Does Democracy Drive Growth? Can China Succeed Without it and India Prosper Under it?

The 20th Century has undoubtedly been the century of democracy. The past 100 years have seen democratic government move from being an anomaly for modern states to being the rule, with the number of democratic countries in the world increasing from under 10 in 1900 to over 120 in 2007, covering nearly 60% of the world’s population. The fall of Communism late in the 20th century was seen as the final triumph for liberal democracy and the capitalist economic system it supported. However, in the minds of many, China’s economic rise over the past 30 years cast doubt over the superiority of democratic government, at least with regards to creating economic growth and prosperity, its own brand of state capitalism having delivered decades of double digit GDP growth. India in contrast stood as a developing country that failed to demonstrate the economic growth from its democracy. Today, developing countries appear to have the choice to reject liberal democracy without rejecting economic growth, by following China’s authoritarian-based development model. However, the question of democracy and the role of freedom in economic growth has resurfaced as China sees its own growth slowing and struggles to once again re-invent its economy while preserving its authoritarian political institutions. In contrast, India’s growth has started to increase under its new leadership. Understanding freedom’s impact on economic development appears to once again be critical for both the likely economic trajectory of major economies such as China and India and indeed for the continued growth of democracy in the world, which at least in Western minds, is not just an economic growth enabler but also a fundamental human right.

Do Democracy and Freedom Drive Economic Growth?

This seemingly straightforward question has sparked much debate and analysis, which has typically sought to separate the impacts of democracy (defined as "a system of government in which all the people…are involved in making decisions about its affairs” ) from that of freedom. In terms of the former, strong arguments have been voiced both in favour of and against democracy’s impact on growth. Its supporters point to the developed world and the OECD in particular, arguing that only democracies have to date created post-industrial economies and societies. Its detractors point to China, who under authoritarian leadership has embarked on one of history’s most amazing development feats, and to countries such as India, which despite (or because of, they argue) its democracy has suffered from low growth for much of its modern history. Logical arguments about democracy’s impact or lack thereof on growth support both sides of the debate. Supporters of democracy point to the accountability it creates for leaders and the checks and balances on their power that it instils in addition to democracy’s broader promotion of fundamental human rights and the dignity of the individual, which are (more or less) universally recognised as worthy goals in and of themselves. Democracy’s detractors on the other hand point to the distorting effects that elections give rise to, ranging from a skewed focus on short-term priorities over long term needs to the undemocratic impact of special interest groups shaping government policy.

While it is clear that democracies (and politically free) states are on average richer than authoritarian and unfree states, studies that have tried to statistically quantify democracy’s impact on economic growth, have been inconclusive .This is should be no surprise given the complexity in separating cause and effect in topics related to social science and impact of variables other than freedom impacting economic growth. In broad-based studies, authoritarian states include the majority of the world’s high growth oil states, while the democratic states include among others African states at the time of their independence, then lacking the basic institutions required to ensure security, stability and development.

More straightforward however, is the question of economic freedom on economic (GDP) growth, which has been clearly demonstrated. The key transmission mechanisms whereby economic freedom drives growth include the creation of strong institutions (including property rights, the rule of law and free markets), a focus on creating and unlocking value from human capital and the reduced importance of government consumption in the economy. Some combination of these factors, if not all of them, have been critical components to the successful economic development of every major economy in the world during the past 50 years. Importantly, these growth promoting economic freedoms are not necessarily accompanied by political freedoms or democratic government: Chile and South Korea (not to mention China), for example in the early phases of their development implemented economic freedoms under authoritarian regimes and still grew successfully as a result. Further, as the events of the Global Financial Crisis has shown, economic freedom, particularly an excess of freedom in the form of a fundamental lack of regulation, can have high economic costs, enabling extreme cycles, market bubbles and subsequent crashes. However, despite big swings, these freedoms also create systems of enterprise that are self-balancing and end up putting the country and its people back on an upward trajectory of growth, which explains their enduring success (and the corresponding failure of communist economic planning).

While democracy’s statistical impact on economic growth may remain uncertain, economic growth’s impact on democracy is clear, and strongly positive. The increased standards of living that result from growth (which are a result of economic freedoms) invariably drive demands for political rights too, and only a few countries have been able to resist the demands of its citizens for political reforms over the long term. What is less clear is what happens to growth once these political reforms and freedoms are implemented and whether democratic transitions on balance hurt or help further economic growth, especially in the short term. “Hindsight shows us that the Western political system…would have been incompatible to a country where efficiency has driven remarkable economic growth and social development”
Xinhua, Mar-2014

“Strong growth … especially China, has given the misleading impression that authoritarianism is good for business.”
Freedom House, Aug-2015

