Is Democracy Bad For Growth?

The time was July, 1959, and the place was the American exhibit in Moscow. Against a background of kitchen cabinets, U.S. Vice-President Richard Nixon and Soviet First Secretary Nikita Khrushchev sparred. Nixon extolled the prosperity that capitalism had brought to Americans and the freedom of choice and liberties that democracy gave them. Khrushchev retorted that socialist workers were happy and had everything they needed. Besides, he thundered, in seven years we shall surpass you.

Khrushchev was wrong. But was Nixon right? Does the American way of life ensure growth and prosperity? Is democracy the best way to achieve economic growth? In the former Soviet Union and Eastern Europe, in Latin America and Africa, even in Asia, where a few countries have yet to board the growth express, this has become one of the biggest issues of our time: What is the best political system for achieving economic growth and lasting prosperity?

The answers aren't obvious. Americans have always believed that democracy is good for growth. Two centuries of steady development fed that belief, and only the Great Depression shook the faith for a time. Since World War II, though, democracy and prosperity have seemed of a piece. Only democracy offers freedom of choice, everywhere from the polling place to the supermarket.

But that freedom of choice is hardly a prerequisite for economic growth. On the contrary, it often seems to hinder it. India has languished under democratic leadership, while Chile and South Korea, both dictatorships until recently, are success stories. Today, capitalism thrives without democracy, as the rapid growth charted by China's communist leaders amply demonstrates.

Nor does democracy ensure growth for the world's leading industrialized nations. Many are mired in recession or sluggish recovery, and democratic governments from Italy to Japan have been damaged by scandal and aren't delivering growth. Just a few years after the fall of the Berlin Wall and communism's failure in Eastern Europe, democracy's weaknesses seem glaring.

Just what is the relationship between democracy and growth? John F. Helliwell, an economist at the University of British Columbia, compared economic results for nearly 100 nations from 1960 to 1985 and concluded that there was a slight downdraft for democracies compared with nondemocracies or authoritarian regimes. His findings confirm the view that over the near term, authoritarian governments, especially those that offer citizens "economic rights" such as the protection of private property, can achieve strong results.

But while the evidence shows that democracy does not lead to growth, it makes a powerful case that growth leads to democracy. This was something that Britain's worldly philosophers of the 18th century knew in their bones. Now, as this century comes to a close, it is a pattern being played out around the world. Growth leads to democracy for two reasons. First, as a small slice of the population is enriched, the rest of the citizens agitate for their fair shot at doing better, and such privilege is granted only in democracies. Then, too, rising incomes at first go toward needed goods and investment, then later toward more and more of what economists call "luxury goods," such as higher education. A more educated population tends to demand political and civil rights, and so democratization begins.

Perhaps the best example of this progression is South Korea, where a strong autocratic regime set growth targets and goals for industry over the past 30 years or so through an Economic Planning Board. By the mid-1980s, Korea had a strong industrial base, but there were draconian antilabor laws on the books, and labor activists were persecuted. The June, 1987, uprising brought calls for democracy, and President Roh Tae Woo, who took over in 1988, started the process by guaranteeing basic labor rights and adopting sweeping reforms. Now President Kim Young Sam--freely elected in 1992--is moving quickly to weed out corruption.

Authoritarian governments have accomplished economic growth through rigid controls from the center, as South Korea, Singapore, and numerous other regimes have done. But larger nations such as China have decentralized the process, and rapid gains have been achieved. The example of other economically successful dictatorships strongly suggests that the push for more freedoms will intensify in China. For Russia, though, the prospects seem dimmer: Democratization has begun, but output is shrinking, ensuring that many parties will battle for fewer spoils. Only decentralization, akin to the federalism that boosted America's early growth, is likely to bring about both a growing economy and wider freedoms.

All governments inevitably play a role in ordering people's lives, but how they do so is critical in determining not only how free people will be but also how prosperous. For most economists, less government rather than more is preferable on the grounds that it leaves individualism unhindered and promotes economic efficiency. Few, however, take as extreme a view as Nobel laureate Milton Friedman, who has been a leading apostle of the minimalist view of government.

In real life, such minimalism doesn't exist, because as democracies have evolved, their role in determining economic outcomes has deepened. For the 24 members of the Organization for Economic Cooperation & Development, for instance, gross public debt amounted to 63% of gross domestic product in 1992--up from 54% in 1984. For the U.S., the share was also 63%--up from 45% in 1984. Total local, regional, and federal government outlays for all OECD nations shrank slightly to 40% in 1989, the latest year for which complete data is available, from a peak of 41.5% in 1983. For the U.S., the share has been at 36% to 37% since 1983.

