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The Political Economy of Development

BY SERGEI GURIEV 17/04/2016

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In recent decades, economists have come to an agreement on what policies promote economic development. Protection of property rights, rule of law, effective market competition, macroeconomic stability, and openness to foreign direct investments – all of these benefit economic growth. The emerging consensus, however, immediately raises the question as to why many countries do not follow such policies.

 

The answer is very simple: political economy. In many developing countries political institutions are structured in such a way that policies that benefit the general public are not necessarily the ones that benefit the ruling elites. At first glance, it may sound strange: if there is a policy that increases the size of total GDP, why wouldn’t it be chosen by the ruling elite? Can’t the elite develop a mechanism that distributes the gains of the GDP growth in such a way that all parties – both the elite and the general public – benefit?

 

Unfortunately, the answer to this question is often negative. The explanation is straightforward: reforms that promote the protection of private owners from the state, an independent judiciary, competition and openness empower the middle class and may increase the probability of the political change. The ruling elites understand that good policies increase GDP. However, they also understand that these policies raise the chance that the elites will lose their hold on power and hence will not be able to enjoy the benefits of the economic growth. Hence they prefer stagnation to growth.

 

If the regime’s opposition could strike a deal with the elites on compensating them for giving up power, a straightforward application of the so-called Coase theorem would assure a win-win solution. As reforms would result in a higher GDP, they would raise the welfare of every citizen. However, as Daron Acemoglu argues in his eponymous 2003 paper “Why not a political Coase theorem?”, what works in economics does not necessarily work in politics. In economics, the Coase theorem assures that if property rights are well-defined and there are no transaction costs of bargaining, parties will consensually prefer the outcomes that maximise their total welfare. Assets move from less efficient owners to ones who make better use of them – and those who give up their assets are compensated in a mutually beneficial exchange. However, in politics, the subject of bargaining is the power of setting the rules itself, and those who give up power no longer believe in the credibility of the new elites’ promises to compensate their counterparts. Of course, in countries with strong political institutions this does not have to be the case – a change of the ruling party does not result in a change of the rules. However, in non-democratic regimes it is impossible to commit to preserving the rents that the ruling elites used to enjoy.

 

Other factors that aggravate the problem of suboptimal policy choices in non-democracies are resource rents, state monopolies and inequality. If a country is abundant in natural resources, the elites that capture resource rents have higher stakes – they have more to lose from reforms and therefore have stronger incentives to resist growth-promoting policies. The same argument applies if the elites control state monopolies. Finally, inequality matters as well. If inequality is high, the regime can choose policies that  redistribute from the middle class to the poor, instead of pro-growth reforms that will empower the middle class. Since the support of the poor is relatively cheap, such policies pay off.

 

These arguments highlight the risk of a vicious circle. If a country has weak economic and political institutions, the ruling elites may prefer resisting reforms that can improve either the economic or political system. Such change would threaten the elites’ hold on power. The longer such elites stay in power, the less likely the country is to experience growth in its middle class, reduction in inequality levels, increased levels of competition within industries and diversification of the economy. This, in turn, reinforces the incentives of the elites to preserve status quo.

 

However, just because a country is at risk of entering a vicious circle does not necessarily mean it is doomed to a future of permanent decline or stagnation. Eventually, the public comes to understand the true cost of bad institutions and policies, which leads to regime change. Also, it often happens sooner rather than later, as non-democratic rulers are prone to making mistakes. However, the modern political economy of development (or, rather, of under-development) does help us understand why many countries are still not on the right track.

Article solicited and edited by Aleksandr Khodov 

SERGEI GURIEV

is the Chief Economist at the EBRD, a Professor of Economics at Sciences Po, Paris and Research Affiliate at the Centre for Economic Policy Research (CEPR), London. He is also a Co-Editor of the Economics of Transition, and a Panel Member of the Economic Policy.His work has been published in international refereed journals, including American Economic Review, Journal of European Economic Association, and the Journal of Economic Perspectives.

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