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there are capable of implementing it.

These dilemmas are of enormous importance for today™s poor
countries. What institutions should they adopt and what policies
should their governments be encouraged to follow? There is little
point in embarking on grandiose projects (steel mills,
petrochemical plants, land reform, public health programmes, free
education) unless a country™s institutions have the necessary checks
and balances to limit corruption and wastage. This brings us back to
our earlier question: how did those institutions that promoted
economic growth in today™s rich countries become established and
¬‚ourish? Despite the attention the question has received from the
world™s most outstanding economic historians, the matter remains
unsettled. In the next chapter I shall show why it is inherently so
dif¬cult to ¬nd a satisfactory answer (which, I guess, is itself a mark
of increased understanding). In view of the dif¬culties, it is safest to
regard institutions as the explanatory factor when we seek to
understand why Becky™s and Desta™s worlds differ so much in terms
of the standard of living.

The Oxford English Dictionary de¬nes institution as ˜an
established law, custom, usage, practice, organization, or other
element in the political or social life of a people™. We shall follow
that lead, but recast it so as to stress the role of institutions in
economic life. By institutions I shall mean, very loosely, the
arrangements that govern collective undertakings. Those
arrangements include not only legal entities, like the ¬rm where
Becky™s father works, but also the iddir to which Desta™s father
belongs. They include the markets in which Becky™s family purchase
goods and services, and the rural networks Desta™s household
belongs to. They include the nuclear household in Becky™s world
and the extended kinship system of claims and obligations in
Desta™s world. And they include that overarching entity called
government in both their worlds.

Macroeconomic history
Institutions are de¬ned in part by the rules and authority structure
that govern collective undertakings, but in part also by the
relationships they have with outsiders. The rules on the factory ¬‚oor
(who is expected to do which task, who has authority over whom,
and so on) matter not only to members of the ¬rm, they matter to
others too. For example, rich countries have laws relating to
working conditions in factories. Moreover, environmental
regulations constrain what ¬rms are able to do with their ef¬‚uents.
In every society there are layers of rules of varied coverage. Some
rules come under other rules, many have legal force, while others
are at best tacit understandings.

The effectiveness of an institution depends on the rules governing
it and on whether its members obey the rules. The codes of
conduct in the civil service of every country include honesty, but
governments differ enormously as to its practice. Social scientists
have constructed indices of corruption among public of¬cials. One
such index is based on the perception private ¬rms have acquired,
on the basis of their experience, of the bribes people have had to
pay of¬cials in order to do business. The index (see Table 1) “
which is on a scale of 1 (highly corrupt) to 10 (highly clean) “ is

less than 3.5 for most poor countries (African countries and
Eastern Europe are among the worst) and greater than 7 for most
rich countries (Scandinavian countries are among the best). It
used to be argued that bribery of public of¬cials helps to raise
national income because it lubricates economic transactions. It
does so in a corrupt world: if you don™t pay up, you don™t get to do
business. But corruption isn™t an inevitable evil. There are several
poor countries where corruption is low. Having to pay bribes
raises production costs; so less is produced. Citizens suffer,
because the price they have to pay for products is that much

Economists have speculated that government corruption is related
to the delays people face in having the rule of law enforced. The
thought is that delays are a way of eliciting bribes to hasten legal
processes. To enforce a contract takes 415 days in the poor world, as
against 280 days in the rich world. It may be that corruption is also

related to government ineffectiveness. To register a business takes
66 days in the poor world, 27 days in the rich world. In poor
countries, registering property takes 100 days on average, while in
rich countries the ¬gure is 50 days. Some economists have
suggested that government of¬cials in poor countries create lengthy
queues (that™s government ineffectiveness) so as to elicit bribes
from applicants if they want to jump those queues (that™s

How do government corruption, ineffectiveness, and indifference
to the rule of law translate into the kind of macroeconomic
statistics we have been studying here? They leave their imprint on
total factor productivity. Other things being equal, a country
whose government is corrupt or ineffective, or where the rule of
law is not respected, is a country whose total factor productivity is
lower than that of a country whose government suffers from fewer
of those defects. Some scholars call these intangible but
quanti¬able factors social infrastructure, others call them social

Institutions are overarching entities. People interact with one
another in institutions. A more basic notion is that of
engagements among people. The possibility of engagements gives
rise to a fundamental problem in economic life. We study that

Macroeconomic history

Chapter 2

Imagine that a group of people have discovered a mutually
advantageous course of actions. At the grandest level, it could be
that citizens see the bene¬ts of adopting a constitution for their
country. At a more local level, the undertaking could be to share the
costs and bene¬ts of maintaining a communal resource (irrigation
system, grazing ¬eld, coastal ¬shery); construct a jointly useable
asset (drainage channel in a watershed); collaborate in political
activity (civic engagement, lobbying); do business when the
purchase and delivery of goods can™t be synchronized (credit,
insurance, wage labour); enter marriage; create a rotating saving
and credit association (iddir); initiate a reciprocal arrangement (I
help you, now that you are in need, with the understanding that you
will help me when I am in need); adopt a convention (send one
another Christmas cards); create a partnership to produce goods for
the market; enter into an instantaneous transaction (purchase
something across the counter); and so on. Then there are mutually
advantageous courses of action that involve being civil to one
another. They range from such forms of civic behaviour as not
dis¬guring public spaces and obeying the law more generally, to
respecting the rights of others.

