show it, deserves emphasis. Evolutionary analysis appears indeed to be the only way to justify fully in theory the policy advice that most practical economists now give to countries in economic difficulties, advice such as privatization, deregulation, and replacement of government allocation or control of productive investment by development of civilized financial markets, including risk-capital markets. This policy advice can find only half-hearted support in standard analysis: because of the great freedom in the choice of its simplifying assumptions, this analysis proved equally able in showing the optimality of the opposite policies.
On the other hand, my evolutionary analysis was only very rough. While it showed the futility of looking for adaptive institutions elsewhere than among variants of modern capitalism, it said little about their possibly significant details. Much structural adaptability may indeed depend on institutional details — such as details in the formulation of bankruptcy law, patent law, or antitrust law — which remain a largely uncharted territory. It is also in such details that even the institutions with the highest adaptation potential may still have to be adaptable, 14It is such important nuances that the recent developments of law and economics and modern institutionaleconomics is often about. As noted, however, most attention is paid to the effects on static efficiency, and much lessto those on adaptability. While sometimes the two types of effects work in the same direction, at other times theymay conflict: for example, duplication of research efforts or investment in unsuccessful ventures may appearallocatively inefficient — yet both may be the necessary price to pay for finding the initially missing informationabout what projects of which agents can be part of a successful structural change, and thus be invaluable forstructural adaptability.
ready to change in face of new developments, such as important technological and A recent example is the development of information technologies and the spread of products with high information content in general. To deal with such fundamentally novel types of products and technologies in ways that facilitate suitable structural adaptations and prevent most of the unsuitable ones, even the most adaptable capitalist economies turned out to require institutional changes, such as modifications of and additions to the legislation of property rights.
This example also illustrates what is often viewed as a causal arrow between technological and institutional changes: the former are seen to cause the latter. This view has a long history, as it already appears in the old Marxist thesis that technological development (which is roughly what Marxists call 'the development of the forces of production') is exogenous, as if automatically falling from the sky, and constitutes the prime cause to which the prevailing institutions (included in the marxist term 'superstructure') are forced, possibly by means of revolution, to keep adapting. What appears less often noted is that this is only a half of the story. The other half was pointed out by North and Thomas (1973), who found that a not less important causal arrow leads in the very opposite direction: their study of the property rights that define the freedoms and incentives of inventors and innovators made it possible to conclude that it is the form of the prevailing institutions that determines whether technologies will The present view leads to a synthesis of the two arrows with a strong qualification of the Marxist one. Since technological innovations can be counted as special parts of the economy's output, their production is seen to depend, along the North and Thomas arrow, on the prevailing institutions: the institutions strongly influence the forming and the working of the economy's organizational structure, by which the output is produced. The qualification of the marxist arrow is that the changes caused by the actually produced innovations are in the first place structural (e.g., some new markets may have to open, some incumbent firms may have to reorganize or exit, and some new firms may have to enter) and not necessarily institutional. Institutions are required to change only if their adaptation potential is not sufficiently high, so that the structure, to accommodate the innovations, would have to be more adaptable than the This implies that two arrows form a feedback loop, which may seem to allow several institutional equilibria, states in which an economy's institutions would not be forced to change.
A necessary condition is that the institutions must not allow a greater variety of innovations to be generated than the one to which they allow the economy's structure to adapt. It may thus seem that both institutions with a low adaptation potential and those with a high adaptation potential may be sustainable, provided that they both satisfy this condition. This, however, may only be true for isolated economies. Otherwise, when different economies enter into economic or military competition, the more adaptable ones will prove to have a decisive comparative advantage over the less adaptable ones. This will force the latter to increase the adaptation potential of their institutions by a possibly radical reform, or to suffer a lasting decline.
7 Some implications for cultural relativism and development policies
The economically relevant findings of the previous section may be summarized as follows: (1) the institutions of economies, to be sustainable in severe and variable environmental conditions, must have a high adaptation potential; (2) to have this potential, the institutions must contain many components of what is usually called 'modern capitalism.' A serious problem arises if the actual environmental conditions of an economy are indeed severe and variable, but its institutions, instead of the needed components, contain some detrimental rules — for instance, they hinder establishment or smooth functioning of markets, or require extensive government ownership of firms, or let market competition be damaged by private cartels and/or corruption The general strategy for solving this problem is clear: the institutions need to be adapted (reformed, transformed) to satisfy point (2). But how actually to implement this strategy is much less so. As follows from Section 5, and in somewhat different words from Vanberg (1992), Denzau and North (1994) and Knight and North (1997), the adaptability of institutions is constrained by the adaptation potential of the prevailing culture. What makes these constraints particularly strong is that they act through several parallel, mutually reinforcing channels. The incumbent culture not only constrains people as cultural agents in their abilities and willingness to modify informal institutions, but it also constrains, through its more or less 15This effect of competition among institutions can indeed explain why Western Europe, which was duringcenturies divided into many relatively small competing states, could evolve institutions with a high adaptationpotential, which have allowed it to prosper, while much larger but relatively isolated empires — such as China andMongolia — could preserve for a long time institutions with a low adaptation potential, but at the price of asubsequent long-lasting decline. For this explanation, or reasoning leading to it, see, e.g., Bernholz (1995), Kerberand Vanberg (1995), and Rosenberg and Birdzel (1986).