Understanding this relationship is critical to understanding the economic value of democracy, (its fundamental value as a fundamental human right aside). Is democracy a “luxury good” that, while valuable for its own sake, can only be afforded past a given level of national wealth or is it a required cost in ensuring sustainable growth above a certain level of development that virtually all countries need to make? The answer to this question likely depends not only on what happened to GDP growth after democratisation but also on at what levels of GDP the transition itself took place at. History has shown that democratisation in the absence of strong institutions and a base of economic performance has led to serious economic and political disruptions and even regime failure in some cases (e.g. post-colonial Africa and certain former members of the USSR). What is more, the process of democratisation by revolution and mass uprising can destabilise existing institutions, thereby depressing economic development and undermining the political reform process itself, as the lessons of the Arab Spring in countries such as Egypt demonstrate. This is by no means to say that the choice of people to rise up en masse is not a legitimate part of the process of social-political change; it is to recognize that it can lead to economic and political setbacks and unintended consequences. The key questions to ask therefore are (i) where along the development curve does the pressure to democratise sustainably build up, (ii) whether democratising at this stage drives or restricts further GDP growth and (iii) how long do the adjustment pains last after which one can expect the trajectory to continue to be an upward one.

These questions are highly relevant to both India and China: India has (many believe) paid a high price in the past for being a democracy, and the key questions for it are whether and where along its own development curve the hoped for “democratic dividend” will kick in. China on the other hand has for a long time enjoyed economic success from having implemented many of the economic policies and (to a lesser extent) freedoms that help growth while continuing to run an authoritarian political regime. Given the dramatic shift down of China’s economy, markets and currency, for China observers (if not China itself), the question of the value of democracy to continued prosperity and when the demand for democracy is likely to be at critical or irresistible point is critical, given that successive leaderships have appeared to be committed to maintaining the political status quo indefinitely, regardless of economic development levels and growth considerations.

When Do States Democratise?

What is undeniably true is that there are only a few examples of developed and at least moderately wealthy countries that are not democratic and politically free. The table below captures all of the countries with GDP/capita levels above US$7,500, and compares economic prosperity with political freedom. While this does not provide an indication of when and how countries have democratised during their development, it does show that the pressure towards political liberalisation has been resisted by only a small number of well to do countries.

A closer look at the undemocratic outliers above reveals their being in one of two groups, either resource rich states (e.g. the Gulf States and other oil producers) or countries that have delivered consistent and a few nations with long-term high economic growth (e.g. China, Turkey, and to a lesser degree Singapore).Resource-rich states of course either directly own the natural resources in question or generate the majority of their tax income from them, making them less dependent on, and receptive to its citizens’ wishes, impacting the balance of power between state and society. However, the Arab Spring has demonstrated that this cannot be taken for granted indefinitely, particularly in states with large young and increasingly well connected populations with access to information. High growth states, on the other hand, have a powerful currency in the form of increasing household wealth that they can offer its citizens in exchange for continuing to forfeit increasing political freedom. The former of these models is of course dependent on the continued production of natural resources, while the latter model is dependent on delivering consistent and on-going growth. The table on the right captures the long-term growth rates and effective resource dependency of the outliers, indicating their grouping in one or the other of these categories.

Given the above, for a majority of countries democratising is not really a question of if, it is one of when. Making predictions about the timing of political reform by empirically comparing countries that have democratised at different times, in difference places and under different circumstances is challenging given the context and number of variables involved. For every Franco or Syngman Rhee, where democracy movements emerge after the leader’s death, there is a Pinochet, who led the transition himself. For every Czech Velvet Revolution, bloodless and successful, there is a Tiananmen Square. However, limiting the analysis to countries that successfully transitioned to democratic regimes while in the midst of rapid economic expansion leads to a much smaller set of comparables. Taiwan, Chile and Korea all moved from single party authoritarian regimes to multi-party democracies peacefully and without major socio-economic dislocations. Importantly also, the transformation processes themselves were orderly in nature and mainly due to the gradual build-up of pressure from demands by increasingly educated and well-off populations. The non-disruptive nature of these countries’ transitions make them good comparables for both the timing of their transition and its impact on economic growth. As the table on the left shows, these states initiated the reform processes when GDP/capita levels (on a purchasing power parity basis, reflecting the relative domestic wealth of the countries) reached US$4,000-6,000 per capita.

