6th Lecture, STV4346B: “Theories of democratization & the economic effects of institutions”

Carl Henrik Knutsen, Department of Political Science, UiO24/11-2008

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Part I: Theories of democratization In the last lecture, we discussed modernization theory

and the role of economic development for democratization and democratic stability

Today, we will take a look at some other suggested economic variables that are argued to affect political regime type, like income inequality and the type of production structure (mobility of capital assets)

The discussion will focus on the contributions by Boix (2003) and Acemoglu and Robinson (2000). The latter is technically difficult, so the advice as usual is to make sure you understand the underlying logic and not spend to much time on the mathematics.

NB! Because of the technical difficulty of A&R, this text is also moved to a “semi-core” status in the curriculum, but you should definitely read it! Boix is moved to core curriculum instead!!

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Boix 2003, Ch 1. Three regime types: Democracy, left-wing

authoritarian, right wing authoritarian Two crucial independent variables: Income

inequality, mobility of capital assets Politics and interest conflict between groups,

material motivation. Regimes and political power distribution have implications

for economic distributions. Actors know this and take optimal actions on regime change, given constraints

Main results: Low/medium levels income inequality and asset

specificity (high mobility of cap), political strengthening lower classes democracy

High levels income inequality and asset specificity: revolutions, civil wars, repression continuation right wing authoritarian regime or introduction left wing authoritarian regime

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Boix cont’d Crucial assumption for model: No credible

commitments possible, if these commitments are not in self-interest in next round of game: Subgame perfection Higher classes cannot promise to redistribute to avoid

democratization, and lower classes cannot promise to tax lightly to gain democracy. These assumptions drive results, and you can find them again in A&R

Each round of the game: new generation, no utility for welfare of other generations. But historically given regime and economic structure initially in each period of the game, that resulted from earlier generations’ actions.

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The model Two groups: wealthy (w) and poor (p), poor

make up a share α>1/2 of population K=Kw + Kp, and production is a linear function of

capital, denoted in per capita terms (lowercase letters) for each group: yj = kj, where j is either w or p. When moved abroad, capital looses a share of its

value: y=k(1-σ); more specific capital larger σ capital loses more of its value abroad. Financial capital: low σ, Oil resources: σ=1?

Utility functions are linear: Uj = E(yj) – cj, where cj is the cost of the political system

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The model cont’d Right wing auth: poor excluded from system, rich set

tax to maximize their utility (low tax!) Democracy: median voter decides tax-rate: linear tax-

rate (τ) which applies for all, revenue is distributed equally among all..(everybody gets τ multiplied by average capital per person, which is 1, τ)

Marxist/left-wing auth: Poor expropriate all capital from rich and divide among themselves

Welfare losses from taxation (tax distortion) given by τ2/2

Therefore under democracy, the median voter, which is poor, maximizes (1- τ)kp/α + τ - τ2/2 (own income after tax subtracted+

redistribution from tax – welfare loss). Poor sets optimal τ BUT: Median voter might set lower tax if there is risk that

rich will move capital abroad: a typical maximization under constraint problem

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The model cont’d The poor median voter will set high tax if:

Large income inequality (much to gain from redistribution)

Low capital mobility (rich cannot threaten credibly to move their capital abroad)

Thus, the rich will loose more from democracy in these instances.

What the rich can do to fight off the poor: investment in repressive capacity, ρ. Cost of repression can take high or low value (stochastic). High value Not possible to fight off poor. (collective action problems among the poor, organization, type of supporters, geography etc)

What if revolution/ciwil war breaks out? If high cost of repressionpoor will win and expropriate everything that cannot be moved: yp =kp +σkw – ω (ω: cost of war)

Rich win: yw =kw – ω and yp=0

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We now have a game! What will happen under full info? Both parties

know who will win from war, but if rational and given perfect foresight do not want war, since waste of resources. Result: No war, but strongest party wins or maintains political power.

