II. MARKET-ORIENTED POLICIES FOR PROMOTING ECONOMIC DEVELOPMENT, 1955–1960s

The thrust of North’s earliest development policy recommendations is captured in a lecture he gave in 1959 at the Economic Institute of the International Bank for Reconstruction and Development in New York, where he was an invited lecturer from 1959 until 1961.Footnote ² Also in 1961, he spent three weeks in Brazil lecturing on economic development and providing policy advice, sponsored by the US State Department and the Getulio Vargas Foundation. Boianovsky (Reference Boianovsky2018) details the economic context and North’s advisory role there. In both these lectures and early publications (North Reference North1955; North [1961] Reference North1966), the young economic historian at the University of Washington in Seattle used Western economic growth as a model, advocating market-oriented policies shaped by his historical studies of US economic growth.

North recommended that developing countries open their economies to international trade, believing that the growth of several Western nations, particularly the United States, was initiated by trade gains from specialization based on comparative advantage. His early historical research on the regional bases of US economic growth (North Reference North1955), and his first book (North [1961] Reference North1966), argued that US growth was driven by commodity trade, especially agricultural products (North [1961] Reference North1966, especially pp. 1–2 and 7–8).Footnote ³ His thesis resembled the “staple thesis” of Canadian historian Harold Innis, who argued that Canada’s economic growth originated in “staple” exports to Europe (North Reference North1955, p. 247). Unlike Innis, however, North’s explanation relied on neoclassical price theory, particularly Stigler’s “Adam Smith theorem” (1951), which established a direct relationship between market expansion (extensive growth) and productivity gains (intensive growth). North argued that US growth illustrated the Adam Smith theorem: within the US competitive market system, growth came from the productivity gains resulting from technological progress and specialization made possible by an expanding market size (North Reference North1959, p. 944; North [1961] Reference North1966, pp. 10–11, 177; North Reference North1961, pp. 35–36).Footnote ⁴

Based on this historical analysis, North argued that industrialization is not a prerequisite for economic growth and that specialization in the primary sector is generally not a brake on growth. On the contrary, he claimed that an agricultural export base could serve as a basis for diversification and growth. The main obstacle to Third World development, he argued, was not low savings from diminishing returns in agriculture, as Walt Rostow (Reference Rostow1956) had suggested, but rather small markets and trade isolation (North Reference North1959, pp. 943–944, 950–951; North Reference North1961, p. 36). Accordingly, North (Reference North1959, Reference North1961) advocated a development strategy for Third World countries based on the export of raw materials, arguing that industrial investment was justified only in regions with a comparative advantage in this sector.Footnote ⁵

North claimed that, based on his historical analysis of US regional growth, export-led strategies are generally successful, with only rare exceptions. He hypothesized that exports automatically lead to economic growth when the economy is profit-oriented, based on competitive markets, and when export sectors are numerous with constant returns to scale production functions—conditions found in the US North and West. Under these circumstances, producers specialize according to factor endowments and reinvest export earnings in complementary and subsidiary activities, including those that enhance productivity, such as human capital and technological innovation. Thus, export revenues initiate the virtuous cycle described by the Adam Smith theorem: they serve as a basis for expanding markets, developing new comparative advantages, and improving factor productivity. North identified a singular exception in the antebellum South, where a single, labor-intensive export sector with increasing returns to scale reinforced its dominance and hindered economic diversification. In these rare circumstances, export earnings could fail to stimulate growth (North Reference North1955, pp. 254–257; North Reference North1959; North [1961] Reference North1966, especially pp. 1–11 and 177).

North’s market-oriented recommendations were further informed by his historical analysis of the US government’s role in fostering economic growth. His assessment of this role was also based on neoclassical theory, particularly the ideas of another University of Chicago economist, Theodore Schultz. Like Schultz, North argued that government intervention could stimulate growth by addressing market failures—either by replicating the outcomes of competitive markets or by aligning private and social returns in cases involving externalities, such as those associated with infrastructure, human capital, and scientific research (North Reference North1961, pp. 47–48). However, because of the relatively small size of US government spending as a share of GDP and the difficulty of assessing its effectiveness, he emphasized that government intervention played only a “modest” and secondary role, if any, in fostering American growth (North Reference North1966, p. 104). Instead, he identified efficient markets, driven by competition among self-interested agents and unaided by the state, as the primary driver of American expansion (North Reference North1955; North Reference North1959; North [1961] Reference North1966, pp. v–vii; see also North Reference North1966, pp. 98–107, 183–185, 189).