strongly self-protected ideological beliefs, the cognitive abilities of social scientists needed to produce or import the knowledge about what institutional changes are necessary and of politicians needed to understand this knowledge and use it to suitably change formal To be sure, as has often been pointed out, institutional change is also constrained by the vested interests of currently privileged agents. Ultimately, however, even this constraint depends on the culture. While initially much of it is determined by the resources with which the privileged agents can defend their position, the relative importance of the culture is bound to grow over time: as the economy continues to decline, these resources inevitably dwindle. What then matters most is the actual understanding of the situation and the learning abilities by which this understanding can be adapted to new facts, which are both, as noted, strongly culturally conditioned. What happens next depends on how these abilities are divided between the incumbent elite and the other agents: for instance, if its learning abilities are high, the elite may start reforming the economic institutions itself, and thus save, at least for some time, its privileged position. The Chinese political leaders, who still call themselves 'communists' but are in fact transforming Chinese economic institutions into highly capitalist ones, illustrate this The crucial role of culture in institutional change, and the fact that different cultures differ in how they help or hinder institutions in evolving toward and remaining close to favorable forms, have important implications for cultural relativism and development policies. Cultural relativism turns out to be strongly limited by certain absolute conditions. Although the notion of truth may indeed be relative to cultures — different cultures can be found to contain different beliefs (ideologies, hypotheses, theories, mental models) — these beliefs turn out to be subject to the ultimate sanctions of nature (in the above broad sense), which are absolute. The beliefs that favor efficiency and adaptability of economies thus endow their cultures with important evolutionary advantages over cultures whose beliefs consist of less relevant fantasies.
Why these advantages have often been overlooked may be due to the fact that they were of low importance in the generous and stable environments which surrounded for a long time many primitive human societies, especially those living in tropical climate, and which some social scientists still appear, more or less implicitly, to assume. As noted, such environments tolerate both low efficiency and low adaptability, and thus allow a wide variety of cultures with a wide variety of beliefs to prosper. This may then give the impression that 'anything goes' and nothing is absolute. It is only when the environments of economies grow severe and variable, as they now appear to do virtually everywhere, that these advantages become decisive — whether But the limitation of cultural relativism also has its limits. It concerns only those parts of cultures that determine informal economic institutions and influence the behavior of humans as economic agents and as authors of formal economic institutions. The other parts of cultures — such as music, dances, fashion and diet — are not concerned. Although even they may be connected to efficiency and adaptability of economies — e.g., the diet of some cultures may be healthier than the diet of other cultures, which may cause significant differences in labor productivity and the costs of medical care — these connections are relatively weak. For these parts, cultural relativism can fully flourish.
The finding that cultures are economically unequal, in the sense that some of them provide for economic development and prosperity while others cause economic stagnation and misery, is not very new. But its implications for development policies are still little developed. The present one is that in the frequent cases in which economic underdevelopment is caused by lack of adaptability of structures and institutions, the dominant culture is crucial: unless it has, or can be supplied with, a sufficiently high adaptation potential, all other efforts to promote economic development are bound to fail. While North (2000) is certainly right that the favorable cultural conditions of the developed Western economies took several centuries to form, and that we do not know how to form them more rapidly, to try to learn it and to use the knowledge acquired both for assistance to legislation and for educational campaigns is the only promising strategy of helping poor countries to become richer. A necessary condition for this strategy to work is that the developed 'West,' instead of suffering from guilt complexes, becomes fully aware of the economic advantages of its culture and institutions, without which the educational campaigns could hardly be convincing.
Emphatically, however, that the poor 'South,' to become richer, must be helped to adopt economically favorable cultures and institutions by the prosperous 'West' is no reason for the 'West' to become pretentious. On the contrary, it must be modest enough to recognize that most of its present success is due to past chance: it has simply been extremely lucky that its cultural development, which cannot be claimed to have been driven by knowledge of the conditions of 16For similar results, see, e.g., Banfield (1958), North (1990), Grief (1994), Knight and North (1997), andLandes (1998).
economic success, happened to coincide so well with these conditions. Moreover, its success is still far from definitive. As mentioned in the beginning of Section 6, if economic efficiency is not to work in the wrong direction, it needs more knowledge about the ultimate criteria of nature, and another large portion of good luck, to choose sufficiently wise criteria of economic performance, which would allow it to steer clear of both the Scylla of exaggerated environmentalism and the Charybdis of neglecting vital spillover effects which could fatally damage its natural environment or its moral basis.
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