Economic Growth and Democratic Institutions

Professor William Easterly recently presented (link) an intriguing empirical evidence on the relationship between nation’s politics and economic growth. In particular, professor Easterly presented data on long-run economic growth and the scope of democracy for a majority of countries between 1960 and 2008. Professor Easterly identified that the highest-growing countries in the world were those with autocratic political regimes. Among ten highest-growing economies between 1960 and 2008, all of them, except for Cyprus, have been characterized by hybrid and autocratic political regimes. On the other hand, ten countries with the lowest growth rates of real GDP per capita between 1960 and 2008 were equally known for authocratic political systems or flawed democracies.

Presumably, the evidence bodes against the recent prediction by Dani Rodrik that authoritarian political regimes ultimately create economic systems vulnerable to external shocks and structural change, thus hampering the prospects of structural change as a neccessary condition for economic development.

To estimate the general pattern of the relationship between economic growth and the nature of political system, I reviewed real per capita GDP growth rates between 1970 and 2007 for a group of 134 countries across the broad spectrum of different levels of GDP per capita. Based on Summers-Heston dataset of real GDP per capita growth rates (link) between the stated time period, I estimated average rates of growth of GDP per capita and collected data from Economist Intelligence Unit on the level of democracy across the world in 2008 (link). The intuition behind this approach is the identification of endogenous and casual direction between the two variables. From the theoretical perspective, it is nonetheless difficult to establish a relationship between the form of government and long-run economic growth. There are at least two possible directions of casuality.

First, the underlying assumption of the relationship could be that systemic changes in political environment are essential to the structural change and, hence, are the main mechanism behind the enforcement of constitutional changes and public policies. The assertion of the underlying theory is that autocratic and authoritarian political system hinder structural changes and the establishment of institutions and democratic governance that is crucial for economic growth. This particular view has been asserted by Dani Rodrik (link), Andrei Shleifer, Florencio Lopez de Silanes and Rafael La Porta (link). While Dani Rodrik’s perspective heavily relied on the importance of institutions for long-run economic growth, Shleifer, Lopez de Silanes & La Porta captured the essence of economic development in the legal origins of nations.

Second, the causality in economic growth and political system could also stem in the opposite direction. The basic underlying assumption could be that higher rates of economic growth encourage systemic changes in the political system and enable the adoption of democratic institutions. The notion of economic growth as the engine of democratic changes has deserved a strong empirical support.

Robert Barro’s analysis of long-run economic growth across the world (link) has examined the relationship between the level of democracy and long-run economic growth rate. The empirical evidence suggests a non-linear, inverted-U relationship between democracy and 10-year growth residuals, both coefficients in partial quadratic equation and the partial correlation coefficient being statistically significantly different from zero.

The notion would suggest that as countries depart from a low level of real GDP per capita, the adoption of democratic institutions accelerates economic growth but only up to some point. After the tipping point, the economic outcome of further democratization results in lower growth of real GDP per capita, partly because a high level of democracy tends to promote public policies that diminish growth prospects such as higher tax rates on labor and capital and the redistribution of income, all of which exert a somewhat negative effect on productivity growth and incentives for labor supply and investment.

The first table portrays the distribution of real per capita GDP growth rates across 134 countries between 1970 and 2007. The distributive pattern resembles the properties of normal distribution curves. In fact, the estimated coefficients of skewness and kurtosis suggest a rather very mild departure from the assumption of normality which is of the high importance, especially in testing hypotheses about the effects of explanatory variables on long-run growth dynamics. The normality assumption of normally distributed errors was not tested via normality tests.

Ten highest growing countries in terms of real GDP per capita between 1970 and 2007 are Equatorial Guinea (8.39 percent), Taiwan (5.98 percent), China (5.97 percent), St. Kitts & Nevis (5.49 percent), Botswana (5.45 percent), Bhutan (5.38 percent), Maldives (5.38 percent), Hong Kong (5.37 percent), Macao (5.30 percent) and Singapore (5.29 percent). In real terms, the estimated average real per capita GDP growth rates suggest that it took only 13 years for Singapore’s real GDP per capita to double and 21 years to triple. In China, where the estimated average growth rate exceeded Singapore’s growth rate only by 0.69 percentage point, it took roughly 11 years for real GDP per capita to double and only 19 years to triple. In the lower tail of growth distribution are mostly countries from Sub-Saharan Africa such as Democratic Republic of Congo, Liberia, Somalia, Central African Republic and Niger. Average real growth rates of GDP per capita of these countries were negative. The negative average real GDP per capita growth rate occured in 11 percent of country observations.

