Democracy Makes Economic Sense

In today’s world, most rich countries are democratic and most dictatorships are poor. In the developed countries, democracy goes hand-in-hand with political institutions that promote economic freedom – an environment characterised by the protection of private property and the ability of individuals to engage in voluntary exchange of goods and services.

Economic growth is primarily a consequence of the accumulation of both physical and human capital. The accumulation of capital is sensitive to the choice of public policies, which, in turn, depend on the political institutions in place.

In a classic study, economist Robert Barro explained that democratic institutions provide checks on government power that impose limits on politicians’ ability to amass wealth and enact unpopular policies. These constraints, he noted, help improve economic freedom.

However, authoritarian governments may also improve economic freedom as a matter of policy without the need for institutional constraints; an example is the rule of Augusto Pinochet (Gen.) in Chile.

Barro’s study of about 100 countries over the period 1960 to 1990, found that, at low levels of political freedom, an increase in political rights might enhance economic growth by imposing limits on the government. But he noted that in countries that have already achieved medium levels of democracy, further increases in political rights might impede growth because of growing concerns about income redistribution.

After controlling for the presence of free markets, maintenance of the rule of law, education and initial level of income per capita, he concluded that the overall effect of democracy on growth is slightly negative. Although Barro’s study was not the first, his findings spurred a debate among economists that has continued in more recent studies.

One view establishes that the adoption of democracy or, more generally, of political institutions that impose checks and balances on the government promotes investment in physical and human capital, and, therefore, growth. In contrast, a second view establishes that reaching a certain level of economic development is what allows countries to adopt better institutions.

I espouse the view that political institutions promote economic performance. Growth and development cannot take place in an institutional vacuum.

Economic maturity and the growth of markets require an institutional framework that allows transactions to take place in an orderly manner and in which agents know that the decisions they take and the contracts they make will be protected by law, and enforced. Depositors, investors, consumers, entrepreneurs, workers and risk-takers of all kinds need a framework of rules, if rational and optimising decisions are to be made. They also need some guarantee of economic stability and certainty, which can be provided only by good governance and sound economic policy-making. The alternative to a lack of property rights, law and order, and political stability is economic anarchy and failed states.

Douglass North, in his famous book, Institutions, Institutional Change and Economic Performance, says: “I wish to assert a fundamental role for institutions in societies: they are the underlying determinants of the long-run performance of economies – Third World countries are poor because the institutional constraints defy a set of pay-offs to political/economic activity that do not encourage productive activity.”

North also argues that “the inability of societies to develop effective low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the Third World, because the absence of secure property and contractual rights discourages investment and specialisation.” Mancur Olson makes the same point in his classic book, The Rise and Decline of Nations.

The reason why institutional structures and rules of behavior are a necessary condition for economic activity to flourish is that incentives and price signals, so vital to a market economy, cannot function properly without them. Markets require institutions because they are not self-creating, self-regulating, self-stabilising or self-legitimising. Which institutions are important and which are not will differ across space and time according to the history of a country, its geography, stage of development and its political aspirations, that is, what sort of society its people want.

In small rural communities where everyone knows each other, the scope for cheating, fraud and not honoring contracts is limited. Transaction costs associated with the costs of information, negotiation, monitoring, coordination and enforcement of contracts are low, and communities survive by adhering to norms of behavior; but economic development is limited through a lack of specialization. In contrast, in large, modern, industrial societies, where transactions are impersonal, there is widespread scope for opportunistic behavior.

Transactions (and therefore production) costs may be very high without institutional structures that curtail such behavior, such as the enforcement of property rights and the rule of law, the provision of limited liability, the guarantee of contracts and patent protection. With low transaction costs, firms and markets can concentrate on the job of investment in the knowledge that property rights are secure.

There is no one set of institutions that will suit all countries, but there is a consensus among development economists that at least five main types of market-supporting institutions are necessary, if not sufficient, conditions for rapid economic progress; market-creating institutions for property right and legally binding contract; regulatory institutions for market regulating; market-stabilizing institutions; market-legitimizing institutions for social insurance; and market-legitimizing institutions for conflict management.

The challenge for any government, whatever its structure, is to provide leadership in resolving collective action problems, which means a commitment to formulating and implementing development policies in the interests of all the people, and to prevent groups going their own separate ways. Democracy can make this more difficult because politicians can succumb to vested interest groups and take short-term decisions.

On the other hand, dictatorships may have no interest in maximizing total output, and may allocate resources very inefficiently. Democracy makes life difficult for corrupt elites.

In my view, at least in dealing with the nexus between democracy and growth, it is important to distinguish between democracy defined as free and multi-party elections, on the one hand, and civil and economic liberties, on the other. Some non-democratic regimes in the first sense (such as China) give their citizens a lot of economic rights, and vice versa.

But political instability is not the same as the nature of the political system. Here, I shall highlight two major studies on the role of democracy by Dani Rodrik and Barro.

Rodrik examined data for 90 countries over the period between 1970 and 1989, using the Freedom House Index of Political Rights & Civil Liberties as a measure of democracy which ranks countries on a scale of zero to one. He draws four important conclusions: democracies deliver more predictable long-run growth rate; produce greater short-term stability; handle adverse shocks much better; and promote a fairer distribution of income.

Democracies produce better outcomes in these ways because they produce superior institutions better suited to local conditions. There is little evidence that the average growth rate is higher in democracies than in more autocratic regimes, but the variance around the average is significantly lower in democracies.

One reason for this is because adjustment to shocks requires managing social conflict, and democratic institutions are more efficient institutions for conflict management. Democracies deliver better institutional outcomes because they tend to create more equal opportunities for people, especially in the fields of health, education and employment opportunity, which manifests itself in a higher share of wages in national income.

In general, therefore, democracy helps to build better institutions based on local knowledge: ‘participatory and decentralised’ political systems are the most effective ones we have for processing and aggregating local knowledge.


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