Democracy, diversification, and growth reversals

David Cuberes, Michal Jerzmanowski 15 August 2009

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The last twenty-five years have been a period of remarkable stability among developed economies. This stability, termed by some “The Great Moderation”, has been particularly noteworthy in its contrast with the instability experienced by developing economies. Poor countries suffer not only from persistently low incomes but also from large doses of economic volatility. Even the current economic crisis – which originated in financial markets of developed countries and affected their economies very severely – is causing equal if not greater damage in developing countries. Russia’s economy is forecast to contract by 6% this year, and Botswana’s is projected to drop by one-tenth (IMF, 2009). Are developing countries doomed to suffer high volatility?

While much ink has been spilled on what country-characteristics are conducive to long run growth (Barro and Sala-i-Martin 2004; Doppelhofer, Miller, and Sala-i-Martin 2004), much less is known about the determinants of economic volatility (Koren and Tenreyro 2007; Fatas and Mihov 2003). However, there is one interesting robust correlation in the volatility literature. While various studies find that the effect of democracy on growth is rather weak (Przeworski and Limongi 1993; Barro and Sala-i-Martin 2003),1 the volatility literature finds a robust link between a greater degree of democracy and lower economic instability. In important papers, both Rodrik (1999) and Quinn and Woolley (2001) provide strong evidence that democratic countries experience less volatility. Similarly, Acemoglu, Johnson, Robinson, and Thaichoren (2003) emphasise the importance of institutions in explaining differences in instability across countries.

In a recent paper (Cuberes and Jerzmanowski 2009), we explore the link between democracy and economic volatility further. We depart from the existing literature by focusing on medium-term growth volatility. Unlike previous papers, we look at medium-term (periods of ten years or longer) swings in trend growth rather than computing volatility as annual variation in growth.

We choose to focus on the medium term because several recent studies emphasise that, except for a handful of rich countries, most economies switch between periods of rapid growth, stagnation, and decline. Easterly et al. (1993) were the first to point out the instability of growth at longer horizons. More recently, Pritchett (2000, 2006) observed that, in most developing countries, a single time trend does not accurately characterise the evolution of income. Hausmann et al. (2005), Jerzmanowski (2006), and Jones and Olken (2008) explore the medium-term growth variation in greater detail and all document frequent episodes of fast growth coupled with equally common episodes of decline.2 To make things concrete, consider a country like Jordan whose income per capita increased by only 30% between 1970 and 2000, while that of Singapore increased 7-fold (Figure 1).

Figure 1. GDP per capita relative to initial level; Singapore vs. Jordan

Researchers have long tried to explain this difference by looking for factors – openness to trade, protection of property rights, high investment rates, etc. – which are necessary for growth that Jordan lacks and Singapore has in abundance. However, when looked under a “medium-term microscope” (Figure 2), the thirty years of Jordan’s economic history suggest a more complex story. It turns out Jordan did not perpetually stagnate but instead had periods of rapid growth and dramatic decline; Jordan’s economic growth seems to wax and wane.

Figure 2. Economic growth in Jordan

Explaining such medium-term cycles in economic performance seems key to understanding long-run economic growth and discovering the right set of policies for development and stability. Our contribution lies in exploring the relationship between democracy and the frequency and magnitude of medium-term growth swings.

Our strategy consists of two steps. First, we identify instances where trend growth changes significantly (using a statistical test developed by Bai and Perron 1998). Second, we study the magnitude and frequency of such breaks. Figure 3 shows several examples of large growth breaks. We refer to such large swings in economic performance as growth reversals or cycles.

Figure 3. Examples of growth reversals

Note: This plots the logarithm of real per capita GDP relative to the technology frontier (taken to be the U.S.) to capture changes in growth that stem from changes in the country-specific component of the growth process. None of the results of the paper is crucially affected by this normalisation.