Distribution of economic growth across 134 countries between 1970 and 2007

Source: own estimate based on Summers-Heston dataset

The following graph illustrates the relationship between long-run average growth rates and the level of democracy in 2008 for the entire sample of 134 countries. The attempt to analyze the effect of democracy level on long-run economic growth is based on the notion that democratic institutions elevate economic growth in the longer run. The estimated slope coefficient (0.2277) suggest that a one-point increase in democracy index increases the average long-run per capita GDP growth rate by 0.2277 percentage point controlling for other factors.

Although the cross-country variation in the level of democracy explains only about 9 percent of growth rate variance, and even though the direct effect of democracy on economic growth seems minor and almost non-existent, the estimated sample regression coefficient is statistically significant at 5 percent level. It suggests that the effect of democracy on growth is persistant and evident in the particular sample.

Democracy and average long-run growth rates in a sample of 134 countries
Source: own estimates
Hence, to account for different degree of variation in average real GDP per capita growth rates, I divided the sample into quartiles. The goal of the pursued empirical strategy is to see whether the difference in variance composition between countries with similar growth rates persists. I divided the total sample into four groups: high growth performers (average growth rate higher than 3 percent) moderate growth countries (average growth rate below 3 percent and above 2.05 percent) and low growth countries (average growth rate below 1.09 percent). The next graph shows the relationship between democracy and average real GDP per capita growth rate in high-growth countries between 1970 and 2007. The parameters suggests a different relationship. The estimated slope coefficient is negative (-0.1638), suggesting that a one point increase in democracy index decreases the average real GDP per capita growth rate by about 0.1638 percentage point.

The share of variance explained by the democracy variable increased by 22.5 percent. In the statistical sense, the effect of democracy on economic growth in high-growth countries has been more powerful compared to the total sample. The estimated slope coefficient is statistically significant at 5 percent level. I also estimated beta coefficient (-0.338) to account for the effects of standard deviation increase on the average growth rate in real GDP per capita. The estimated beta coefficient suggests that a one standard deviation increase in democracy level (2.4 points) would, on impact, decrease the average real GDP per capita growth rate by 0.338 standard deviation or 0.394 percentage point in real terms.

From a theoretical perspective, the enforcement of democratic policies in high-growth countries would have a minor negative effect on economic growth, holding all other factors constant. Surprisingly, authortarian regimes previal in 44 percent of countries in the high-growth sample. Thus, the hypothetically negative effect of democracy on economic growth is evident but it is far from significantly negative.

Democracy and average long-run growth rates in high-growth countries
Source: own estimates based on Summers-Heston and EIU datasets

The next graph portrays the relationship between democracy and average real GDP per capita growth rates in low-growth countries. Contrary to the sample estimate in high-growth country group, the effect of democracy on real GDP per capita growth rate is positive and persistent. The correlation coefficient is positive and moderate (0.458) and statistically significant at 1 percent level. The beta coefficient (0.458) from the regression specification suggests that a one standard deviation increase in democracy level (cca. 1.497 points) would raise the average real GDP per capita growth rate on impact by 0.458 standard deviation or 0.382 percentage point, ceteris paribus. In fact, the variability in level of democracy explains 21.1 percent of the variance of average per capita GDP real growth rates. The estimated slope coefficient is statistically significant at 2.1 percent level and 0.6 percent level, suggesting a very low probability of rejecting the null hypothesis and a strong influence of democratic institutions on economic growth in the long run.

Democracy and average long-run growth rates in low-growth countries
Source: own estimate based on Summers-Heston and EIU datasets

In the next subsample, I jointly added high-growth and low-growth countries in the single sample and changed the casual direction. The underlying assumption is that democracy level is endogenously determined by the long-run average real GDP per capita growth rate. In real terms, I assumed that the public choice of political institutions across the world depend on the real GDP growth rate. Hence, I estimated the relationship by including the squared term in the regression equation. The estimated slope coefficients suggest a typical inverted-U relationship between real GDP per capita growth rate and the level of democracy. The real GDP per capita growth rate alone explains 30.6 percent of the cross-country variaton in the level of democracy. Intuitively, the results suggest that there exists an optimum level of real GDP per capita growth that maximizes the level of institutional democracy.

