exploring the impact of democratic capital on prosperity
TRANSCRIPT
Exploring the Impact of Democratic Capital on Prosperity Lisa L. Verdon*
SUMMARY
Capital accumulation has long been considered one of the driving forces behind economic
growth. The idea that democratic experience accumulates and depreciates like other forms of
capital is a relatively unexplored idea. Much like financial and physical capital, it has been
suggested that democracy is a necessary but insufficient condition for economic growth.
Building on the work of Persson and Tabellini (2006b), this paper constructs several alternative
calculations of democratic capital. These values of democratic capital are then compared to
GDP, as a measure of prosperity, and economic freedom for 161 countries. The results of this
analysis support the idea that democracy acts indirectly through economic freedom to enhance
prosperity. The causal relationships between democracy, economic freedom, and prosperity
appear to be self-perpetuating.
ABSTRACT
Capital accumulation is one of the driving forces behind economic growth. The idea that
democratic experience accumulates and depreciates like other forms of capital is a relatively
unexplored idea. Like other forms of capital, it has been suggested that democracy is a necessary
but insufficient condition for economic growth. This paper constructs several alternative
calculations of democratic capital. These values of democratic capital are then compared to
GDP per capita and economic freedom for 161 countries. The results support the idea that
democracy acts indirectly through economic freedom to enhance prosperity and the relationship
is self-perpetuating.
JEL CLASSIFICATIONS: E02, O43
* Assistant Professor of Economics, College of Wooster, 206 Morgan Hall, Wooster, OH 44691, 1 (330) 263-2216, [email protected]
I. INTRODUCTION
It is a standing tenant of growth theory that capital is an essential component. This capital comes
in many forms including physical, human, and financial capital. For any form of capital to grow
there must be continuous investment in excess of depreciation and other losses.
A relatively new idea is that democracy can be thought of as a form of capital. The idea of
democratic capital is that the more experience or history a country has with a democratic system,
the more likely that country is to develop and maintain the institutions of democracy. Although
democracy and free-markets are not synonymous, there is a very strong correlation between
these two ideas.
The purpose of this paper is to more clearly identify the impact of democratic capital on
prosperity. I begin by recreating a basic measure of democratic capital based on the work of
Persson and Tabellini (2006b). I then suggest and calculate alternative measures of democratic
capital. Using these measures of democratic capital, I measure the impact of democratic capital
on prosperity, measured as GDP per capita. Finally, I identify the direction of the relationship
between democratic capital, economic freedom, and GDP per capita.
II. LITERATURE REVIEW
The positive connection between democracy and capitalism has been believed for many years.
Almond (1991) provides a survey of economists’ views on this relationship. Among those
economists is Schumpeter who suggests that democracy is supportive of capitalism. The counter
argument by Marx that there will always be a tension between democracy and capitalism has
proven invalid, or at the very least, inconsequential. However, understanding and quantifying
this relationship is a matter that has only been addressed in the past few decades.
Helliwell’s (1994) analysis of the relationship between democracy and growth is the basis of
most of the literature in this line if inquiry. Helliwell looked at 125 countries from 1960 to 1985
and determined that income has a positive impact on democracy and that democracy has a
positive but indirect affect on growth through increases in education and investment. A multitude
of papers follow which suggest different measurements and/or model specifications. These
differences result in mixed results on the nature of the relationship between democracy and
growth.
There are many papers that identify a positive correlation between democracy and growth. Arat
(1988) identifies the positive correlation but determines that economic growth is not a sufficient
condition for democracy. Alesina and Perotti (1994) find that there is a strong positive
correlation between democracy, GDP per capita, and education. Alesina and Perotti then turn
their focus to the stability of political regimes rather than the structure, finding that instability
reduces growth regardless of the type of regime. However, Feng (1997) determines that
democracy reduces the probability of a regime change and thus indirectly promotes growth
through stability.
Taking a different approach, Burkhart and Lewis-Beck (1994) use Granger causality to
determine that growth Granger causes democracy but democracy does not Granger cause growth.
This causality relationship holds up even in the poorest countries. However, Heo and Tan (2001)
suggest that the relationship between democracy and growth could go either way and use
Granger causality on 32 individual, developing countries. Heo and Tan find that 34 percent show
growth Granger causing democracy, 31 percent show democracy Granger causing growth, 9
percent show a feedback loop, and 25 percent show no relationship.