Imagine next that the parties have agreed to share the bene¬ts and
costs in a certain way. Again, at the grandest level the agreement
could be a social contract among citizens to observe their

constitution. Or it could be a tacit agreement to be civil to one
another, such as respecting the rights of others to be heard, to get on
with their lives, and so forth. Here we will be thinking of
agreements over transactions in goods and services. There would be
situations where the agreement was based on a take-it-or-leave-it
offer one party made to another (as when Becky™s mother accepts
the terms and conditions set by the ¬rm called in by her to ¬x the
plumbing). In other contexts, bargaining may have been involved
(as when Desta™s mother purchases household ¬neries at the
regional fair, which is not altogether different from a Middle
Eastern bazaar). Later in this book (Chapter 4) we will study an
idealized version of prices in the markets Becky™s family visits,
where both buyers and sellers face take-it-or-leave-it offers. But we
will not study how agreements are reached when bargaining is
involved in either Becky™s or Desta™s worlds, nor look for principles
of equity that might have been invoked during negotiation. To do
that would take us into bargaining theory, a beautiful but dif¬cult
branch of the theory of games. We ask instead a question that is

pertinent in both Becky™s and Desta™s worlds: under what
circumstances would the parties who have reached agreement trust
one another to keep their word?

Because one™s word must be credible if it is to be believed, mere
promises wouldn™t be enough. (Witness that we warn others “ and
ourselves too “ not to trust people ˜blindly™.) If the parties are to
trust one another to keep their promise, matters must be so
arranged that: (1) at every stage of the agreed course of actions, it
would be in the interest of each party to plan to keep his or her word
if all others were to plan to keep their word; and (2) at every stage of
the agreed course of actions, each party would believe that all others
would keep their word. If the two conditions are met, a system of
beliefs that the agreement will be kept would be self-con¬rming.

Notice that condition (2) on its own wouldn™t do. Beliefs need to be
justi¬ed. Condition (1) provides the justi¬cation. It offers the basis
on which everyone could in principle believe that the agreement

will be kept. A course of actions, one per party, satisfying condition
(1) is called a Nash equilibrium, in honour of the mathematician
John Nash “ he of The Beautiful Mind “ who proved that it is not a
vacuous concept. (Nash showed that the condition can be met in
realistic situations.) The way I have stated condition (1) isn™t due to
Nash, though, but to John Harsanyi, Thomas Schelling, and
Reinhard Selten, three social scientists who re¬ned the concept of
Nash equilibrium so that it could be applied to situations where
Nash™s own formulation is not adequate.

Notice that condition (1) on its own wouldn™t do either. It could be
that it is in each one™s interest to behave opportunistically if
everyone believed that everyone else would behave
opportunistically. In that case non-cooperation is also a Nash
equilibrium, meaning that a set of mutual beliefs that the
agreement will not be kept would also be self-con¬rming. Stated
somewhat informally, a Nash equilibrium is a course of actions

(strategy, in economic parlance) per party, such that no party would
have any reason to deviate from his or her course of actions if all
other parties were to pursue their courses of actions. As a general
rule, societies harbour more than one Nash equilibrium. Some yield
desirable outcomes, others do not. The fundamental problem every
society faces is to create institutions where conditions (1) and (2)
apply to engagements that protect and promote its members™
interests. When we come to study what economics has to say about
the ideal role of the state (Chapter 8), we will have much to add
about those interests.

Conditions (1) and (2), taken together, require an awful lot of
coordination among the parties. In order to probe the question of
which Nash equilibrium can be expected to be reached “ if a Nash
equilibrium is expected to be reached at all “ economists study
human behaviour that are not Nash equilibria. The idea is to
model the way people form beliefs about the way the world works,
the way people behave, and the way they revise their beliefs on the
basis of what they observe. The idea is to track the consequences

of those patterns of belief formation so as to check whether the
model moves toward a Nash equilibrium over time, or whether it
moves about in some fashion or other but not toward an

This research enterprise has yielded a general conclusion. Suppose
the economic environment in a certain place harbours more than
one Nash equilibrium. Which equilibrium should be expected to be
approached “ if the economy approaches an equilibrium at all “ will
depend on the beliefs that people held at some point in the past. It
also depends on the way people have revised their beliefs on the
basis of observations since that past date. But this is another way of
saying that history matters. The narrative style of empirical
economics that I spoke of earlier becomes necessary at this point.
Model-building, statistical tests on data relating to the models, and
historical narratives have to work together synergistically if we are
to make progress in understanding our social world. Unfortunately,
the study of disequilibrium behaviour would lengthen this

monograph greatly. So I shall only allude to it from time to time. We
will discover that, fortunately, a study of equilibrium behaviour
takes us a long way.