But when information asymmetry, both might rationally choose to fight (underestimate power of the other..) Empirical implication: Updating of imperfect

information and the timing of civil war, revolutions, democratization waves etc: An interesting explanation. What did people in Romania learn from democratization in other East European countries about the strength of the Ceausescu-regime?

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The game tree.. Payoff wealthy payoff poor

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Equilibrium of the game depends on exogenous conditions

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IF low inequality or asset specificity democracy independent of repression cost

IF medium level inequality and specificity Democracy IF high repression cost Repression IF low repression cost. No revolt, because

poor knows that under these conditions the rich would not repress if they were not strong Right-wing regime

IF modestly high level inequality and specificity Repression and acceptance right wing regime (poor

do not know if high or low repression cost, but low enough probability of high repression cost so that accept and do not dear to gamble)

IF very high level of inequality and specificity Likely that we can have repression and war, but no

optimal strategy for the rich if costs of repression high. Try to fake low costs sometimes..

Some empirical issues

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Big landowners and resistance to democratization (high asset specifity: cannot move land and high inequality). Russia, Prussia, Central America, Southern US

If agrarian economy: must have high equality for democratization to be a prospect, Norway as example.

Industrialization, Moore’s bourgeoisie, low level of asset specificity smaller threat of expropriation increased probability of democratization (Britain)

Other issues Oil and asset specificity: why rich oil countries are authoritarian

(much to loose from democratization) contrast with Welzel et al.: no broad modernization no emancipative values in these countries even though high GDP per capita

Globalization and capital mobility more democratization Small countries: easier to take capital and move higher

probability of democratization If repression costs up for low ineq/spec countries more

democratization. If costs up for (very) high ineq/spec countriesmore revolutions

3 actors: the role of the middle class

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Movement to limited democracy when middle class increases in strength with industrialization. Co-optation of middle class from upper class rather than repression

Movement to universal suffrage if income becomes more equal, middle class has less to lose..

Less easy for working class to threaten its way to democracy if scattered (ethnically or otherwise divided)

Multiple sectors and sectoral alliances (rather than class-based): Industrialists and industrial labor vs landowners for example. Lipset-Rokkan and urban-rural cleavages..Reason: variability of capital mobility.. Possible to extract from landowners only

Acemoglu and Robinson

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Why did elites in Western countries extend the franchise?

Strategic decision by elites to prevent revolution (or social unrest with its negative productivity effects more generally). In a “first-best world” for the elites, they would not have extended the franchise

Non-credible promises of redistribution under limited franchise democratic government as a credible solution!

Actors have material objectives, distribution affected by regime, just like in Boix’ model..

Some notes

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Two groups: elites and citizens (alt. rich and poor) Regime-types: right-wing dictatorship and

democracy (+ left-wing dictatorship) In democracy: Median voter determines policies In right-wing dictatorship: Elites determine policy Question: Why do elites democratize? Answer: the

alternative is worse.. Institutions as commitment devices! When opportunity for revolution is present, it is

not always sufficient for elites to just redistribute (bread and circus) in that period, because poor know that they will not keep on redistributing once revolutionary threat is gone..

Some results from the model in the 2000-paper

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Elites might opt for democracy voluntarily, even if taxed highly. Want to avoid revolution

Counterintuitive result: A well organized opposition democratization less likely! Now redistribution in future is credible because the revolutionary threat is likely to be there also in the next period(-s). Why did Bismarck institute the first welfare programs? The threat of the

German socialists.. (Bismarck was a rational actor!!) Inequality:

Very equal societies may not democratize because little social unrest (note: but only if actors are motivated merely by material gains, which they are in this model) Taiwan and South Korea land reforms and reduced revolutionary threat kept

authoritarian regimes for a long time More unequal society: difficult to credibly redistribute without

democratization Very unequal societies: might have revolution even if democracy is

offered Notice the different effects from inequality on democratization between

this model and Boix’ model; what drives these differences? (time horizon, possibility to redistribute credibly, sequencing of events/actions..)