For years, the governments of the developed world have borrowed and spent heavily to extend more benefits to the poor, the elderly, and the infirm, to buy defense, and to employ the millions of workers at vast numbers of agencies and departments of government. The objectives were often worthy, but was the money well spent? Increasingly, both the size and the effectiveness of government is being challenged, and nowhere more so than in developing nations. The fastest-growing non-democracies have, in fact, been those countries that have overturned years of government ownership and management of business and extended numerous protections to private property owners--from sensible regulations to lower business taxes.

Take Mexico, long an authoritarian democracy in which one party dominated and rigid economic rules prevailed. After Harvard-educated Carlos Salinas de Gortari took over the presidency in 1988, he relaxed restrictions on foreign investment, privatized banks and other industries, and eased hundreds of economic controls and regulations. Incomes grew, worker productivity rose rapidly, and capital that fled the country in the early 1980s during Mexico's debt crisis returned. Mexico's example shows that function, rather than size, defines government's role in the economy.

Sometimes, culture plays a role in promoting growth, as did the rise of the Protestant faith and the Protestant work ethic in Western Europe. Similarly, the Confucian tradition in East Asia may have permitted strong leaders to exercise authoritarian rule. But today, more and more economists believe that it is politics, policies, and institutions--none of which are necessarily culture-specific--that help or hurt growth. "It's these arrangements that are overwhelmingly responsible for economic performance," argues Mancur Olson, an economist at the University of Maryland. In South Korea, for instance, thousands of laws explicitly designed to control economic activity may be undone, allowing businesses to make decisions independently. In developing countries, streamlined regulations and paperwork may encourage new business formation.

Similarly, burgeoning bureaucracies and interest groups in both developing and industrialized nations can throw sand in the economic gears and lead to political paralysis or instability. And political instability is one surefire predictor of poor economic performance, says Harvard University economist Alberto Alesina (table). In developing countries, the accompanying uncertainty reduces investment and encourages capital flight, while among industrialized nations, instability leads to poor policy choices. "If a government is unlikely to be reelected, it has an incentive to follow particularly shortsighted policies," argues Alesina. Italy's revolving-door governments, for instance, averaging about one per year since World War II, let the government budget deficit climb to 14% of gross domestic product. Its central bank, meanwhile, has struggled to control inflation. Italian voters, fed up with widespread scandal and corruption, recently decided to scrap the proportional representation system.

Before democracy was an idea, much less a system, despots and dictators ruled the world. Some were more benevolent than others, but by and large, these autocrats looked after their own interests first, seizing property and taxing income for tribute, ensuring impoverishment for the population at large by their larceny. Today, many such dictators continue to rule. But in recent years a new model has emerged--of an autocrat willing to forgo bounty in the near term to enhance growth prospects and future revenues.

"The puzzle of the post-cold-war era," says Harvard economist Andrei Shleifer, "is the emergence of the secure-property-rights dictator. The Pinochet example is striking." The experiment of President Salvador Allende in socialism had bitterly divided Chile and left the economy in shambles. It wasn't until two years after the military junta, led by General Augusto Pinochet, took over that dramatic economic reforms were adopted, including the lifting of controls on foreign investment and the drastic reduction of import tariffs. Occurring against a backdrop of human-rights abuses, including killings and "disappearances," the economic shock produced other hardships: The textile industry disappeared overnight, and unemployment reached 19.6% in 1981. Eventually, labor unions started demanding political reform and the Chileans--who enjoyed a strong democratic tradition before Pinochet appeared on the scene--voted in a plebiscite to hold elections. Yet by the time democracy returned in 1990, Chileans were convinced that the economic model Pinochet had imposed was the right one. In 1992, unemployment was down to 4.4% and per capita income had grown 66% in real terms since the reforms began in 1975. What's more, today, Chileans have a strong measure of control over their own assets: Their social security payments, and matching payments by employers, now go into private accounts that are managed by finance companies, not the government.

The autocratic government that directs economy policy with a firm hand from the center is but one successful model for growth. An equally compelling one, and one that many believe can coexist with democracy, is that of a federalist union, with policies, laws, and regulations allocated between the center and the regions.

Such power-sharing and decentralization of government has historically proved a powerful impetus to growth and development: Britain's Industrial Revolution occurred in the "new" cities of the north, such as Birmingham and Manchester, where laws and regulations in the wake of the Glorious Revolution of 1688 were looser than in the old financial centers, such as London. And in the U.S., rapid growth in the 19th century was propelled in part by a federalist, states' rights system that allowed agriculture and industrialization to thrive free of central control.

To be effective in promoting growth, federalism must be "market-preserving," says Barry R. Weingast, a senior fellow at the Hoover Institution. That is, it must limit the degree to which a political system can encroach upon markets. Under a federalist system, localities and regions evolve into "competitors," and if conditions aren't favorable, people move between regions.