Convinced that American economic growth was primarily the result of efficient and competitive markets, North naturally argued during his 1961 visit to Brazil that the country’s poverty, unemployment, and high levels of inequality were largely due to bureaucratic regulation and planning. These barriers prevented economic agents from reaping the benefits of specialization, making Brazil’s market economy highly inefficient and stagnant. To enhance economic efficiency and stimulate growth, he recommended market-oriented policies: reducing government controls on the economy, concentrating state intervention on sectors with high externalities—particularly education and infrastructure—and opening the country to international trade (Boianovsky Reference Boianovsky2018, pp. 163–168). Moreover, he championed Schultz-style cost-benefit analysis as a key tool for improving government efficiency by prioritizing projects with the highest net social returns (North Reference North1961, pp. 47–49, 65–72). More generally, in the exceptional case where a country had a dominant comparative advantage in the production of a single raw material with increasing returns—such as plantation crops in the antebellum American South—he advocated public investment in sectors with high externalities to encourage successful exporters to diversify their investments into sectors other than plantations (North Reference North1959, p. 950).

North’s neoclassical conceptual framework and market-oriented recommendations contrasted sharply with those of Brazilian economist Celso M. Furtado (1920–2004). Furtado preferred a “structuralist” approach to economic development that emphasized the unequal structure of the global economy and advocated economic planning and import substitution industrialization to achieve greater economic autonomy.Footnote ⁶ The sharp contrast in policy recommendations between North and Furtado also reflected ideological differences. Compared with Furtado, North had much greater confidence in the benefits of the competitive market economy for economic development. Indeed, he believed that Furtado was wrong because he was a “leftist” who greatly underestimated the harmful effects of central planning on economic efficiency (quoted in Boianovsky Reference Boianovsky2018, p. 168).

As his remarks about Furtado suggest, by the early 1960s he was, as North himself acknowledged, a “very rigid neoclassical, Chicago type economist” and a “right-wing reactionary” (Reference North and Horn2009, p. 164).Footnote ⁷ Thus, in the first version of what would become one of the bestselling economic history textbooks in the United States, North (Reference North1966, pp. 3–10) emphatically argued that the “self-regulating” market system was the key driver behind the exceptional improvement in economic efficiency and welfare in the West, equating welfare with GDP per capita. In his opinion, the virtues of competitive markets had long been understood by none other than Adam Smith, rigorously demonstrated by neoclassical theorists like Stigler, and best illustrated by American economic history (1966, pp. 8–9). Therefore, he insisted that the solution to the problem of widespread poverty in the Third World was first and foremost to produce more income more efficiently—not to redistribute it.

III. THE ORIGINS OF ECONOMIC DEVELOPMENT: FROM SELF-REGULATING MARKETS TO EFFICIENT INSTITUTIONS, 1970s

In 1966, the year his textbook on American economic history was published, North spent a year at the University of Geneva as a Ford Faculty Fellow. For the first time in his career, he worked on European economic history. By his own admission, studying it convinced him that neoclassical price theory was inadequate to explain the origins of economic development (North Reference North and Horn2009, p. 165). While it could explain the success of the US economy, it could not explain the substitution of the market system for the feudalistic economy that was central to Europe’s development (North and Thomas Reference North and Thomas1970; North and Thomas Reference North and Thomas1971; North Reference North1971; North Reference North1977a). North’s belief in the importance of institutions was reinforced by his study of productivity gains in ocean shipping from 1600 to 1850, a topic that had fascinated him since his service in the merchant marine during WW II. In 1968, he found that these gains were due mainly to reduced piracy and better economic organization, rather than technological progress (North Reference North1968). This historical research led him to shift focus from market forces to the economic, political, and legal institutions underpinning them (Wallis Reference Wallis, Galiani and Sened2014; Krul Reference Krul2018, especially pp. 34 and 44).