An explanation of the Kuznets curve

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The Kuznets curve. Inequality increases in income at low income levels, but starts decreasing after a certain level of development is reached

Beginning of industrialization: low income inequalities and rich rule. As time goes by, the rich accumulate capital higher inequality After a while, high inequality and threat of revolution becomes large enoughexpand franchise median voter (poor) sets tax rate poor start accumulating capital inequality decreases

Income inequality as an EFFECT of regime type. Empirical evidence in favor of the democratization

explanation of the Kuznets curve (see paper)

Empirical evidence and alternative theories

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Britain, the threat of revolution and franchise extension “in 1831, the prime minister Earl Grey said "There is no-one more

decided against annual parliaments, universal suffrage and the ballot, than am I ... The Principal of my reform is to prevent the necessity of revolution.... I am reforming to preserve, not to overthrow” (p.1182)

France Germany, and the strong socialist movement credible

commitment to redistribution and no democratization Sweden and extended franchise after Russian revolution and

economic crisis Alternative theories

Enlightenment theory Social values change among elites (Welzel et al..) argued by A&R to

be relevant for female suffrage Political party competition

possible alliances with new voters who are grateful for being granted rights

Middle class drive Middle class changes balance of power in their favor when including

workers

PART II: The economic effects of institutions

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Douglass North ch 12 Institutions as the underlying determinant of long run

economic performance/development: Dynamic vs static focus on the economy

The reason perfect rationality assumption works well for modern Western markets are the low transaction costs. This is a historical exception higher transaction costs and opacity procedural rationality as most appropriate behavioral assumption Acknowledge complexity of human motivation and

cognitive processes Success stories: where you have had institutional

innovations that have reduced transaction costs expanded areas where specialization and exchange in markets are possible: Lower TC ability to capture more of the gains from trade

North Ch 12 cont’d

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What political conditions allow for such economic institutional innovations, crucially including well-specified and secure property rights, and the possibility of compensating losers from economic change so that they won’t block it? Answer: Democracies with universal suffrage

But: Many problems even here: better is different from perfect. Principal-agent problems and asymmetric info, rational ignorance by voter etc..

Efficient markets are difficult to develop: require institutional conditions that are difficult to obtain (both formal and informal)

Incentives for production or for grabbing/predation? If it is beneficial to be a pirate, people will invest in

becoming good pirates. PRIVATE and SOCIAL benefits from action alligned?

North ch 12 cont’d

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We know that certain policies are bad for development, but why are these chosen in the first place? Focus on political-economic conditions that generate such policies are necessary.

Also, the importance of path dependent processes in analysis of institutions (we have already discussed this..)

Britain and Spain compared: What happens when the relative price of war goes up with new technology (16th centrury)? King needs money. How did this affect the two countries? Very divergent effects.. Spain: Centralization of power, expropriation from certain

groups, loan default, policies with disincentives for productive activity

Britain: Parliament and balance of power, security of property rights, development of judiciary, loans repaid, opening private capital market, incentives production and innovation

Initially, the conditions were more favorable in Spain, but structure of political systems generated diverging paths with Britain eventually more successful.

Democracy and property rights (from lecture 3) Democracy and property rights, positive effects. Who

guards the guardians under autocracy: The role of checks and balances, and the importance of having “vested interests” protecting the system of PR (Olson, 1993).

Dictators might violate PR because a) in their own interest or b) in their important backers’ interest (North, 1981).

An example: The King, the Parliament and loans in 17th Century Britain vs Spain, France (absolutist monarchies). Credible promises! Why would a King not confiscate in the future

even if he promises not to do so? (North and Weingast, 1989) Availability of capital to King in Britain (low interest rates),

because of Parliament’s role: The King could not confiscate in t+1. Spanish and French Kings could confiscate and default because of concentrated power

The importance of making promises credible allows exchange over time: How to devise institutions in a way that makes promises credible

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North Ch 13

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Why stability in some instances and change in others? Change from traditional self-sufficient villages