On this basis, China, with a current GDP/capita level of nearly two to three times this level, has clearly succeeded in managing democratisation pressure for nearly a decade, based on a combination of continuous high economic growth (yielding US$3.7 trillion of reserves that stand as a well from which to meet citizen demands) and aggressive policies against demands for political reforms. Lessons from other countries however show that in the absence of growth, repression alone may not enough. In the Arab Spring, repression itself in many cases was one of the triggers of the revolution, e.g. in Egypt and Tunisia, where protestors took to the street to demand freedom of speech and political reform in addition to in addition to addressing unemployment and economic conditions. In Asia, too, the failure to deliver growth has driven popular regime change. Suharto ruled Indonesia single-handedly for 31 years with the support of a complacent middle class benefitting by his economic policies, only to be toppled in the wake of the Asian Financial Crisis. GDP growth, which averaged 8% annually from 1980-1997, had contracted by nearly 12% in the year before his ouster. While China is clearly not facing an imminent collapse of this magnitude, it has seen GDP growth rates halved during the past five years, reducing the effectiveness of the government’s carrot to its citizens and, in the absence of handouts (which it if it chooses it can well afford), increasing the pressure to wield the stick more tightly than before.

After Democracy: What Happens Next?

Having (hopefully) successfully democratised, what happens next, economically speaking? Does the rate of GDP growth in- or decrease with political liberalisation? Empirically, the number of countries that have undergone a democratic transition in the past 50 years is large, with the portion of the world that is democratic increasing from 25% in 1960 to over 60% today. Assessing the impact of democracy on growth therefore depends on the selection of appropriate benchmarks. While the collapse of the Soviet Union and the Warsaw Pact saw the creation of no less than 15 states that are today categorised as democracies or hybrid regimes , all of these states underwent significant economic transitions from planned to market economies during their political reform processes, and given the variations in their implementation don’t provide a like for like comparison for pre and post democratisation growth. More relevant as comparables are the countries that democratised at a time when they were already broadly economically free, following more or less consistent economic policies through their period of political reform, making Chile, Korea, and Taiwan the most appropriate benchmarks again. Looking at a chart comparing the five year average per capita GDP growth rates before and after democratisation for each of these countries shows that growth actually remained broadly flat, easing a little in the case of Taiwan and Korea, who were growing at double digits, and expanding in the case of Chile. This growth consistency is significant given the tendency of economic growth to slow over time with increasing industrialisation and development, which further supports the conclusion that introducing of democracy further underpinned and supported the economic trajectory the countries were on. Importantly, the continuity of growth these countries experienced also points to the fact that democratic transition processes, if managed in an orderly fashion, need not create even short term growth dislocations.

Perhaps even more telling than the absolute impact of democracy on growth is its impact relative to that of authoritarian regimes in similar circumstances. reforms). The chart below tracks the median annual GDP per capita growth for the above democratising countries for a period of five years before and after reform, and compares this to median growth of authoritarian countries (China, Vietnam and Turkey) before and after crossing US$5,000 GDP per capita (the average level at which the other groups kicked off For both groups, growth after crossing the US$5,000 GDP per capita level remained constant, regardless of whether they introduced political reforms or continued authoritarian policies. Interestingly, the countries enacting political reforms were the higher growth performers of the two groups. While not statistically significant given the small number of countries used the comparison, this result on reflection is logical, as increasing development over time changes the structure of the economy. As industrialisation becomes comprehensive and wealth increase, so do production and labour costs, driving a shift in the focus of growth from mass production to services, consumption and value add, with a greater focus on innovation, all which are areas where countries with authoritarian regimes lag behind democracies. While the above of course does not conclusively prove the need to political reform at a given level of wealth nor the benefits of doing so for all countries, it does provide instructive lessons for developing nations such as India and (potentially) politically evolving countries such as China.

Conclusion: What This Means for India and China

Open and free societies are better at facilitating the free flow of good services people and information required to create post-industrial societies capable of sustained growth, as demonstrated in previous Sign of the Times, including “China and the Freedom Advantage” (April 2012) and “China’s Changing Competitiveness” (April 2014). Following a 30 year bull-run, China’s investment led growth model appears to have reached its limits and the country’s economic slowdown has been quick to follow. Growth in fixed asset investment has gone from 30% p.a. a few years ago to 12% currently. There is simply not enough left to (economically) build in China in terms of new infrastructure, despite the fact that much of the country’s existing infrastructure is already ageing and due for renewal . Further, its position as the world’s factory is eroding with rising costs and increasing competition. For China the question is not of getting back to 10% growth, it is of making the transition to the next stage of development with a new model of growth. While it is true that economic balancing in China is happening, albeit very slowly and gradually, this is more due to a “Only democracy - having the capacity to question itself - also has the capacity to correct its own mistakes.”
Adam Michnik
drop in exports and investment rather than to the growth of consumption and innovation. Until China achieves the sustained growth from innovation, it is unclear how far the current rebalancing will go, and as growth bottoms out, it is also unclear where continued optimism will come from for the population of investors. Given, only politically free countries have been able to support sustained long-term innovation and consumption growth and given the pace of economic and structural reforms in China already appears to be flagging, the country’s leaders will need to resort to more radical measures to restart its economy. It remains to be seen therefore, how long political reform, perhaps the most radical measure of all, can remain off the table.