Most recently, Persson and Tabellini have produced a series of working papers looking at the
relationship of democracy and growth. In their 2006 paper they look at the experience a country
has with democracy, identifying that experience as “democratic capital.” They use this idea of
democratic capital for a country and its neighbors to model the probability of a country
becoming democratic and the probability of staying democratic. They find a “dynamic, positive
feedback loop” between democratic capital and growth. They find that becoming a democracy
accelerates growth by 0.75 percentage point and that this affect is still positive and significant
when paired with market reforms. In their 2007 paper they suggest that previous measures of the
effects of democracy on growth have been significantly underestimated. They find that the
positive impact of democracy is up to 1.8 times greater than any previously reported estimates
and the negative impact of autocracy is at least 1.8 times greater than previous estimates.
III. MEASURES OF DEMOCRATIC CAPITAL
Quantifying the accumulation of democratic capital, or any other type of institutional capital, is
full of challenges. The most obvious challenge is accounting for periods of external control. I
approached this challenge as having several possibilities. The first possibility is that a nation is
formed after being a colony. The second possibility is that a nation is in existence but is occupied
and controlled by another country for a period of time. The third possibility is that a smaller
nation splits from a larger existing nation. Finally, there is the possibility that two or more
nations join together.
The case where a country splits from a larger country seems the easiest to handle. A country like
Bangladesh, that was part of Pakistan until 1972, shares a democratic and institutional history
with Pakistan. So when Bangladesh became its own country in 1972, it started with the same
democratic capital as Pakistan at that time. The opposite of this is where two or more countries
join together to form one country. This is the case for Germany that was once split between East
and West. For this situation, the current country shares both histories. For these cases I use the
simple average of the countries’ democratic capital during the period(s) of separation1. For
countries that were formerly colonies, there is evidence that the legal institutions tend to stick.
The same cannot be said for political institutions. For that reason, I calculate democratic capital
for former colonies starting from zero at the time they become an independent country.
The most interesting challenge is for countries that are occupied and controlled by another
country. This situation has occurred to many countries and on several occasions. The most
glaring examples are the countries of the former Soviet Union. Many of these countries were
independent and democratic before they were overtaken. During the period of foreign control
there are two possibilities regarding democracy. People either buy into or accept the new regime
or they resist and resent the change. It seems unlikely that democratic capital can grow in this
scenario but it is also not realistic to assume that the country takes on the democratic capital of
its oppressors. Therefore, for these situations the democratic capital accumulated before
occupation is simply depreciated while occupied.
1 It could be argued that a weighted average, based on population or some other measure of relative power, should be used. I use the simple average to avoid questions of determining relative power.
Table 1 – Measures of Democratic Capital
My calculations of democratic capital are based on the work of Persson and Tabellini. Persson
and Tabellini (2006a) identify two different types of democratic capital, domestic and foreign.
For the purposes of this paper, I concern myself only with the domestic measure of democratic
capital. To calculate democratic capital, Persson and Tabellini use the Polity II value to identify
if a country is democratic or autocratic. If a country has a positive Polity II value then it is
considered democratic. To calculate the democratic capital, countries receive a 1 each year they
are democratic, 0 otherwise, but depreciate only in years of autocracy. They estimate a
depreciation rate between 0.06 and 0.01. Like Persson and Tabellini, I will use the depreciation
rate of 0.06 for δ throughout the remainder of the paper.
The binary variable of democracy is represented in formula 1 as Dt. The stock of democratic
capital is represented as DCt-1. My calculations based on this method2, identified as Binary, are
reported for select countries in Table 1.
(1)
This calculation is a good place to start. A potential problem with this measure is that it only
depreciates democratic capital in years of autocracy. In contrast, when we look at other types of
capital accumulation, depreciation of the capital stock occurs every year. Beyond this technical
argument, there is an idea in the public choice literature that suggests people become complacent
in their valuation of democracy. That is, the longer they live in a democracy, the more they take
it for granted. Van Den Doel and Van Velthoven (1993) support this idea with theory and
evidence. In particular, they describe Olson’s model of participation in democracy as supporting
very low participation when policy is either very near optimal or very far from optimal. When
policy is near optimal, people believe things will continue to go well so their participation is
unnecessary. When policy is far from optimal, people believe their contributions will have no
impact so refrain from participation. With these arguments in mind I calculate a second measure
of democratic capital, identified as Binary Depreciated, based on formula 2.