Differentiating the conditional expectation function of the level of democracy with respect to the real GDP per capita growth rate yields the partial derivate dy/dx = -(ß2/2ß3). Plugging the two coefficients in the partial derivate yields 3.65. Thus, the growth rate of real GDP per capita that maximizes the level of institutional democracy is 3.65 percent. Hence, both coefficients are statistically significant. The p-values are 0.000 suggesting a zero probability of rejecting a null hypothesis when it is, in fact, true – and a strong predictive influence of both variables on the expected level of democracy.

The effect of long-run economic growth on democratic institutions in high-growth and low-growth countries
Source: own estimates based on Summers-Heston and EIU datasets
Countries with the comparable growth rate are Iceland, Ireland, Trinidad & Tobago and Spain. Except for Trinidad & Tobago, none of these countries is either flawed democracy or an authoritarin political regime. Therefore, the expected level of democracy is low in countries where the average growth rate of GDP per capita is either very low or negative or very high.

Hypothetically, the conditional pattern of real per capita GDP growth supports the notion that the highest-growing countries in the 20th century such as Singapore, Taiwan and Botswana had a relatively low level of democracy and a significant degree of political authoritarianism. In addition, countries with the lowest growth rate of real GDP per capita such as Liberia, Sierra Leone and Somalia were also authoritarian political regimes. The predictive power of the regression equation is reasonably high since more than 30 percent of the variance of the level of democracy is explained by a non-linear shifts in the long-run average real GDP per capita growth rate.

Democracy is a controversial question of the modern theory of economic growth. Indeed, the empirical evidence suggests that the highest growth rates were achieved in those countries with a considerable degree of political dictatorship. However, the lowest long-run growth rates of real GDP per capita were achieved by countries in which political dictatorship prevails. The pattern suggest that the quality of institutions such as the rule of law, judicial independence and a constitutional democracy complement the significance of human capital which is the essential engine of long-run economic growth.

The most important growth engine of the highest growing countries such as East Asian tigers and Ireland has been the emphasize on human capital that resulted in a high level of knowledge intensity and high productivity growth rate. These countries were known for heavy doses of state interventionism aimed towards the implementation of industrial policy conducive to economic growth. However, the conclusion should be taken with caution. Political dictatorship or authoritarianism were detrimental to least-developed countries since it encouraged predatory political behavior and resulted in the political environment with a complete absence of the rule of law, judicial independence, protection of private property rights, institutional integrity and constitutional democracy.

The question which set of growth policies is essential to high long-run growth of real GDP per capita involves two answers. First, the primacy of institutional quality alongside the investment in human capital is by far the most important engine of long-run economic growth. Without first-class institutions and human capital, the vicious circle of poverty and social deprivation for less developed nations can be endless. And second, the components of constitutional democracy such as electoral rights and pluralism, good functioning of government, high level of political culture and civil liberties can deliberately increase the prospects of economic growth.

However, if the power of state is left unrestrained by the absence of the rule of law and a coherent set of checks and balances on the coercive strenght of redistributive interest groups, even a high level of democracy would not alleviate the persistence of poverty and weak structural indicators. On the contrary, it would only worsen the prospects of long-run economic growth.

Obama: More Tax Cuts for Small Businesses

Late last month, President Barack Obama signed legislation that will cut taxes and provide credit help for small businesses. It is yet another step that the government is taking to continue programs that spur job growth in the U.S. economy.

The Small Business Jobs Act is now the fourth jobs measure that Congress has enacted this year — it is likely to be the last before the Nov. 2 midterm congressional elections.

The bill provides billions of dollars worth of tax cuts over the next 12 months, with the bulk coming through “bonus depreciation.” The measure allows companies to more quickly write off the cost of business-related purchases. The bill also revives stimulus provisions that cut fees and increase limits on loan guarantees offered by the government’s Small Business Administration.

Economic Events on October 4, 2010

At 10:00 AM EDT, the Factory Orders report for August will be released.  The consensus is for an decrease of 0.3% in orders, after a rise of 0.1% in July.

Also at 10:00 AM EDT,the value of the pending home sales index for August will be announced.

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