Wednesday, 28 May 2014

Democracy and the causal growth link

Is democracy good for growth? The ultimate question of political economy of growth to which we'll hardly get a clear answer. A lot of academics would emphasize that empirically higher level of political rights need not necessarily translate into economic growth. Furthermore, many academics would agree that even if we accept the argument that democracy works for rich countries, it doesn't work in poor (low-income) ones. This goes back to the argument that some countries just aren't culturally or even geographically fit for a capitalist democratic system. They need to have a dictatorship to produce growth. 

Most of these arguments are false.

Democracy perhaps doesn't cause growth, but it is the key necessary precondition for growth and development. Many will point to China and say this isn't true - China seems to be a prime example of a non-democratic system (state capitalism) achieving exuberant growth rates in the past few decades. I've written so much on China's economic potentials (here, here or here) and the real problem with China is the lack of inovativeness, or more precisely the lack of trial-and-error that characterizes most capitalist democracies. Democracy implies innovation. It strives on trial and error. Both of these categories are the essential ingredients for the driving force of capitalism - creative destruction. Without it technological progress wouldn't be possible. And if anything is important for long-run economic development of a society, than it's technological progress (after all, remember which countries are technological innovators, and which are the followers).

Furthermore, democracies can be much more efficient in providing public goods and educating their population. And even though it's not immediately obvious, democracies are arguably more successful in implementing institutional reforms necessary for systemic adaptation to change. Even though such reforms are usually faced with a number of interest groups preventing change (examples range from fights for worker rights in the 19th and 20th century to modern-day unions preventing the necessary restructuring of industries, or politicians preventing reforms aimed at disturbing their winning coalitions), making the process extremely hard and long, democracies do in the end succeed. And it all works to the benefits of the economy and long run growth.

With respect to this debate there is new evidence proving the aforementioned arguments wrong. Acemoglu, Naidu, Restrepo and Robinson find that democracy does indeed cause (lead to/result in) higher economic growth. The argument is summed up in the following figure:
Source: Why Nations Fail blog
"This figure shows the evolution of GDP per capita following a democratization event compared to nondemocracies (all democratizations are lined up to date 0 so as to visually trace out average growth following democratization relative to the control countries in which there is no democratization). The first thing that jumps out from the figure is that a typical democratization takes place when a country is undergoing an economic crisis ... Our baseline estimates suggest that a country that democratizes increases its GDP per capita by about 20% in the next 20-30 years. Not a trivial effect at all."
However note also that the first five to ten years are crucial in a painful consolidation process. The first five years are extremely fragile and on average the population cannot see any of the immediate benefits of a democracy. This is because it takes time for the proper institutional consolidation to yield its effects. As I've mentioned earlier, people get preoccupied with elections before they set up the proper legal and constitutional framework. This often results in negative selection at the very top of society, which can easily lock the country up in cronyism and state capture. The lesson is that after the democratic consolidation process stabilizes, which takes time and patience, it will lead to higher growth. Perhaps not directly, but it will indirectly accumulate all of the necessary preconditions, such as the rule of law and a proper legal system, which will first and foremost lead to a higher accumulation of capital, improved labor productivity and send a signal of positive investor confidence. Economic growth is a necessary consequence. 

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