(2)
Both of the measures produced to this point have been based on a binary value of whether a
country is democratic or autocratic in a given year. The Polity II values that this binary is
2 Because they are concerned with probabilities, Persson and Tabellini adjust their calculation to stay bounded between 0 and 1. My calculation does not impose this restriction.
calculated from can provide more information. The Polity II value ranges from negative ten to
positive ten. This scale provides more information (and potentially reduces measurement error)
in that two countries may be considered democratic because they have positive Polity II values
but one may have a score of 2 while the other has a score of 8, implying that the second is far
more democratic than the first.
Figure 1 – Comparison of Measures (Ghana)
If you believe that all autocracy has the same impact, it would be appropriate to only use the
positive values of Polity II. In this case, the annual measure of democracy is equal to the Polity II
value if it is positive and zero otherwise. Using these values or democracy in equation 2 provides
a measure referred to as Positive Polity II. Finally, using the full range of Polity II provides a
measure that allows for the varying degrees of both democracy and autocracy. Using the full
range of Polity II values for democracy in formula 2 provides the final measure of democratic
capital which I refer to as Polity II.
Comparing the alternative measures, it is clear that the binary measures provide very smooth
time paths. There is often little difference between the Binary and Binary Depreciated values as
shown in Figures 1 and 2. However the Positive Polity II and Polity II time paths show much
more variation and volatility. Additionally, there are obvious breaks in trajectory that can
generally be tied to major political events. This is an important distinction that the use of
different measurements makes inherent assumption about government stability which must be
recognized. If your view is that political institutions are generally stable over time, use of the
binary measures fits this assumption. If your view is that dramatic shocks to the political system
are important and far reaching, then the broader measures of Positive Polity II and Polity II are
more appropriate. It should be obvious at this point that whichever assumption is made regarding
political institutions will affect any subsequent analysis.
Figure 2 – Comparison of Measures (Chile)
IV. DATA ANALYSIS
My approach to the analysis involves three parts. The first part employs a graphical analysis
focusing on a few select countries. The second part uses regression analysis on the panel dataset.
The third and final part looks at causality with a series of Granger type tests. The data set is
based on the calculations of democratic capital described in the section three. The democratic
capital measures cover the period 1800 to 2004 for approximately 160 countries3. Addition data
includes economic freedom from the Fraser Institute’s Economic Freedom of the World covering
the period from 1975 to 2005 and GDP per capita from the World Bank for the same period. The
difference in scale of these variables makes the use of logs very appealing. However, the
democratic capital value based on the full Polity II scale ranges into negative values. Taking logs
of this variable cuts the sample size in half. For this reason, it is necessary to conduct some of the
analysis using raw values.
1. Graphic Analysis
For the graphic analysis, I compare five countries: China, Estonia, United States, Venezuela, and
Zimbabwe. These five countries represent a wide range of political histories and economic
prosperity. I first look at the Binary democratic capital versus the Polity II measure. This visual
inspection confirms the general accuracy of the measures as we see the US at the top and China
at the bottom. It is more interesting to note that Venezuela is above Estonia in both measures.
However, a closer look at the Polity II measure reveals Estonia to be on a steep upward path4
while Venezuela’s path is headed downward. If we revisit this data in 50 years and both
countries stay on their current trajectories, Estonia will have greater democratic capital than
Venezuela.
3 The Polity IV project reports values for all independent states with populations greater than 500,000. The number of countries changes when states split, merge, etc. 4 The democratic capital for Estonia and other former Soviet block countries start (or re-start) in the mid-1990’s as they established their independence. See section III for further explanation.