What's driving rapid economic growth in China, Weingast figures, is federalism, Chinese-style. The central government doesn't enforce basic commercial standards or codes of conduct across regions, as a truly federalist system would. But at the township and village level, industry has been "marketized" through an elaborate system of incentive contracts for production and profit. In China, growth has averaged a stunning 10% annually for the past decade.

Today, Russia's Boris Yeltsin could do worse than take a leaf from the Chinese experience by pursuing decentralization aggressively. Yeltsin's power to govern Russia, a federation of regions, is severely constrained, and power is spinning away from the center. Now, Yeltsin hopes to corral those forces in his new constitution, which attempts to clarify the rights of local and regional governments.

Grigory Yavlinksy, an economist who has worked closely with the region of Nizhni Novgorod to implement economic reforms, says local governments should be able to set up their own regulations governing new enterprises, trade, and how tax proceeds should be allocated locally. Procedures should be simplified, as they have been in Nizhni Novgorod, where entrepreneurs may now register a new business at the post office.

Federalism may even be getting a new lease on life in mature democracies, where government's role in promoting economic growth is coming under increasing scrutiny. The U.S. has become far less federalist since the early years of its development, and now some experts are arguing in favor of allowing more and more economic decision-making to percolate up from the grass roots. That way, local problems can be solved closer to their source. Economist Alice M. Rivlin, now Clinton's deputy budget director, has urged a move to a form of federalism in the allocation of tax revenues, by having the federal government let more spending powers devolve to the states. And in Italy, the Lombard League, which has gained increasing popular support by appealing to discontent over massive income transfers from the prosperous north to the poorer southern regions, is advocating a federalist platform of political and economic decentralization.

In the early 1960s, the sociologist Daniel Bell made a simple but telling observation: Every four years to 2000 and beyond, Americans could be certain that there would be Presidential elections. "How many countries in the world can you say that about?" he asked.

That certainty--and the stability it conveys--is a unique characteristic of democracies. Yet along with stability comes flexibility and the opportunity for change. In democracies, a whole panoply of individual rights are protected constitutionally. Meanwhile, political parties battle for control. Businesses and individuals compete for profit, advancement, and prestige. And social institutions, from houses of worship to institutions of learning, compete for loyalty and support. Nowhere but in democracies do such competing interests exist. This juxtaposition of certainty and flux is, ultimately, the best guarantor of economic well-being.

A democratic polity, says economist Douglass C. North of Washington University in St. Louis, cannot long survive in an environment in which there is no economic growth--different groups would be constantly warring over how to split a pie unchanged in size. The obverse is also true: Growth and prosperity cannot long be sustained in an environment that is undemocratic. "Over the short run, dictators can always get good growth," says North. But after a time, if democratization does not begin to secure gains for all the people who have earned them as well as ensure millions of others the opportunity to do better, anything can happen: a change of regime, confiscation, rebellion, a reversal of fortunes.

The democratic system is an imperfect one, but it is the most desirable one. At that meeting in Moscow 34 years ago, Khrushchev told Nixon that his grandsons would live in a communist America, and Nixon retorted: "No, your grandsons will live in a capitalist Russia." Russia may not yet be capitalist, but Nixon was more correct than he might have imagined. Recently, Khrushchev's son, Sergei, a visiting scholar at Brown University, became a legal, permanent resident of the U.S. His sons live in Moscow, and Sergei Khrushchev says he misses his homeland. But, he observes, "I'm feeling much freer here in my own decisions....In Russia, we must always go and ask for permission. It's not enough to declare democracy. These changes take a long time."

                      Annual Average for 1982-92
                    Avg.    Avg.    Avg.  Index of
                inflation  unemp. misery political
                   82-92  82-92   index stability*
                     (A)    (B)   (A+B)    
      SPAIN         7.6%  18.7%  26.3%  4
      GREECE        18.0   7.6   25.6   4
      PORTUGAL      14.9   6.6   21.5   4
      ITALY          7.4   10.1   17.5   4
      BRITAIN        5.5   9.6   15.0   2
      BELGIUM        3.5   10.9   14.4   3
      AUSTRALIA      6.4   7.8   14.2   2
      CANADA         4.3   9.8    14.1   2
      FRANCE         4.4   9.6   14.0   3
      NEW ZEALAND    7.9   6.1    14.0    2
      DENMARK        4.2   9.4   13.6   3
      FINLAND        5.3   5.8    11.0   2
      UNITED STATES  3.8   7.1    10.9   2
      NETHERLANDS    1.9   8.7   10.6   3
      NORWAY         5.7   3.7   9.4    2
      SWEDEN         6.7   2.4   9.1   2
      GERMANY        2.2   6.0   8.2   2
      AUSTRIA        3.0   3.5   6.5   2
      JAPAN          1.8   2.5   4.3   1
      SWITZERLAND    3.1   0.9   4.0   1
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