Stage 1) Geographical trade and specialization Stage 2) Specialization within communities, reaping

benefits from economies of scale, urbanization Stage 3) From Agriculture Industry Services (as

dominant sectors); modern society Which institutions allow for this specialization and

complex exchange? Stage 1) social norms within community no longer

sufficient devise institutions for measurement and enforcement (common units of measurement, contracts etc), networks (kinship ties etc)

Stage 2) creation capital markets, the manufacturing firm as institution, secure property rights

Stage 3) High transaction costs development of the transaction sector (finance, banking, law, formal regulation, etc)

North Ch 13 cont’d

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But why was this process followed in Western Europe and not other places? Because learning and skills required in this environment

induced creation of more sophisticated institutional structures. Organizations innovate better institutional structures further incentives for innovation of new technologies. Innovations that 1) increased mobility capital, 2)lowered

information costs, 3) spread risk Crucial factor that allows for institutional and

technological innovation that reduces transaction costs: Legal institutions and judicial enforcement especially with regard to contracts and property rights. Without this: No incentive to innovate (private gains are

uncertain or small even if social gains are high) KEY POINT: In general, institutions that reduce the

discrepancy between private and social return to activity generate incentives for innovation and productive activity.

Acemoglu et al (2001)

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How do institutions affect economic performance?

Empirical investigation. The endogeneity problem: Economic

performance affects institutions (“rich countries choose or can afford better institutions”) Solution: 2SLS Instrument for good institutions: settler mortality

rates among colonialists Main result: Insitutional structures have an

enormous impact on economic performance (income per capita here), explains much of the variation in economic performance among ex-colonies.

Acemoglu et al cont’d

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What institutions? Focus on institutions that protect property rights. Incentives for

production rather than predation. Political institutions that curtail government-induced distortions and expropriation.

Three premises: 1) Different colonial policies: Some places, extractive institutions

set up, institutions devised only for grabbing resources (Leopold in Congo as the worst example!) Other places: “Neo-Europe”. Institutions set up that protect property rights and checks and balances on government created

2) Colonization strategy depended on feasibility of settlement: “If we are going to live here, let’s make us some good institutions. If not, we just want to make sure we can extract resources!”

3) Institutional inertia and relatively high degree of persistence colonial institutions. New institutions are costly to set up New elites after de-colonialization often had incentives to keep

extractive institutions Complementary investments by different actors (+ other path

dependency arguments)disincentive for institutional change

The basic story and the empirical strategy

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(potential) settler mortality settlements early institutions current institutions current performance

Empirical strategy: use settler mortality rates as instrument for institutions today Settler mortality explains 25% of the variation in the

institutional index used, which is the Political Risk Service’s “risk of expropriation” index: Instrument correlated with X-variable.

The crucial premise for the empirical strategy: factors correlated with settler mortality (the instrument), other than institutions, cannot have (large) effect on current performance (see note on 2SLS)

Therefore: The long discussion on the effects of malaria and yellow fewer and the differential impacts on Europeans and locals. If disease environment economic performance, then some trouble for Acemoglu et al

OLS on expropriation risk and income

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Settler mortality and expropriation risk (first stage regression relationship)

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2SLS (IV) results

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Some comments to the empirical tests

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Institutions explain a very large share of variation in income example: according to 2SLS estimates, improving Nigerian

institutions to the level of Chile’s7-fold increase in Nigerian GDP, whereas empirical difference was 11-fold in 1995

2SLS yields larger parameter estimates than OLS. Given that income better institutions, we would have expected the opposite, since 2SLS takes away this causal effect. Interpretation: 2SLS also takes away random measurement

error in x-variable (institutions) attenuation bias existent in OLS-estimates disappears

Colonizer’s identity not as important as others believe. Although robustness checks show that British colonies perform better, the effect is much smaller when we control for settler mortality.

Other robustness checks that leave the basic results standing Percentage Europeans in population, legal origin, climatic

variables, disease variables, health variables, soil quality, landlocked countries, ethnolinguistic fractionalization

Baseline

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Institutions matter, and they matter a lot, for development

There is institutional inertia, but there is hope: institutions can be changed

Political institutions economic institutions development