From then until the end of his career, North sought to extend neoclassical theory by incorporating institutional dynamics to explain how some Western societies developed institutions that fostered markets and promoted growth, while other countries remained burdened with institutions that hindered development (Krul Reference Krul2018; Telles Reference Telles2024). This shift in perspective ultimately influenced his development policy recommendations. Central to this transformation was his historical analysis of institutional change, particularly the transition from feudalism to capitalism over the centuries and the origins of modern economic growth in Europe. North found that long-term productivity gains in Western Europe were primarily driven by innovations in political, legal, and economic institutions initiated by profit-seeking individuals (North and Thomas Reference North and Thomas1970; see also Davis and North Reference Davis and North1970). Reforms in property rights, such as the introduction of patent laws, provided incentives to invest in human capital and technology by increasing their private returns, while major changes like enclosures, the development of formal private property rights in land, and the abolition of serfdom improved the efficiency of factor markets. The creation of corporations and joint-stock companies facilitated economies of scale, and insurance companies and stock exchanges reduced market imperfections (North and Thomas Reference North and Thomas1973, pp. 1–18). These and similar historical cases convinced North that the institutional framework—particularly the structure of property rights—is the basic determinant of economic incentives and performance: by altering market efficiency and either incentivizing or discouraging productivity-enhancing activities, institutions can lead to either economic growth or stagnation.Footnote ⁸ Thus, institutions became central to his theory and his policy recommendations.

North applied economist Ronald H. Coase’s transaction cost theory to explain how institutions affect economic performance.Footnote ⁹ Institutions shape market efficiency by influencing transaction costs—encompassing all costs associated with the specification and enforcement of property rights, including those tied to risk, information, and externalities (North and Thomas Reference North and Thomas1970, pp. 5–6; North and Thomas Reference North and Thomas1977; North Reference North1974; North Reference North1977b, pp. 193–194). Within this expanded framework, North viewed efficient markets as the rare case where transaction costs are zero, a condition contradicted by many historical examples in Europe where institutions hindered market efficiency. North thus identified “inefficient” institutions—those that increase transaction costs and lead to poorly defined and enforced contracts and property rights—as the primary cause of economic stagnation, from medieval Europe to the contemporary Third World (Davis and North Reference Davis and North1970; North and Thomas Reference North and Thomas1970; North Reference North1971; North and Davis Reference North and Davis1971, pp. 3–25; North and Thomas Reference North and Thomas1973, pp. 1–18; see also North Reference North1981, pp. ix–12; North Reference North1989; North Reference North1990, pp. 7–9, 110). Thus, reducing transaction costs through institutional reforms became central to his development policy recommendations.

North’s study of institutional history also reshaped his view of the role of the state in economic development, influencing both his theoretical framework (as discussed by Fiani Reference Fiani2004) and his policy recommendations. It convinced him that government plays a far more significant role than he had previously believed (North Reference North1977b, p. 195; North Reference North1977c; North Reference North1984).Footnote ¹⁰ Two historical case studies were crucial. First, comparing France’s stagnation and Spain’s decline with England’s and the Netherlands’ growth in the seventeenth century highlighted the dual nature of government: it can either support or distort markets, depending on society’s institutions. In France and Spain, monarchs traded economic regulations for tax revenues and political loyalty, fostering “rent-seeking” at the expense of efficiency.Footnote ¹¹ Conversely, English and Dutch representative systems limited rulers’ discretionary control over the economy, ensuring a more efficient system of property rights and fostering growth (North and Thomas Reference North and Thomas1973, pp. 120–158; North Reference North1977c, pp. 166–167; North Reference North1981, pp. 134–157). This study led North to place greater—and indeed considerable—emphasis on reforming state institutions in development policies. He concluded that the main challenge to Third World development is to create a system of limited government that acts as an impartial third-party arbiter rather than a self-interested mafia (North Reference North1984, p. 264; North Reference North1989; North Reference North1990, pp. 58–59).

Second, North observed that governments have historically played a central role in defining and enforcing property rights and contracts (North Reference North1977c). Market exchange without a state occurs only in primitive societies, where markets are small enough that property rights and contracts can be defined and enforced through shared customs and interpersonal relationships. As markets grow and exchange becomes impersonal, customs lose relevance and states emerge to regulate transactions. Based on this observation and the assumption that coercive institutions have a comparative advantage in providing public goods like justice and defense (North and Thomas Reference North and Thomas1973, pp. 6–7), North argued that the development of state institutions is essential for market growth—a departure from his earlier view of governments as secondary and mostly negative. Without a state-enforced body of rules regulating property and contracts, North argued, transaction costs would become prohibitively high, and property rights and contracts would be too poorly specified and imperfectly enforced for markets to function. Parties to exchanges would be incentivized to breach their contractual obligations and engage in opportunistic behavior (free riding, cheating) instead (North Reference North1981, especially pp. 17–32; North Reference North1984, pp. 257–259; North Reference North1989; North and Wallis Reference North and Wallis1982). Accordingly, North (Reference North1981) distinguished his position from “free market” ideologies (pp. 53, 166–167), creating tensions with classical liberal economists like Donald McCloskey, who believed most contracts are self-enforcing (North to McCloskey, July 27, 1987, Box 5, Folder July 1987: Donald McCloskey, Robert Keohane, Yoram Barzel). He also challenged public choice theorists by arguing that governments are not merely costly redistributive mechanisms, directly opposing figures like Robert D. Tollison and Robert B. Ekelund (North Reference North and Rowley1987).Footnote ¹²

