Democracy and economic prosperity

Does the form of government condition economic performance? And if so, is democracy superior to an authoritarian rule? We tend to think like this because most developed economies are democratic, but you cannot tell whether they are rich because of, or in spite of, being democratic; or if economic success has helped these societies to turn democratic.

But let’s begin first with a thought experiment to test your democratic beliefs. Take the country of Siestaland, where 51% of its citizens like to nap and collect — democratically voted — generous unemployment benefits. These, have to be financed by the other 49% of the population, who are industrious workers. On the contrary, we have Seriousland, where 51% of the voters are diligent workers, while the remaining 49% take a nap and get nothing from the state. Strictly speaking, democracy helps each majority to achieve its respective economic optimum.

 

From a perspective of total economic optimality, the average individual in Siestaland would be better off with fewer naps and an authoritarian ruler. However, there is no such thing as an «average individual,» who works in the morning and naps in the afternoon. Therefore, despite having very similar populations in both countries, the form of government that maximizes economic utility for the respective majorities is diametrically opposed.

 

The previous example serves to illustrate the role of history as a determinant of economic success. However, it is an obvious oversimplification of reality, since the form of government affects other variables beyond redistribution policies, such as the quality of institutions and the ability to foster innovation and entrepreneurship, which profoundly impact economic growth. Unfortunately, the economic literature is not conclusive about the chain of causality (see Glaeser, Edward L., Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer. 2004 for a survey). Empirical data shows that there is a certain correlation between democracy and GDP per capita, as can be seen in the graph below, but also that democracy is neither a necessary nor a sufficient condition for economic growth.

 

 

The examples abound. You can find democratically elected governments that follow unsuccessful central planning policies, such as Venezuela under Chávez; authoritarian countries such as China or Vietnam that enjoy rapid economic growth after embracing their own versions of state capitalism; and monarchies like Qatar, whose wealth is mainly a consequence of its vast endowments of natural resources.

 

If democracy is not a silver bullet for economic growth, its benefits should not be underestimated either. Despite the appeal that authoritarian regimes have for those frustrated by the slow pace of change characteristic of democracy, it cannot be forgotten that the integrated checks and balances provided by the latter act as a very powerful risk mitigator.

 

History shows that elites and enlightened leaders often make foolish mistakes, which when kept unchecked, can lead to disastrous results. Democracy, like natural evolution, heavily punishes short-term mistakes and, therefore, considerably limits the extent of failure.

 

The wisdom of the crowds involves political shortsightedness and risk aversion, which undoubtedly have an opportunity cost. This contrasts sharply with the creative destruction that drives innovation in the corporate world, and can make us succumb to the temptation to get rid of democracy to accelerate economic growth. However, unlike investors who can maintain a diversified portfolio of shares, as a citizen, it is not possible to diversify political risk (unless you manage to accumulate a portfolio of passports), and democracy still offers the best risk-adjusted returns.

 

 

Fernando de Frutos, MWM Chief Investment Officer

 

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