We started this chapter by observing that mutual trust is the basis of
cooperation. In view of what we have learned about the multiplicity
of Nash equilibria, we are now led to ask what kinds of institution
are capable of supporting cooperation. To answer that, it will prove
useful to classify the contexts in which the promises people make to
one another are credible.

Mutual affection
Consider the situation where the people involved care about one
another and it is commonly known that they care about one
another. The household is the most obvious example of an
institution based on affection. To break a promise we have made to
someone we care about is to feel bad. So we try not to do it. From

time to time, though, even household members are tempted to
misbehave. As people who live together can observe one another
closely, the risk of being caught misbehaving is high. This restrains
household members even when the temptation to misbehave is

That said, the household can™t engage in enterprises that require
people of many and varied talents. So households need to ¬nd ways
to do business with others. The problem of trust reappears at the
interhousehold level. This leads us to search for other contexts in
which people can trust one another to keep their word.

Pro-social disposition
One such situation is where people are trustworthy, or where they
reciprocate if others have behaved well towards them. Evolutionary
psychologists have suggested that we are adapted to have a general

disposition to reciprocate. Development psychologists have found
that pro-social disposition can be formed by communal living,
role-modelling, education, and receiving rewards and punishments
(be it here or in the afterlife).

We don™t have to choose between the two viewpoints; they are not
mutually exclusive. Our capacity to have such feelings as shame,
guilt, fear, affection, anger, elation, reciprocity, benevolence,
jealousy, and our sense of fairness and justice have emerged under
selection pressure. Culture helps to shape preferences, expectations,
and our notion of what constitutes fairness. Those in turn in¬‚uence
behaviour, which are known to differ among societies. But cultural
coordinates enable us to identify the situations in which shame,
guilt, fear, affection, anger, elation, reciprocity, benevolence, and
jealousy arise; they don™t displace the centrality of those feelings in
the human makeup. The thought I am exploring here is that, as
adults, we not only have a disposition for such behaviour as paying
our dues, helping others at some cost to ourselves, and returning a
favour, we also ease our hurt by punishing people who have hurt us

intentionally; and shun people who break agreements, frown on
those who socialize with people who have broken agreements, and
so on. By internalizing norms of behaviour, a person enables the
springs of his actions to include them. In short, he has a disposition
to obey the norm, be it personal or social. When he does violate it,
neither guilt nor shame would typically be absent, but frequently
the act will have been rationalized by him. Making a promise is a
commitment for that person; and it is essential for him that others
recognize it to be so.

People are trustworthy to varying degrees. When we refrain from
breaking the law, it isn™t always because of a fear of being caught.
The problem is that although pro-social disposition isn™t foreign to
human nature, no society could rely exclusively on it. How is one to
tell to what extent someone is trustworthy? If the personal bene¬ts
from betraying one™s conscience are large enough, almost all of us
would betray it. Most people have a price, but it™s hard to tell who
comes at what price.

Societies everywhere have tried to establish institutions where
people have the incentives to do business with one another. The
incentives differ in their details, but they have one thing in
common: those who break agreements without cause are punished.
Let us see how that is achieved.

Laws and norms
There are two ways. One is to rely on an external enforcer, the other
on mutual enforcement. Each gives rise to a particular type of
institution. Depending on the nature of the business they would like
to enter into, people invoke one or the other. The coded term for one
is the rule of law; for the other, it is social norm. People in the rich
world rely heavily on the former, while in the poor world people
depend greatly on the latter. Subsequently we will study the claim
that it is because they have been able to depend extensively on the
former for centuries that people in the rich world are now rich.

I shall illustrate the two methods of enforcement with the help of a
numerical example of bilateral agreement. The numbers will allow
us to draw insights without fuss. The example itself is based on the
˜putting-out system™ of production, widely practised in Europe in
the 17th and 18th centuries and prevalent in poor countries today in
the crafts. The system amounted to a patron“client relationship,
but for our purposes here it can also be thought of as a partnership.

Imagine that person A owns some working capital (raw material,
say), worth $4,000 to him. A knows B, who has the skills to use that
capital to produce goods worth $8,000 in the market. A doesn™t
have those skills. However, A has access to the market, which B
doesn™t. A proposes to advance his capital to her, with the
understanding that he will sell the goods once B produces them and
share the proceeds with her. If B was not to work for A, she would
use her time to produce goods for her home, worth $2,000 to her.
In order to get her to accept his offer, A proposes a sharing rule that

is hallowed by their tradition: the $8,000 would be used ¬rst to
compensate both parties fully “ $4,000 for A (the amount A would
enjoy from the best alternative use of his working capital, which
economists call the working capital™s opportunity cost) and $2,000
for B (which is the opportunity cost of B™s time and effort); the
remaining $2,000 would then be divided equally between the two.
A would receive $5,000 and B $3,000. Each would gain $1,000
from the arrangement.

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