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January 23, 2006

What effect does the institution of democracy have upon the economic growth and development of a nation?

If you look around the world today, you can find that the wealthiest countries are typically democratic, while the most non-democratic nations of the world rank among the world's poorest. But why is that? Does the presence of democratic government promote the growth of a nation's income? And what difference does democracy make in the economic growth of a nation?

Many of these questions were recently addressed in a working paper by Daron Acemoglu (MIT), Simon Johnson (MIT), James A. Robinson (Harvard) and Pierre Yared (MIT): "Income and Democracy?" (summary available via Smart Economist - free, registration required.) In the paper, the authors examine a variety of economic (GDP per capita, trade, savings, etc.), demographic (population, education, etc.), political (various democracy measures) and historic (date of independence, data for 143 countries over 500 years of their history, and a smaller set of 28 countries over 160 years of their history, seeking to correlate their economic growth and development with the development of democratic institutions. Their key findings:

  1. A nation's economic growth has little to no effect in promoting the development of democratic institutions within the nation.
  2. The development of democracy and a nation's economic growth are positively correlated over the longer term (500 years), but not over the shorter periods of time (160 years.) In other words, the presence of democratic institutions promotes greater economic growth over the long term.

One example of the first finding may be found in the example of the nation of Saudi Arabia. Here, while having become one of the wealthiest nations in the world as a result of the value of its major natural resource (oil), Saudi Arabia has not developed any significant democratic institutions as a result of its increasing income, at least, over the comparatively short term.

Over the Long Term

To understand how the development of democratic institutions can affect a nation's economic growth and development over time, let's look at the example of the development of banks in the United States and Mexico from the nineteenth century onward. The following is excerpted from the World Bank's Development Report on Equity Development (links and emphasis added):

Banking in the nineteenth century, Mexico and the United States

Much recent work on growth and development has focused on financial and capital markets. A central issue is to understand why financial systems differ. For example, studies of the development of banking in the United States in the nineteenth century demonstrate a rapid expansion of financial intermediation, which most scholars see as a crucial facilitator of the economy’s rapid growth and industrialization. Haber (2001) investigated the development of banks in the nineteenth century in Mexico and the United States. He shows that “Mexico had a series of segmented monopolies that were awarded to a group of insiders” (24). In 1910 “the United States had roughly 25,000 banks and a highly competitive market structure; Mexico had 42 banks, two of which controlled 60 percent of total banking assets, and virtually none of which actually competed with another bank.”

Why this huge difference? The relevant technology was certainly widely available, and it is difficult to see why the various types of moral hazard or adverse selection connected with financial intermediation should have limited the expansion of banks in Mexico but not the United States. Indeed, Haber shows when the U.S. Constitution was put into effect in 1789, the structure of U.S. banking looked remarkably like that arising later in Mexico. State governments, stripped of revenues by the Constitution, started banks as a way to generate tax revenues and restricted entry to generate rents. Yet this system did not last because states began competing among themselves for investment and migrants. As Haber (2001) puts it,

The pressure to hold population and business in the state was reinforced by a second, related, factor: the broadening of the suffrage. By the 1840s, most states had dropped all property and literacy requirements, and by 1850 virtually all states ... had done so. The broadening of the suffrage, however, served to undermine the political coalitions that supported restrictions on the number of bank charters. That is, it created a second source of political competition — competition within states over who would hold office and the policies they would enact (10).

The situation was very different in Mexico. After 50 years of endemic political instability, the country became unified under the highly centralized 40-year dictatorship of Porfirio Díaz until the revolution in 1910.

In Haber’s argument, political institutions in the United States allocated political power to people who wanted access to credit and loans. As a result, they forced state governments to allow free competitive entry into banking. In Mexico, political institutions were very different. There were no competing federal states, and suffrage was highly restrictive. As a result, the central government granted monopoly rights to banks, which restricted credit to maximize profits. The granting of monopolies turned out to be a rational way for the government to raise revenue and redistribute rents to political supporters (North 1981).

Haber (2001) documents that market regulation was not aimed at solving market failures, and it is precisely during this period that the huge economic gap between the United States and Mexico opened (on which see Coatsworth 1993, Engerman and Sokoloff 1997).

And so, the early expansion of effective democratic institutions led to the divergence in economic growth between Mexico and the United States. Likewise, the democratic nations of the world have outpaced all others in their economic growth. As the research findings contained in "Income and Democracy?" suggests, it's not an accident.

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