One final historical analysis was crucial to North’s revised view of economic development: the history of US economic, legal, and political institutions, particularly the expansion of the size and functions of the federal government since the nineteenth century. North’s study, initiated in collaboration with his colleague Lance Davis (North and Davis Reference North and Davis1971), suggested that this expansion was largely driven by political movements advocating economic redistribution and Supreme Court rulings authorizing federal regulation of private enterprise. They also found that decisions by legislators, activists, voters, and judges often appeared to be motivated more by “ideological” factors—such as moral views of the “public good”—than by economic interests (North Reference North1978, p. 976). This ideological influence suggested that the growth of government was not purely the result of rational economic calculation but reflected a turn against “free market capitalism,” as envisioned by Joseph Schumpeter (Reference Schumpeter1942). The resulting market regulation and welfare state altered the structure of property rights, affecting market efficiency. North concluded that ideologies significantly influence economic performance and are key to explaining the persistence of inefficient institutions.Footnote ¹³ Reforming political-legal institutions to foster growth is difficult because ideological factors, such as shared beliefs and preferences, can obstruct reforms and undermine the enforcement of rules by delegitimizing them (North Reference North1978; North Reference North1981, especially pp. 36–37, 44–58, 180–188, and 202–208; North Reference North1984; North Reference North1985).

North’s study of Western institutional history thus convinced him that fostering economic development was more complex than was suggested by the neoclassical economic theory he had once embraced. Because of positive transaction costs, simply limiting government intervention and deregulating markets, as he advocated in the 1950s and 1960s, was insufficient to create the virtuous cycle described by Adam Smith. Far from self-regulating, markets need government reform and a restructuring of the rules of the game to enhance their efficiency. However, the persistence of predatory governments and ideological resistance posed significant barriers to institutional reform.

IV. IMPLEMENTING FAR-REACHING INSTITUTIONAL REFORMS FOR ECONOMIC DEVELOPMENT, 1980s–1990s

After revisiting the relationship between institutions and economic performance in the 1970s, North returned to Third World development policy in the early 1980s. In 1983, after over thirty years at the University of Washington in Seattle, he was appointed the Henry R. Luce Professor of Law and Liberty at the Washington University in St. Louis. The following year, he became director of the newly established Center of Political Economy (CPE) there.Footnote ¹⁴ North joined the CPE because he believed it had some of the best specialists in the “political economy of development,” including political scientists Robert H. Bates, Kenneth A. Shepsle, and Barry R. Weingast. They shared his belief in the importance of political institutions for economic performance, and his ambition to apply the main lessons of economic history to economic development: that economic development in the Third World is hampered by high transaction costs, mafia-like systems of government, and inefficient property rights (see North Reference North1984, pp. 258–259, 263–264; North Reference North1989, pp. 1320–1324; North and Weingast Reference North and Weingast1989). North’s involvement in development policy and his specific recommendations during the 1980s and 1990s remain largely unexplored. The following analysis draws on archival documents to address these issues.