For India, democracy and freedom seem enshrined in the culture and the political systems of the country. India’s people seem willing to forego economic growth for fundamental human rights. And even PM Modi, who some herald as a Chinese style dictator, has been measured in the concentration of power to the centre. In fact, India’s states are being used as the lever to implement economic growth. The positive impact to date on growth is encouraging. The maligned Hindu rate of growth of under 2% (per capita) lagged far behind its most common comparator, China. However, India’s low growth can be well explained by the country’s socialist economic policies from independence through 1991, including central planning, restrictions on scale of industry, government-controlled licencing, trade restrictions, a closed financial system and an outsized public sector. It is telling that GDP/capita growth in the 30 years before the 1991 economic reforms (aimed at addressing the issues above) averaged 1.9%, while growth since then has averaged 4.8%. Another telling comparison is that of India and Pakistan, two countries which share a common history as well as many structural issues relating to human capital, including low rates of literacy and low female workforce participation but different in many aspects but particularly with one being democratic and one with a legacy of authoritarian regimes. Since 1991, Pakistani GDP/capita growth has lagged far behind India’s 4.8%, expanding at an average of 1.8% annually.

While India’s current level of GDP per capital at $5,800, is likely not yet at the level at which democracy appears to become a requirement for further growth (compared to China, where growth rates started to decline when GDP per capita hit US$8,500 in 2010) it is today clearly getting closer to reaping the democratic dividend. Further, India has decades ago put in place the economic and political freedoms required for longer-term innovation led growth, with the tech sector being the country’s largest private sector employer. “The ultimate aim of government is not to rule, or restrain by fear, nor to exact obedience, but to free every man from fear…In fact the true aim of government is liberty.”
Baruch Spinoza
India’s near term priority bias is therefore less focused on the promotion of more freedom but increasingly on the continued delivery of good governance and the support of institutions underpinning economic growth generally. As India in the past has shown, its democracy alone does not drive efficient markets, fight corruption, implement market driven policies or improve regulatory efficiency.Prime Minister Modi appears to have recognised this and made it his government’s mission to drive efficient and effective government while seeking to permanently break away from the low historic growth that has plagued the country for much of its independent existence. Today India is indeed set to become the world’s fastest growing major economy for the remainder of the decade, at least. More action will be required of course, to solidify these gains and create a more permanent foundation for India to deliver long term growth as an industrialised and diversified economy.

What is encouraging is that transition to democracy largely appears to be a one way street. There are far more instances of dictatorships transitioning to democracies than the other way around, and the few states that do readopt authoritarian regimes typically do so following great economic, social or political disruptions (or even by coup d’etat) rather than through peaceful transitions, (e.g. Putin’s rise in Russia or the introduction of military rule in Thailand.) Citizens, unsurprisingly, in other words, appear to clearly prefer democracies over dictatorships. While many of us take freedom and democracy for granted as a moral and political right, authoritarian regimes have refuted (or quashed) these arguments when raised by their own citizens. The Arab Spring has shown both the appetite for freedom in recent times and the perils to the people of demanding it without the right institutions in place, and even more so in the face of an armed and determined dictator. Having shown themselves impervious to moral and legal arguments for freedom, it is hopeful that dictators over the long run will be more susceptible to economic arguments for the same. While Syria may not offer that hope, the world’s nations have certainly learned that in today’s highly interconnected world, the consequences of a dictatorship that does not support the people’s demand for freedom can quickly lead to civil war and failed states, whose citizens end up on the doorstep of their neighbours, which in turn challenges the economies and institutions of their neighbours and the world at large. The need to avoid this cost promises to occupy analysts and policy makers on what it takes to avoid this level of dislocation and suffering and the collateral damage caused by failing states on the rest of the world and this in turn holds the possibility to redefine new international rules of conduct.

The world should not hold its breath for a change in China any time soon though, even though the lesson above will certainly not be lost on China’s leaders, who have been excellent in their systems analysis of how societies and economies work. US$3.7 trillion of reserves goes a long way in buying time to figure out how to make change in a very long-term and very Chinese way.

Notes:-

1. Oxford English Dictionary

2. One meta-study (Brunetti, 1997) found that among 17 empirical studies “nine studies report no relationship, one study a positive, one study a negative, three studies a fragile negative relationship and three studies a fragile positive relationship between democracy and economic growth”

3. Economist Intelligence Unit Democracy Index 2014

4. See the March 2015 Sign of the Times: “The China Dream: Beyond the Purge, Arresting Decay”

5. See the March 2014 Sign of the Times: “12% Growth Agenda: A Blueprint for India’s New Government”, August 2014: “Unleashing India’s Industrial Potential: Building a Globally-Competitive Manufacturing Base” and September 2015: “Creating Growth Through its States, How India Can Become A Long Term Driver of Economic Growth”