Growth reversals like the ones shown above are in fact quite ubiquitous, but they are decidedly more common in less democratic countries. Here we illustrate this by plotting the (smoothed) distribution of the magnitude of growth changes at the time of the break, separately for democracies and non-democracies (we draw the line between the two groups at the median of our democracy measure).

Figure 4. The distribution of changes in trend growth in democracies and non-democracies

Clearly both groups experience trend changes but it is also apparent that for democracies these changes are usually small (mode close to zero) while for non-democracies they are most commonly large in either the positive or negative direction (bimodal distribution) and frequently very large (fat tails).

More formally, we use three different tests to analyse whether democracy has a significant mitigating effect on growth swings. First we study whether the magnitude of the growth reversals is reduced by democracy. In order to do this we regress the growth rate after a break on the growth before it and an interaction term between growth before break and democracy. We find a negative coefficient on the lagged growth – indicating a general tendency for reversals – but, more importantly, the sign on the interaction term is positive, indicating that more democratic countries tend to cycle less. Interestingly, the level of income does not seem to have any effect on a country’s propensity to cycle. In other words, once we control for the degree of democracy, we do not find that poorer countries tend to cycle more than the average country.

Second, we estimate the probability that a country experiences a growth reversal. We find that a 10% increase in the index of democracy reduces the probability of experiencing a growth reversal by around 2%. This is true even when we control for the level of income and the fact that less democratic countries tend to rely more heavily on natural resources.

Motivated by these findings, and building on the theory of Acemoglu and Zilliboti (1997) and empirical work of Djankov et al. (2004), we present a model of democracy and diversification with risky technologies. We show that non-democracies, with higher barriers to entry for new entrepreneurs, suffer from greater industrial concentration: only a few sectors account for the bulk of the GDP. This leads to infrequent but large growth accelerations when one of the few disproportionately large sectors is successful. However, these accelerations are followed by large declines when inevitably fortunes change in favour of the disproportionately small or non-existent sectors; this results in episodes of very fast growth followed by a decline or a severe slowdown. This is the only model that we are aware of that explains non-democracies' high propensity for both growth disasters and spectacular growth accelerations. We provide empirical evidence showing that less democratic economies tend to be less diversified.

Conclusion

The literature on growth accelerations finds that periods of rapid growth are not uncommon and conclude from this that sustaining – not initiating – growth is the more difficult part of a successful development enterprise. Our results put a different perspective on these findings. Less democratic countries not only fail to sustain growth, but also see its fruits undone by large slowdowns or periods of decline that follow their growth spurts. In fact, the growth spurts themselves can equally correctly be viewed as periods of successfully initiating growth or as symptoms of the underlying weakness of the economy which, by limiting diversification, makes large growth accelerations possible, while at the same time facilitating the dramatic reversals. Here our research suggests that democratisation helps stabilising the economy through greater diversification. However, while the frequency of dramatic collapses will decrease, spectacular accelerations will also be less likely.

Finally, a note of caution – although adopting democratic institutions enhances industrial diversification, it does not guarantee it. Even democratic countries (especially small ones) may end up too concentrated in a few sectors and subject themselves to large swings in growth (as demonstrated recently by the case of Iceland.) We recognise the fact that, while many other factors may determine the composition of a country’s GDP and thus its susceptibility to economic instability, its institutional environment – and in particular its level of democracy – is an important one.

Footnotes

1 One notable exception is Pappaioannou and Siourounis (2008) who, using within-country time series evidence, find that democratization is unambiguously good for economic growth.

2 Aguiar and Gopinath (2007) argue that the international real-business-cycle model fits the experience of emerging countries more accurately when one allows for trend breaks in productivity.

References

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Aguiar, Mark, and Gita Gopinath (2007), “Emerging Market Business Cycles: The Cycle is the Trend.” Journal of Political Economy, February, vol.115, Number 1, pp. 69-102.

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Topics:  Development

Tags:  democracy, growth, volatility, diversification

Assistant Professor of Economics, University of Alicante

Assistant Professor at The John E. Walker Department of Economics at Clemson University

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