Sunday, May 3, 2009

Votes and Markets: the relation between democracy and development

Publicado por Gusilcan
One of the most hot current debates in political science and economics is about the effect that democracy has on economic development. For decades, many Western scholars boasted that the constraints on executive power and the power dynamics that are associated with democracy increase predictability and lower transaction costs, thus fostering economic growth through time. When kings and dictators are replaced, or at least constrained, by parliaments that are elected fairly and freely, fiscal policy becomes less extractive, expropriation is reduced and public goods (education, health care, roads, etc.) are better allocated and managed. Economists such as Douglas North and Mancur Oslon are proponents of this causal link between democratic institutions and prosperity. The West could feel complacent that it had embraced a form of government that was good both politically and economically.

But then, the Asian tigers and China woke up, showing that democracy was not necessary at all to achieve fast economic growth. Democracy as we know it does not exist in Hong Kong nor Singapore, but their income per capita is well above US$30,000 a year. After decades of starvation and stagnation, China's economy has come today to surpass in size all of Europe's economies, according to some estimates.
Yet, the Communist Party's grip on power remains as tight as usual, with its parliament being nothing more than a rubber stamp organization to the whims of the Party's leaders. These Asian countries bypassed democracy in their roads toward economic progress, and there is no sign that they will embrace democratic institutions anytime soon.

I decided, then, to look for data on democratic institutions. The Economist Intelligence Unit produces every year a Democratic Index, in which they examine the political institutions of 162 countries from 0 (least democratic) to 10 (most democratic). The index assesses the quality of the electoral process, the functioning of government, political participation, political culture, and civil liberties. At first sight, the Democratic Index of the EIU looked like bad news for the proponents of democracy as a promoter of economic prosperity: If democracy were the defining factor for development, Uruguay would be richer than France and Costa Rica and Mauritius would be richer than Italy. However, I decided to go further and see whether there was a positive linear association between the democratic character of political institutions and GDP per capita across countries.

The following graphs show what I found:

The positive correlation between more democratic institutions and economic development is evident. In this graph I am not showing oil producing countries (Saudi Arabia, Oman, Algeria, Bahrain, Qatar, Kuwait, Iraq, Iran, etc.) which tend to have low levels of democracy and high levels of GDP per capita. A simple linear regression using Ordinary Least Square estimators tells us that an increase of 1 in the Democratic index of one country (roughly the difference between Latvia and the USA) is expected to increase GDP per capita by 51%. The coefficient is statistically significant at the 99% confidence level.

This positive relation between democracy and development also holds for OECD countries (relatively rich, democratic nations), as the following graph shows.

This means that even for richer, democratic nations, more democracy is also correlated with higher levels of income. Using simple linear regression we estimate that an increase of 1 in the Democratic index of one OECD country (roughly the difference between Italy and Germany) is expected to increase GDP per capita by 54%! This coefficient is also statistically significant at the 99% confidence level.

For Latin American nations, the correlation also holds. There are higher levels of per capita income in countries with better democracies.

Using simple linear regression we estimate that an increase of 1 in the Democratic index of one Latin American country (roughly the difference between Ecuador and Argentina) is expected to increase GDP per capita by 55%. This coefficient is also statistically significant at the 99% confidence level.

This positive relation between the index of democracy and income, however, is much weaker for desperately poor countries. When I graphed the scatter plot using the data points for the 54 countries in my data set with income below US$1500 per year, the slope of the fitted line is much less steep.

Using SLR we estimate that an increase of 1 in the Democratic index of one low income country (roughly the difference between Afghanistan and The Gambia) is expected to increase GDP per capita by a mere 4.4%. This coefficient is not statistically significant, however, and so, it signals that for very poor countries, there is no real association between democracy and income per capita.

What does all this mean? First, that it may well be that economists North and Olson were right: democracy is associated with higher levels of development across countries, although this association is considerably weaker for countries with low levels of income. There comes the problem, then, of convincing poor countries to democratize, when economically it makes little difference. Perhaps this means that what low income countries need first, before democratization, is some economic freedom and investment, accompanied by a strong commitment from the government to protect property rights and capital. After all, that was the road followed by Singapore and Hong Kong, which were very poor in 1950. China also went down that path, obtaining the results we all know about.

Although I think that seeing these associations is very interesting, we must be careful in confusing causation with correlation. Democracy does not cause economic development, and this is not what has been shown here. Rather, the data shows that more democratic countries tend to be richer, or in other words, that democracy and development usually go hand in hand. Even Hong Kong and Singapore get better Democratic Index ratings than many poorer countries (surprisingly, Ecuador and Turkey!). The causality may well go the other way around: it could be development what fosters democracy, or the two factors could be mutually enforcing. Given that democracy is an expensive thing (parliaments, courts, elections, safety nets, etc. cost a lot of money), one may argue that richer countries tend to have better democracies because they can afford to do so.

In any case, we should never forget that democracy is a good in itself, and that related or not to economic development, people should have the right to have a say in how their government manages the affairs of their nation.

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