In today's world, most rich countries are democratic, and most dictatorships are poor. In the United States, democracy goes hand in hand with political institutions that promote economic freedom.
However, democratic governments, even in rich countries, often enact redistributive policies that reduce economic freedom and that are harmful to economic growth. Therefore, although most economists agree that economic freedom promotes growth, it is not clear that more political freedom (that is, more democracy or political rights) improves economic performance.
Economic growth is primarily a result of the accumulation of both physical capital and human capital. The accumulation of capital is affected by public policies, which, in turn, depend on the political institutions that are in place. In a classic study, Robert Barro explained that because citizens express their approval or disapproval when they vote, democratic institutions provide checks on government power that impose limits on politicians’ ability to amass wealth and enact unpopular policies. These constraints, he noted, help improve economic freedom. On the other hand, authoritarian governments may also improve economic freedom as a matter of policy, without the need of institutional limits such as those provided by a democracy.
In a study of about 100 countries from 1960 to 1990, Barro found that at low levels of political freedom, an increase in political rights might enhance economic growth by imposing limits on government. But he noted that in countries that have already achieved medium levels of democracy, further increases in political rights might slow growth because of growing concerns about income redistribution. Barro’s conclusion that the overall effect of democracy on growth is slightly negative continues to be challenged by alternate views.
One alternate view suggests that the adoption of democracy - or, more generally, of political institutions that impose checks and balances on the government - promotes investment in physical and human capital and, therefore, growth. In contrast, a second view suggests that reaching a certain level of economic development is what allows countries to adopt better institutions.
A study that supports the view that political institutions promote economic performance found a strong relationship between a measure of protection against government expropriation (as a measure of political institutions) and economic performance (measured by real income per capita) across a large sample of countries. The study looked at two types of colonization strategies that led to different types of political institutions.
The first strategy was the creation of extractive states. In these colonies, the main goal was to transfer much of the resources of the colony to the European power. Institutions created in these colonies did not provide much protection of private property and did not impose checks against government expropriation. Examples of this were the Spanish colonies in Mexico and Latin America, and the Belgian colonization of the Congo.
In the second colonization strategy, European settlers migrated in large numbers and created institutions that replicated those in their home country. These institutions emphasized the protection of private property and checks against government expropriation. Examples of these were Australia, New Zealand, Canada and the United States. The types of institutions adopted in the early stages of either colonization strategy lasted even after the colonies became independent.
The second view is that it is economic growth that stimulates democracy or the adoption of better institutions. Supporters of this view make the point that the accumulation of human capital is a more important determinant of economic growth than political institutions. Supporters of this belief studied a large set of countries in the period from 1960 to 2000, classifying them in four categories: autocracies, imperfect autocracies, imperfect democracies and stable (or perfect) democracies.
In 2000, nearly all countries with high levels of education were classified as stable democracies, and nearly all stable democracies were highly educated. In contrast, nearly all countries run by dictators were poorly educated. In addition, as education levels increased, democracies were more common, though many were imperfect. In 1960, most of the poor countries in terms of growth were run by dictators. In the four decades that followed, the growth rates among poor countries varied, and some of them managed to get out of poverty while still being run by dictators.
Supporters argue that this evidence suggests that it was not limits on dictators imposed by institutions that led to growth, but rather that dictators chose policies that provided security of property rights to foster investment in physical and human capital - which then led to growth. The study mentions China as an example of a dictatorship in which economic growth has been the result of favorable policy choices and not of institutional limits on the government.
The debate about whether democracy and political institutions generate growth or whether economic development leads countries to adopt better institutions is likely to continue. In any event, fundamental features of Western economic systems, such as free markets and the importance of securing private property rights, seem to be safe bets for economies seeking economic growth.
NOTE: This article was adapted from “Which Came First - Democracy or Growth?,” which was written by Ruben Hernandez-Murillo, senior economist, and Christopher J. Martinek, senior research associate, both of the Federal Reserve Bank of St. Louis, and was published in the April 2008 issue of The Regional Economist, a St. Louis Fed publication.
Keep up with what’s new and noteworthy at the St. Louis Fed. Sign up now to have this free monthly e-newsletter emailed to you.