1. 7 th Lecture, STV4346B: “The economic effects of institutions” Carl Henrik Knutsen, Department of Political Science, UiO 24/11-2008

2. Some introductory notes  Last lecture, we looked at studies that claimed a positive effect on the economy from a complex (of little specified) institutional structures.  Today we are going to be more specific when it comes to the political/institutional (independent) variables.  What is the effect of democracy on economic growth and property rights?  What are the economic effects of particular electoral systems and forms of government, within the set of democracies?

3. Democracy and growth  Conceptual and measurement issues with regard to democracy, see lecture 5  Which aspects of democracy affect the economy, the benefits of an analytical approach: the quest for more concrete mechanisms  The same with regard to ecoonmic growth: Which immediate factors behind growth is affected? Technological change, A (incl efficiency in markets, organizational change that improves efficiency/reduces transaction costs), physical capital, K, Human capital, H, Labor input, L  Y= F(A, K, H, L), with all partial derivatives>0.

4. The Lee-thesis  Amartya Sen (1999:15):  “[A] great many people in different countries of the world are systematically denied political liberty and basic civil rights. It is sometimes claimed that the denial of these rights helps to stimulate economic growth and is “good” for economic development. Some have even championed harsher political systems – with denial of basic civil and political rights – for their alleged advantage in promoting economic development. This thesis (often called “the Lee thesis”, attributed in some form to the former prime minister of Singapore, Lee Kuan Yew) is sometimes backed by some fairly rudimentary empirical evidence”

5. Theoretical arguments  A vast catalogue of potential mechanisms. Knutsen (2006, MA-thesis in political science): at least 20!  These mechanisms point in different directions with regard to whether democracy affects growth positively or negatively, relative to dictatorship.  Interaction effects  Dictatorship as a very eclectic category. Can be classified along different dimensions. See for example Linz and Stepan’s book or Hadenius and Teorell (2007), or Knutsen (2007, MA-thesis in economics)

6. General theoretical arguments, an overview of the theoretical presentations in P&L (1993) and Knutsen (2008) ArgumentPrzeworski and Limongi's conclusionsMy (Knutsen’s) conclusions 1) Democracy and property rightsEither wayFor democracy 2) Democracy and investmentAgainst democracy Either way (for democracy when adding human capital) 3) Dictatorship and insulation against particularistic pressureAgainst democracyAgainst democracy, but with qualifications 4) Autonomous rulers are predatoryFor democracy 5) Democracy and technological change-For democracy

7. The arguments: read through the detailed arguments in P&L and K!  1) The poor median voter and redistribution of property in democracies (Marx, Mill etc). But, rulers with private gains or whose constituencies have private gains, of grabbing property (North)  2) Dictatorship increases investment. Reduces public and private consumption through different policies, since generally less responsive to citizens’ demand for consumption. But: democracy and human capital  3) Autonomous dictatorial regimes, and the ability to ignore special interests  hardhanded reforms and policies for economic growth  4) Dictators might be predatory  Disincentives for growth in these regimes. Concentration and abuse of power  5) Democracies and freedom of speech, media and movement  more innovation and better diffusion of foreign and domestic technologies in the economy

8. P&L (1993): the abstract

9. Methodology  Earlier studies using OLS and problems  Endogeneity and selection of regimes  selection models and sugestive simulations  We might find effects through OLS that are actually not there if there is systematic selection of regimes after how countries perform economically  Panel data vs cross section analysis  Meta-study of earlier studies: even split between those that find a positive and negative general effect on growth from democracy.  No actual effect?

10. The earlier studies investigated by P&L

11. Later studies and nuances  My results (Knutsen, 2008): longer time series, various econometric methods, different measures  There seems to be a positive general effect from democracy on growth. About 1% extra annual growth. This result stands in contrast with the ”no significant effect”-result in P&L 1993.  Barro’s study and the inverse U-curve: semi-democracies grow faster than both ”extremes”. But in Knutsen(2008), this result does not find support.  Rodrik: Democracies have higher wages, show less fluctuation in growth rates (within country), have less variation between countries  The last point is important: Dictatorships vary much more in their economic performances: both the best and the worst performances..  Type of dictatorship and growth?  Different effects from democracy in different regions of the world? Asia vs Africa.