North wanted to go into the field to better understand the origins of transaction costs in the Third World and to propose appropriate reforms to reduce them. To this end, he made several academic trips to Latin America, starting with a week of lectures in Argentina in October 1984, and in May 1985, he advised the Washington DC-based Agency for International Development (AID) on “modeling institutions to promote economic development” (Annual Report 1984–85, Henry R. Luce Professorship in Law and Liberty, Washington University, Box 3, Folder Correspondence by Date July–August, 1985: Robert Bates (Duke), Others). North was invited to Argentina to present his research on economic growth by the Argentine economic historian Caceres Cano, who was said to admire his “methodology and theoretical scheme” and who, like North, believed that “many aspects of Argentina’s contemporary economic pattern” could be traced to its peculiar process of “institutional transformation” since decolonization (cited in Daniel J. Greenberg to North, 1982, October 27, Box 2, Folder Journal of Political Economy, referee reports by North, 1982–1983 (2 of 2)).Footnote ¹⁵ In addition, North was a delegate to the World Bank’s December 1985 conference on “The Political Economy of Poverty, Equity and Growth,” in Cancun, Mexico (Annette Milford to James McCammon, May 29, 1986, Box 4, Folder May 1986). In 1987, North was invited back to Mexico to speak at a seminar on “institutions and economic development,” partly funded by the World Bank and targeted at top policymakers. Its organizer, Mexican economist Arturo M. Fernandez, described it as a follow-up to an earlier two-day event that provided “theoretical and empirical support for trade liberalization as a strategy to promote development and reduce poverty” and was attended by “high rank officials and highly recognized scholars and journalists.” Like North, Fernandez was convinced that “the efforts already made towards trade liberalization are not enough to reinitiate growth. Many institutions, rules and practices are still inhibiting development” (Fernandez to North, June 1, 1987, Box 5, Folder June 1987–June 1988).Footnote ¹⁶

As an AID advisor, North was a guest of Peruvian economist Hernando de Soto at the Institute for Liberty and Democracy (ILD) in Lima, Peru, in 1985 (Annette Milford to James McCammon, May 29, 1986, Box 4, Folder May 1986). The ILD was a classical-liberal think-tank created by de Soto four years earlier with the primary goal of developing Peru’s market economy.Footnote ¹⁷ Through the ILD, North had an unprecedented opportunity to examine in more detail the institutional constraints on the development of Peruvian markets and to apply some of his ideas for loosening these constraints. The ILD began a research program on transaction costs in 1988, funded partly by AID and supervised by North’s PhD student and future World Bank economist Philip Keefer. North was briefed on the progress of the program, whose main objective he described as to “measure transaction costs in various factor and product markets” in Peru (North to Stephen L. Parente, February 2, 1990, Box 7, Folder January 1990) in order to provide “the foundation for an analysis of the way in which institutions and the costs of transacting are major contributors to the persistence of poverty in third world countries” (North to Michael S. Joyce, May 25, 1990, Box 8, Folder May 1990). At the same time, the ILD researched, designed, and implemented institutional reform programs, including a property rights program and an administrative simplification program, as part of an overall strategy to complete the transition to a market economy and a participatory democracy in Peru (de Soto to North, December 6, 1990, Box 8, Folder December 1990). These programs aimed, among other things, to reduce transaction costs by simplifying administrative procedures for doing business and to improve the efficiency of property rights by establishing property titles for informal housing owners. As part of these programs, Keefer was promoted to economic advisor and personal assistant to de Soto and assigned to work on a project on how rules are made in Peru and how the institutional system is detrimental to economic activity (Keefer to Robert Parks, August 2, 1989, Box 7, Folder August 1989). North held de Soto in high regard (North to Jerry Jenkins, May 19, 1987, Box 5, Folder May 1987: Paul David, Robert Haveman, Vernon Smith, T. N. Srinivasan) and was asked to help evaluate the ILD’s programs (de Soto to North, December 6, 1990, Box 8, Folder December 1990).Footnote ¹⁸ His experience in Peru reinforced his belief that persistently high transaction costs are a major impediment to economic development. He saw for himself that the country’s transaction costs were high because of all the “permits” and “paperwork” required by its administration to conduct even the most mundane economic transaction (Centennial Visit Lecture Chicago-Kent College of Law, no page number, Box 47, Folder Centennial Visit Lecture, Chicago-Kent College of Law, 1999).

