David
 James
 Brunner

When I visit Tokyo, I teach an ad hoc, voluntary seminar to Japanese university students.  Each time, we meet for three hours and discuss an assigned text.  The students read the text in Japanese, I read it in English, and we discuss in Japanese.  Last year, we met three times and worked our way through John Kenneth Galbraith’s Affluent Society.  This year, we have been reading Douglass North’s excellent book Institutions, Institutional Change and Economic Performance.  We had our second meeting of the year this afternoon.

During our discussion today, I was particularly struck by North’s conclusions regarding third-party enforcement of contracts and property rights.  He posits capacity for effective third-party enforcement to be a necessary condition for a sophisticated market economy.  This turns out to be problematic:

Third-party enforcement means the development of the state as a coercive force able to monitor property rights and enforce contracts effectively, but no one at this stage in our knowledge knows how to create such an entity.  Indeed, with a strictly wealth-maximizing behavioral assumption it is hard even to create such a model abstractly.  Put simply, if the state has coercive force, then those who run the state will use that force in their own interest at the expense of the rest of the society.  (North, 1990: 59)

North identifies an important limitation of neoclassical economic theory.  In a sophisticated market economy, competition by self-interested agents yields efficient outcomes only given effective third-party enforcement.  Conveniently, the theory assumes both self-interested agents and effective third-party enforcement.  However, North argues that self interest undermines effective third-party enforcement.  If so, then the assumptions of neoclassical theory are mutually contradictory.

To explain the economies of the advanced nations, North suggests that the theory must take into account non-wealth-maximizing human motivations including values and ideologies.  Such internal restraints on self interest appear to be an essential ingredient in the even-handed third-party enforcement that makes possible sophisticated market economies.  With respect to the successful development of third-party enforcement in England during the seventeenth century, North says:

although that story describes a successful outcome, it does not give a definitive answer to the question of how it was achieved.  It was surely a mixture of formal and informal constraints.  Both respect of the law and the honesty and integrity of judges are an important part of this success story.  They are self-enforcing standards of conduct, and I believe that they are important. (North, 1990: 60)

Though the importance of non-wealth-maximizing motivations may seem obvious, they are ignored by most of mainstream economics.  (Sometimes the utility function is said to incorporate non-wealth-maximizing motivations, but this is disingenuous: they are implicitly excluded by the structure of most mainstream models.)

These passages are deeply disconcerting, because they indicate how poorly we understand the foundations of our prosperity.   Moreover, by teaching models that legitimate the pursuit of self interest without regard for social consequences, mainstream neoclassical economics may be weakening those foundations.