Enterprise Issues: Theorists should admit they make mistakes

Look at the damage inflicted by excess of certainty - it must be obvious to even the most hardened ideologue that free markets alone are not enough

IT IS a sign of either greater wisdom or the woolliness of thought that comes with age and motherhood, but it seems to me that the most frightening people are those who are sure they are right. Far less damage is caused by the tentative folks who are prepared to admit they might be mistaken, and that goes for economic policy as much as anything else.

There has been a series of spectacular demonstrations in recent years of the damage inflicted by excess certainty on the world economy. Most of them have involved developing countries which have fallen victim to one theory or another about how economies progress. The transition economies of Eastern Europe and Russia were hammered by the extreme free market ideology of the Thatcher and Reagan era, and the notion that markets were the one and only key to development also carried over to East Asia.

It must be pretty obvious to even the most hardened ideologue by now that markets are not enough. Russia is in turmoil. In Asia, some countries, such as South Korea, seem on the way to recovery, but others, like Indonesia, are suffering terrible dislocation and hardship. There are few parts of the world outside the club of advanced post-industrial economies not experiencing turbulence from the wash of the global financial crisis.

In circumstances like these, economic historians come into their own. A new pamphlet by one eminent historian, Douglass North, published by the Institute of Economic Affairs (the IEA was one of the pioneers of that damaging free-market extremism), makes an eloquent case for being modest about what we can achieve in terms of economic development. Professor North writes: "Economic history is an endless depressing tale of miscalculation leading to famine, starvation, deceit and warfare, death, economic stagnation and decline, and indeed the disappearance of whole civilisations." The spectacular growth of the Western world in the past four or five centuries is, he argues, an aberration.

He suggests there are three ways we normally get things wrong. One is never being able to know enough about reality because the world is so large and complex. A second is being misled by a particular belief system or ideology, which means we will twist evidence to what we think ought to be true. The third, and most interesting in the context of the recent upheaval in emerging and transition economies, is having scant understanding of the role played by institutional structures and politics in economic growth.

Clearly, one of the explanations for the differing abilities of countries to cope with the financial crisis has been their differing institutional frameworks. It has become part of the new conventional wisdom to say that strong banking systems, an incorrupt civil service, the application of the rule of law, and so on, are preconditions for economic development. This has also been emphasised in the work of many outstanding academic economists over the years, including Amartya Sen, last year's winner of the Nobel Prize in economics. But it is true to say it has been overlooked by many professional economists in the recent past and is only now starting to permeate everyday economics.

Professor North spells out here what ought to have been blindingly obvious all along - and was to many non-professionals. "Any market that is going to work well is structured; it is structured by deliberate efforts to make the players compete by price and quality rather than compete by killing each other."

The job of government is to structure the game in such a way as to minimise violence and poverty and maximise economic gains. This will require radically different structures at different times, because circumstances change - technology moves on, for example, turning what was once a natural monopoly into a potentially competitive market.

The conventional elements of the recipe for growth are more people, more physical capital - and a better quality of both - and technical progress. The missing ingredient is the right institutional structure. Some of the gaps in our understanding are starting to be filled by research on globalisation. For the first time there is a lot of comparative work covering the whole planet, not just the advanced or just the developing economies. A book published this week, Global Transformations by David Held and others, is an impressive and comprehensive synthesis of recent political and economic changes. We need a lot more of this sort of insight.

It is not just a matter of preventing Western academics wreaking unintended havoc on developing countries, although there is clearly a need for intellectual modesty here. Insight into institutions and politics also matters for our understanding of our own economies and how their performance might be improved. In a recent speech Lawrence Summers, the US Deputy Treasury Secretary, noted that no two countries with a McDonald's had gone to war with each other. It's a funny line, but makes a serious point.

To get even more parochial, there is an institutional and political chasm between Anglo-Saxon and Continental labour markets. The US has low unemployment, Europe high levels. Wage structures and benefit systems differ widely. Is one model better than the other? Similarly, the US has a vastly greater rate of new business start-ups and dominates the high-technology industries. This is an aspect of the American economy that Gordon Brown would like to import to the UK. The Budget contained a few modest tax incentives, but we actually know very little about what it is in America that fosters entrepreneurship and an aptitude for computers.

The best of Britain's economics profession, gathering in Nottingham this week for the annual conference of the Royal Economic Society, appears to have been smitten with uncertainty compared with years past. The research being presented is heavily weighted towards the empirical and the institutional. Perhaps we will start getting some answers now that the fact there is a question has been acknowledged.

d.coyle@independent.co.uk

`Understanding the Process of Economic Change', by Douglass North (IEA 0171-799 3745)

`Global Transformations', by David Held, Anthony McGrew, David Goldblatt and Jonathan Perraton (Polity Press)