After witnessing the challenges of improving the efficiency of Peruvian markets, North studied Latin American history to better understand the long-term persistence of inefficient institutions. Once again, his study of institutional history led him to further extend neoclassical theory and derive new implications for economic policy. While studying Latin American history and discussing economic development with his colleagues Bates, Shepsle, and Weingast, North was struck by the fact that several Latin American countries had adopted “formal” institutions—especially constitutions—modeled on the US, yet failed to achieve sustained economic growth. For North, this was evidence that “informal” institutions inherited from the colonial period—particularly Spanish political-economic norms and beliefs in favor of political absolutism and economic “corporatism”—negatively impacted the economic performance of Latin American countries. In his opinion, these ideologies, shared beliefs, codes of conduct, and conventions undermined US-inspired formal rules, making their enforcement very costly and creating inefficient property rights and markets (North Reference North and Walker1988a; North Reference North1988b; North Reference North1989, pp. 1322, 1329–1330; North Reference North1990, pp. 113–117).Footnote ¹⁹ Drawing on this historical analysis, North (Reference North1990, throughout) emphasized the central role of informal institutions and beliefs in economic development. He argued that individuals rely on them when the information feedback between reality and their perceptions is distorted by information and measurement costs, leading to imperfect information. He found this phenomenon to be particularly pervasive in politics, where high costs amplify the influence of informal constraints on legislators’ decisions, leading to inefficiency and poor economic performance (North Reference North1990, especially pp. 52 and 109–110).

To explain why inefficient social norms and ideologies persisted for so long in many developing countries after decolonization, North adapted economist W. Brian Arthur’s concept of technological “path dependence” to the analysis of institutions. He first encountered this concept in the late 1980s through Arthur’s and economic historian Paul A. David’s work on technology. They showed that once inefficient technology is widely adopted, network effects create increasing returns that can durably prevent the adoption of more efficient technologies (David Reference David1985; Arthur Reference Arthur1989).Footnote ²⁰ North argued that institutions, like technology, are path-dependent due to economies of scope, network externalities, and complementarities that create increasing returns. Moreover, their development is constrained by predatory elites who defend the inefficient institutions from which they benefit, and by the country’s “cultural heritage” that limits the choices available to policymakers (North Reference North and Walker1988a, Reference North1989, Reference North, Harris, Hunter and Lewis1995, Reference North1997). Path dependence explains why informal institutions like social norms are difficult to change and do not adjust efficiently to changes in relative prices, and why political revolutions can change a country’s formal institutions, such as its constitution (as in the case of Latin America), but leave intact social norms that are “compatible” with the country’s cultural heritage (North Reference North1989, pp. 1324–1325; North Reference North1990, pp. 93–95; North Reference North2005, pp. 112–115, 156–157).

Since path dependence is a major cause of long-term economic stagnation, North argued that the key to economic development is to create institutions that promote decentralized decision-making, thereby leaving open as many learning opportunities as possible—an idea he adopted from the Austrian economist Friedrich A. Hayek, whom he had met in 1973.Footnote ²¹ North called these institutions and the resulting path of institutional change “adaptively efficient.” Such institutions enable decision-makers to maximize trials and errors and find more efficient solutions more quickly. Their openness to innovation makes them rapidly “adjustable” to unpredictable shocks, human mistakes, and relative price changes (North Reference North1990, p. 80–82; North Reference North1992). North (Reference North2005, pp. 103–145) argued that the West’s economic success stems from the greater adaptive efficiency of its “institutional matrix”—the combination of informal constraints (norms and shared beliefs), formal rules, and their enforcement characteristics. This matrix is rooted in a unique cultural heritage that supports democratic government and impersonal market exchange.Footnote ²²

While thinking about reforms to make Latin American institutions more adaptively efficient, North became an advisor to the World Bank in 1990. Although he had some supporters, few economists there paid attention to institutions, transaction costs, or concepts like path dependence and adaptive efficiency. Many were macroeconomists focused on macroeconomic “structural adjustment” programs targeted at reducing public debt and controlling inflation in Latin America (e.g., Dornbusch and Edwards Reference Dornbusch and Edwards1991). Thus, Sharon L. Holt, a World Bank advisor and one of North’s supporters, lamented being “pretty unsuccessful at convincing a group of staunch, World Bank neoclassical economists that organizations and institutions mattered for poverty reduction, let alone economic development.” According to her, North’s recommendation that economic programs should aim to reduce transaction costs was still far from mainstream among World Bank economists. These costs are “rarely identified as central problems of economic development and poverty programs” (Holt to North, May 18, 1990, Box 8, Folder June 1990).Footnote ²³

Among North’s notable supporters at the World Bank were Deepak Lal and Anthony A. Churchill. Lal, a British economist with known libertarian sympathies, then serving as one of the bank’s research administrators, circulated North’s essays about economic development to World Bank affiliates because he sympathized with North’s “longer term historical perspective” on the causes of Latin American underdevelopment (Lal to North, January 22, 1986, Box 3, Folder Correspondence by date: Feb. 1986). Lal had previously argued that development policies up to that point had been largely ineffective because they focused too much on macroeconomic aggregates and did not pay enough attention to market incentives. Churchill, the director of the bank’s Industry and Energy Department, praised North’s contribution to the World Development Report (North Reference North1989) as proof that economic history “provides many lessons for economic development today” (Churchill to North, January 11, 1990, Box 7, Folder February 1990).