Table 2- Summary Statistics
Figure 3 – Binary Democratic Capital
Moving on to economic freedom, we see again that the US is at the top with Estonia close
behind, again showing a steep upward trend until recent years. An important difference
comparing economic freedom and democratic capital is that China is in the middle of the
economic freedom graph. This reflects the many steps that China has taken towards economic
liberation while holding to their politically autocratic traditions. It is also not surprising to find
Zimbabwe at the bottom. Zimbabwe’s trend is downward sloping in the Polity II democratic
capital. Zimbabwe’s economic freedom shows a similar pattern, though the downturn starts later.
This again supports the idea that there is a strong relationship between democratic capital and
economic freedom, though that relationship may be lagged.
Figure 4 – Polity II Democratic Capital
Figure 5 – Economic Freedom
Finally, I turn to GDP per capita. The picture here is not surprising either. The order of the
countries reflects the same order as economic freedom. The US and Estonia both have strong
upward sloping GDP per capita while Venezuela and Zimbabwe have little or no growth. This,
once again, demonstrates the strong relationship between economic freedom and prosperity, as
measured by GDP per capita.
Figure 6 – GDP per capita
2. Regression Analysis
The next step is an attempt to quantify the relationships between democratic capital, economic
freedom, and GDP per capita. I model the relationship of GDP per capita as dependent on lags of
itself, lags of economic freedom, and lags of democratic capital. I choose to use a fixed effects
model with in-panel AR(1) disturbances. The fixed effect absorbs the country specific
characteristics, which allows our results to be a general representation of this relationship.
Including the AR(1) component provides for a consistent estimator5. I consider up to five lags of
each variable. The best fitting model is the simple model that contains one lag of each variable,
represented in equation 3.
(3)
Although it is difficult to interpret the exact relationships between the variables, because of the
large variation in units, the relationships are positive and statistically significant with the
exception of democratic capital. The binary measure of democratic capital is the only version
that is statistically significant. This is a first hint that how democratic capital is measured will be
important to our results. One might challenge the use of OLS or the AR(1) disturbances. As
robustness check, I ran the same OLS regression without the AR(1) disturbances as well as GLS
with and without the AR(1) disturbances. There is little variation in the results of these alternate
methods.
To have a better understanding of the relationship, I rerun the regression using logged values.
Using the logged values results in all of the democratic capital measures being statistically
significant, though some are weakly significant and all are relatively small. From these results
we can see that GDP per capita is highly dependent on previous period GDP per capita values.
For economic freedom, we see that a 1 percent increase in economic freedom is associated with
an approximate increase in GDP per capita of 0.1 percent. The impact of a 1 percent increase in
democratic capital is less than a tenth of a percent.
5 The consistency of the fixed effects, AR(1) estimator holds in the face of heteroskedasticity under most assumptions. It is not necessarily efficient. (Wooldridge 2002)
Table 3 – Estimates of Equation 3
Another approach to this type of problem is to use an Arellano-Bond estimation. In this method,
past realizations of the dependent variable affect its current level and past realizations, beyond
the specified lag(s), of the independent variables are used as instrumental variables. The results
of the Arellano-Bond estimation are presented in Table 56 and are very similar to the previous
results. This provides yet another robustness check. All of the coefficients are still positive and
statistically significant. The primary difference is the estimated impact of democratic capital is
larger while the impact of economic freedom and previous GDP per capita coefficient estimates
are smaller under this method.
6 The model is not estimated using the logged values of Polity II Democratic Capital because the sample was reduced by more than half due to the negative values of the raw variable.
Table 4 – Estimates of Equation 3 with Logs
This set of results has at least two major implications. The first is that democratic capital may not
directly affect GDP, or the direct affect is relatively small. This is not a surprising result, as it has
been suggested by Feng (1997), Helliwell (1994), and Leblang (1996) that the impact of
democracy is indirect. The second, and more important, implication is that how you measure
democratic capital, and democracy by extension, impacts the statistical significance of your
results. This supports the implications of the graphic analysis of Figures 1 and 2 in section 4.1.
Table 5 – Arellano-Bond Estimates
The body of research in this area often goes back and forth as to whether democracy is
important. The results here suggest that those papers that are based on different measures of
democracy are likely to get different results. This is particularly poignant when one considers the
first two results here; Tables 3 and 47 are based on the exact same data and econometric
approach but result in different estimates. Using different econometric methods, as presented in
Table 5, simply adds to the confusion.