12. Democracy and property rights  Due to the centrality of (stable) property rights for economic growth, it is particularly important to investigate the effect of democracy on property rights.  Boix empirical study: less expropriation in democracies  Olsons’s theoretical study: Only in particular instances do dictators have the incentive to protect property rights to the same degree that democratic governments do (representation of broad interests in democratic government). Dictators with long time horizons or with encompassing interest might have strong incentives to protect PR.  But, see James Robinson’s working paper from 2001: If dictators acknowledge that development might affect their political position, the positive effects from encompassing interest and patience on policy might disappear.

13. Olson (1993) Why is dictatorship better than anarchy and democracy better than dict. in terms of generating development Key assumptions – Externalities from roving bandits on other bandits and on society, everybody maximizing consumption  little production (kind of Pris. D. game) – Rational dictator: stationary bandit that monopolizes power. Maximizes utility, which is a function of consumption. Brings security – Taxes have negative effects on productivity, but revenue raised can be used on public goods with positive effects. – Dictator maximizes tax revenue –expenditure on public good: T(Y)-G, let T(Y) be tY, where t is the tax rate. – However; Y is also a function Y(t), where Y’(t)<0: Higher tax rate gives less incentive for people to produce – Interpret tax broadly: Any government activity that increases government’s revenue, while affects total production (negatively). More general protection of individual property rights than tax in the everyday use of the word: private entitlement to own production

14. Olson cont’d Hunting, gathering societies, small groups and ability to solve collective action problems (Olson, 1965) Agriculture and the problem of roving bandits. If no state/protection  incentives for people to become bandits and raid farms rather than produce. In such a world, low production, since no incentives to produce even for those who keep farming A roving bandit settles down, picks up a crown and calls himself King. The stationary bandit has emerged. Why does production increase under the stationary bandit? Shouldn’t he be “predatory”? Olson: the stationary bandit as a cattle rancher rather than a predator. Understands that production will increase if tax set at lower level than max and provide some public goods  more income to tax from!!

15. Olson cont’d Dictator does not care about subjects income but will provide just enough incentives to maximize his own revenue – Tax revenue set at point where direct positive effect from extra tax revenue gathered equals the negative indirect effect on tax revenue via reduced total production. Ex: If assume that revenue maximizing tax rate is 1/3  last tax dollar reduces national income by 3 dollars Dictators will thus tax at a too high rate relative to the social optimum. Which dictators will produce the lowest tax rates, (i.e. be closer to optimum)? – Dictators with some stake in the market (dictators with income from market activity not only from taxes/expropriation etc. The more encompassing the interests are, the more the dictator will internalize the negative externalities on production from taxation – Dictators with a long time horizon (political stability, patience, dynasties): Low taxes  More investment  Bigger cake in the future to tax from. When dictator has very short time horizon  acts like the roving bandit and grabs all he can..

16. Will democracy do better? Yes! Even if we assume that all actors are similar (no nicer guys under democracy), democracy will generally have higher production. Why? – Majority earns a large share of the market income, will thus take into account that taxes/ expropriation reduce their income from the market. Still tax higher than optimal rate, but lower than dictator, which again is lower than when you have scores of roving bandits (grab all you can!) – But, the negative effects of powerful special interests under democracy (Olson, 1982) Expropriation and negative effects on today’s production and investment, but also on incentives to innovate.. The importance of rule of law, independent judiciary and individual rights both for property rights and thus production, but also for stability of democracy Many ways to expropriate/violate property rights: – F.ex. governments with debt can run hyperinflation  government wins, but private capital eroded. When will we have transition to democracy? Balance of power (different groups) and the difficulty of being the only stationary bandit

17. Boix ch. 6 (important, but short presentation: a lot of the points have been covered in other texts) Dictatorship  violation of property rights, corruption and patronage  negative effects on development Empirical evidence for the first link provided. In addition to democratic institutions, newspaper circulation has a positive effect. Look at these results yourselves! The role of political accountability for disciplining democratic governments. Horizontal (group conflict) and vertical (politician-citizen) dimensions of politics. Accountability and the vertical dimension. – Politicians with better info – Citizens’ incomplete control mechanisms Can have some degree of accountability in dictatorships as well (revolution threat, coups etc), but generally weaker than in dem. Differences between dictatorships: those with legislatures do better: The negative effects of power concentration and personalization of power and politics. Absolutism’s negative effects