North severely criticized the World Bank’s development programs in general and structural adjustment programs in particular for overlooking institutional factors.Footnote ²⁴ He had joined the bank to shift the focus of its development programs to improving institutions. Thus he began a war of words against those he called the “orthodox neoclassical economists”—a polemical phrase, referring roughly to all those economists, especially those at the World Bank, who neglected the findings of the new institutional economics (North Reference North, Harris, Hunter and Lewis1995, p. 22; see also North Reference North1990, pp. 133–134; North Reference North1992; North Reference North2005, pp. 64–65, 76–77, 124–125). North reproached these economists for misunderstanding the causes of underdevelopment and making poor recommendations for economic development. He charged that orthodox neoclassical economists were not successful in improving the efficiency of markets because they neglected to address the institutional framework underpinning markets—particularly politico-legal institutions and property rights—while implicitly assuming that the incentive structure arising from this framework is inherently efficient. Instead, they focused on the goal of allocative efficiency, that is, getting market prices “right” by privatizing as many sectors as possible, opening up the domestic economy to international trade, deregulating markets, and taking good care of externalities. North knew well what he was talking about here, since he too believed in the virtues of deregulation and privatization back in the 1960s. However, he was convinced that such policies were often mistaken, because markets cannot become efficient and grow unless they are supported by adaptively efficient institutions and social norms and shared beliefs (including ideologies) that legitimize these rules of the game. Therefore, improving market efficiency is much more difficult than deregulating markets: it requires far-reaching institutional reforms (North Reference North1989; North Reference North1992, p. 485; North Reference North, Harris, Hunter and Lewis1995; North Reference North1997; North Reference North, Dorn, Hanke and Walters1998, especially pp. 103–104; North Reference North2005, pp. 76, 84).Footnote ²⁵

North believed that one of the reasons why neoclassical economists in general do not really understand the role of institutions in economic growth, and property rights in particular, is that they often mistake the so-called Coase theorem (Coase Reference Coase1960) for a proof that markets tend to be efficient (North Reference North1989, p. 1319). On the contrary, he thought that the Coase theorem was an argument showing that markets tend to be inefficient due to transaction costs. Indeed, he explained the theorem in the following terms to political scientist Robert Bates, who was confused about its meaning:

Moreover, path dependence implies that to be successful, institutional reforms must be adapted to each country’s unique cultural and institutional heritage, but neoclassical economists often overlooked the distinctive features of Third World countries. One-size-fits-all reform plans that ignore this heritage lack the legitimacy to be enforced and may therefore lead to political backlash instead of economic development. North even suggested that improving economic performance in the short run might just be impossible in developing countries where deeply entrenched belief systems and norms hinder the establishment of more efficient institutions, and predatory elites—who share a vested interest in the political-economic status quo—possess sufficient bargaining power to maintain it (North Reference North1990, p. 110; North Reference North, Harris, Hunter and Lewis1995; North Reference North1997, especially pp. 13–15; North Reference North, Dorn, Hanke and Walters1998, pp. 96–97, 104–107). This is why he commented to Vinod Thomas, the chief of the trade policy division of the World Bank, that “‘efficient’ markets is one of the most complex things to create that I know” (North to Thomas, April 26, 1990, Box 8, Folder April 1990), a conviction that made him somewhat pessimistic about the developing world’s economic prospects (North Reference North, Kling and Schulz2011, pp. 163–164).

Through the efforts of North and his colleagues, the World Bank began to place greater emphasis on institutions in its research, a shift heralded by its 2002 World Development Report, which was devoted entirely to the issue of institutions in economic development (Ménard and Shirley Reference Ménard, Shirley, Galiani and Sened2014, p. 26). The idea that development policies had not worked as well as hoped in the Third World because they had not been accompanied by far-reaching institutional reforms was also gaining ground among policymakers. In 1986, North received an offer from the US Ambassador to the Asian Development Bank, Joe O’Neal Rogers, to become the chief economist at the Asian Development Bank (ADB). A Ronald Reagan appointee, Rogers was then looking for the right person to head the bank’s research branch, “generate and disseminate ideas on economic growth,” and manage the ADB’s “rather significant mid-life crisis,” as it was “altering its focus from public to private sector activities.” Rogers further explained to North that he was looking for someone to reorient the ADB’s focus from its current approach, based on econometric methods, to one based on the institutional analysis of incentives, because he and others at the bank found this second option more promising (Rogers to North, March 13, 1986, Box 3, Folder March 1986). North declined. He had little time to devote to Asia, being busy with his work at AID and his projects in Latin America.