7 The model in Table 4 is not estimated using logged values of Polity II Democratic Capital. See the previous footnote.
3. Granger Causality
Clearly, the three variables of GDP per capita, economic freedom and democratic capital are
closely connected. There is a strong theoretical connection that has been demonstrated both
graphically and statistically in this paper. This begs the question of which one causes the others
to move. The standard approach to answering this question is Granger causality tests.
Table 6 – Granger Causality using VAR on Binary Democratic Capital
Table 7 – Granger Causality using Wald Tests on Binary Democratic Capital
The challenge here is there is no exact way to translate the traditional Granger causality test to
panel data. For this reason, I took several approaches to the calculations. The first approach is to
collapse the data to a measure of central tendency8, then use the traditional Granger test. The
second approach is to run a series of panel regressions with Wald tests. For these regressions I
used the same fixed effect, AR(1) disturbance model employed in section 4.2.
Determining the appropriate number of lags can be important. Regression results suggest that
one lag is sufficient for this relationship. However, the Granger test can be biased if too few lags
are included. Hsiao testing suggests that the correct number of lags is two. Since including more
lags does not bias the Granger test, I include five lags.
Table 8 – Granger Causality using VAR on Polity II Democratic Capital
Table 9 – Granger Causality using Wald Tests on Polity II Democratic Capital
8 I chose to collapse to the median, instead of the mean, to reduce the impact of outliers.
The results of both approaches were generally consistent. Using the binary measure of
democratic capital the results are exactly the same under both methods. Democratic capital
Granger causes economic freedom and vice versa. Similarly, economic freedom Granger causes
GDP per capita and vice versa. However, GDP per capita Granger causes democratic capital but
democratic capital does not Granger cause GDP per capita.
(4)
Another observation from these results is that improvements in these factors seem to be self-
perpetuating. That is, increases in democracy supports increases of economic freedom which, in
turn, supports increases in democracy and GDP which then supports increases in economic
freedom, and so on. The downside of this is that it also implies a negative loop for those
countries that are low in any of these three areas.
The results are slightly different when using the Polity II democratic capital measure. The results
based on median values suggest that economic freedom Granger causes democratic capital but
the relationship does not go the other direction. A more significant deviation is under the Wald
tests, we find that democratic capital Granger causes GDP per capita but not the other way
around. This is the only place where the results suggest a direct relationship of democratic capital
causing GDP per capita. These variations in results may reflect the volatility of the Polity II
measure that we see in the graphs in section 3 or it may be that there is more noise in this
measure.
Finally, I use simultaneous equations to see if we can better understand the complicated
relationship between democratic capital and GDP per capita. It appears that the complication
comes from the relative strength of relationships. This estimation uses the logged values so one
can simply compare the coefficient estimates. The coefficient estimate on economic freedom, in
the GDP per capita equation, is over 15 times greater than the coefficient estimate on democratic
capital. This implies that even though democratic capital does contribute to GDP per capita, its
contribution is often overshadowed by economic freedom.
Table 10 – Simultaneous Equations
V. CONCLUSION
I have put forth three original measures of democratic capital. Comparisons of these measures
suggest that the most appropriate measure depends on your assumptions about political stability.
I have also demonstrated that econometric results are sensitive to the measure of democratic
capital employed. This sensitivity helps to explain the conflicting results in this line of research.
Using a fixed effects model with in-panel AR(1) disturbances, I show that GDP per capita
depends on lags of itself, economic freedom, and democratic capital. Based on these results the
relationship between GDP per capita and democratic capital is either direct or indirect,
depending on which measure is used. Further analysis, using Granger causality tests, support the
indirect relationship of democratic capital acting through economic freedom to positively
influence prosperity.
VI. FURTHER RESEARCH
The depreciation used to calculate the various measures of democratic capital are based on
calibration of a different model. One extension would be to calibrate each of these measures
separately. Given that two of the measures are based on binary values while the other two have
far larger ranges suggests that the depreciation rates should be different, although the different
depreciations rates may not have a significant impact.
Another area of extension is to include other variables important to prosperity such as other types
of capital and geographic factors. Including these requires dealing with more endogeneity issues
but it will also reduce the unidentified factors that are currently being absorbed into the country
fixed effects and would lend further strength to these arguments.
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