18. Boix cont’d Democracy as a political equilibrium: – Non-specific assets and equality  democracy  increased equality and further diversification of economy (through less corruption and expropriation)  stabilizes democracy .. – From economic structure to politics (Ch.1) and from politics to economic structure (Ch.6) Agrarian economies and specific assets  Incentives to grab and difficulty of democratization Industrialization  reduced asset specificity  democratization (link between Boix’ model and modernization theory, in addition to a possible effect from increased GDP/industrialization on economic inequality) Cycles of revolutions and left-wing authoritarian govt’s. When left-wing govt take power  gather resources for themselves  new economic elite  new revolutions Draws on North And Olson’s frameworks, but additional points – Threat of war and impetus for industrialization – The scattered map of Europe: Increased mobility of physical and human capital: I’ll just move to neighbouring country if King rules like a Tyrant  Incentives to not expropriate to heavily  equality (plus the capital mobility)  Democracy

19. Persson and Tabellini (2004)  For those interested, I can really recommend the 2003 book by the same authors  Among democracies, how do constitutions affect different economic aspects?  Electoral rules (Proportional representation vs plurality rule; but also other details of the electoral system)  Form of government (Parliamentary vs Presidential system)  JEP- article is a general overview of the field, results from 2003 book a natural focus  Theoretical arguments and empirical results

20. Persson and Tabellini Some theoretical points, electoral rules – Plurality rule and political accountability. Voters know who to punish and reward  Improve economic performance, particularly through reduced rents and corruption. – But, plurality rule and small district magnitude: incentive to spend on programs in “swing states” (size of district crucial for how narrow program is), and to spend on narrow groups that are pivotal. PR and broader, more universal programs (“representation issues”) – Open lists  no barriers to entry and electoral accountability  less corruption (can throw out the corrupt). Intraparty competition and patronage..Better to open up the competition to the electorate and have competition between parties – PR  coallition governments  increased spending and maybe increased deficits (narrow, small parties’ demands and collective action problems)

21. P&T cont’d Some theoretical points; forms of government – More accountability under Presidentialism? Simpler chain of delegation and checks and balances  less corruption – But, fixed term for Presidents  Do not have the disciplining device of a no-confidence vote  do not need a stable majority  specific interests benefit – Gridlock between presidents and constituencies  less spending and less ability to implement reform and react to crisis (but increased time horizon under Presidentialism) – Winner-take-all nature of presidential election and possibility of strong political conflict

22. Methodological issues, P&T Selection of electoral rules and form of government: Specific countries tend to have specific political structures. The danger of omitted variable bias Possible to use intra-national variation is small due to inertia in the political structures Solutions: – IV-approach, find exogenous variation in electoral rules and forms of government due to “international fashions” changing over time – Uses matching-approach to allow for non-linear effects. Find most similar countries with differences on the constitutional variables

23. Empirical findings summarized in P&T Plurality rule, and voting on individuals rather than party lists reduce corruption Less corruption in districts with tough party competition (evidence from Italy) Less corruption in districts with small magnitude (less barriers to entry) Under Plurality rule, politicians cut taxes and spending in election year, but not to same degree under PR PR  larger public spending (5-10% than plurality) Much of the effect due to higher frequency of coallition governments under PR PR  1-2% larger budget deficit/GDP

24. Empirical findings summarized in P&T Presidentialism only reduces corruption in “good democracies” (High Polity, low FHI-score). A higher share of presidential countries are “bad democracies” (mere correlation or effect from presidentialism? Winner take all nature of presidential elections and incentives to violate democratic rules of the game).  overall more corruption in presidential countries Presidentialism reduces public spending (5% of GDP) Pro-cyclical fiscal policy under presidentialism. Spend more in good times, contrary to Keynes’ recommendation Positive effect on growth and “good” economic policies from parliamentarism compared to presidentialism (but again, low quality of democracy in presidential countries..is the effect on growth a causal effect?) In large sample with authoritarian regimes included: a positive effect on growth from parliamentary democracy