Think-tanks like de Soto’s ILD likely played a role in disseminating North’s ideas about institutional reforms among high-ranking Latin American and US policymakers.Footnote ²⁷ As Philip Keefer reported:

Keefer’s opinion was based on his personal experience as a policy advisor. In 1989, the US Secretary of the Treasury, Nicholas Brady, asked de Soto and Keefer to present him with an agenda for institutional reform to accompany the restructuration of Latin American debt, for which Brady was preparing a blueprint, later to be known as the “Brady Plan.” Keefer’s recommendations to Brady were grounded in North’s theory: he argued that structural adjustment policies would yield bad results, unless they were accompanied by reforms that put in place the “correct” institutions. Furthermore, the next year, Keefer and de Soto were asked to prepare briefings on the benefits of institutional reforms for Alberto Fujimori, the recently elected president of Peru (de Soto to North, December 6, 1990, Box 8, Folder December 1990; North to whom it may concern, October 30, 1990, Box 8, Folder October 1990). A few years later, in 1995, Venezuelan President Rafael Caldera asked North directly to help him develop a new policy agenda. The country was in a deep economic recession, due in part to falling oil prices. North recommended to Caldera a set of far-reaching institutional reforms that were supposed to:

While North was working on economic development in Latin America, the fall of the Berlin Wall in November 1989 and the subsequent collapse of the communist regimes in Eastern Europe created an unprecedented demand for expertise on the issue of institutional transition. Like many of his fellow economic historians and economists, North began to study economic development in Eastern European countries and Russia.Footnote ²⁸ His diagnosis of the USSR’s collapse was straightforward: it was the perfect example of an “adaptively inefficient” institutional matrix, closed to institutional innovation and therefore incapable of adapting itself efficiently to the political demands created by changes of relative prices, technology, knowledge, and population. For Russia’s and Eastern Europe’s transition towards capitalism to be successful, it was necessary to improve the efficiency of their systems of property rights and make their political institutions less predatory, using incremental and piecemeal reforms (North Reference North2005, pp. 145–154).

North’s recommendations for Russia and Eastern Europe contrasted with the market-oriented policies advocated by economists working at think-tanks like the Cato Institute—the best-funded libertarian think-tank in the United States—with which North occasionally collaborated.Footnote ²⁹ These disagreements burst out into the open at a conference attended by North and organized by the Cato Institute in the vicinity of Moscow in 1990. Conference attendees included a dozen Soviet dignitaries, the Koch billionaire businessmen (who were the Cato Institute’s main funders), and a majority of American academics, including economist James Buchanan. Albin Salton, a managing director of Lehman Brothers, sent a conference memorandum to North to the effect that the “teachings of many of our speakers were radical and uninhibited free enterprise laissez-faire. Minimal government interference was recommended.” Salton was not a libertarian and thus commented to North: “This is dangerous and heady stuff, particularly if applied to the Soviet economy” (Salton to North, September 25, 1990, Box 8, Folder September 1990). North shared Salton’s concern that such market-oriented policies would fail because their success depended on prior institutional reforms that were incompatible with Russia’s tsarist cultural heritage. He interpreted the failure of so-called shock therapy in Russia as further evidence that “laissez-faire” without far-reaching political reform can lead to political-economic instability (see North Reference North1997, p. 3; North Reference North2005, especially pp. 21, 77, 122, and 168; North Reference North, Kling and Schulz2011). By contrast, he believed that the transition to capitalism was more successful in the Czech Republic, because its cultural heritage could support institutional reform. Unlike Russia, the Czech Republic had a thriving market economy and a democracy before 1948, when Austrian law was the law of the land. This period had left the Czechs with an enduring heritage of values, norms, and beliefs that made them much more open than the Russians to political-legal reforms congenial to market efficiency (Centennial Visit Lecture Chicago-Kent College of Law 1999, no page number, Box 47).