Democratic Governance and

Economic Development
GDLN Lecture Series on Governance

Dongil Lee
KDI School of Public Policy and Management

March 12th

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Outline

1. Introduction
2. Why Democratic Governance?
3. Commitment Problems
4. Empirical Evidence?
5. Key Takeaway

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Instructor: Introduction

• PhD in Political Science at New York University

• Tenure-track Assistant Professor at KDI School
• Chair, Global Governance and Political Economy (GP) concentration
• Co-organizer, KDI School–World Bank DIME Development Impact conference
• Find more info about me via dongillee.com

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Outline

1. Introduction
2. Why Democratic Governance?
3. Commitment Problems
4. Empirical Evidence?
5. Key Takeaway

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Why Democratic Governance?

• Why do international donors care so much about democratic governance?

• Why do you think they do?
• Please share your thoughts using the survey below:
• Please go to POLLEV.COM/DLEE050
• Instructor: click HERE

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Why Democratic Governance?

Why do they care about democratic governance?

1. Ideological reasons: ideological/political reasons to promote democracy

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Why Democratic Governance?

Why do they care about democratic governance?

1. Ideological reasons: ideological/political reasons to promote democracy
2. Intrinsic values: moral and ethical reasons to support democracy

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Why Democratic Governance?

Why do they care about democratic governance?

1. Ideological reasons: ideological/political reasons to promote democracy
2. Intrinsic values: moral and ethical reasons to support democracy
3. Instrumental values: practical benefits and outcomes of democracy

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Figure: Democracy fosters economic development.

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Key question

Does democratic governance foster economic development? If so, how?

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Key takeaway

• Why do they care about democracy?

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Key takeaway

• Why do they care about democracy? → It’s good for economic development
• Why do we expect its positive effect?

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Key takeaway

• Why do they care about democracy? → It’s good for economic development
• Why do we expect its positive effect? → It solves the commitment problem
• Do we have empirical evidence?

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Key takeaway

• Why do they care about democracy? → It’s good for economic development
• Why do we expect its positive effect? → It solves the commitment problem
• Do we have empirical evidence? → Yes, evidence supports the expectation

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Figure: Can you guess which countries we’re looking at?

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Figure: North vs. South Korea
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Economic divergence

Two Koreas were the same country about 70 years ago

• South Korea: $44,200 (2021 est., GDP per capita) ≈ United Kingdom
• North Korea: $1,500 (2015 est., GDP per capita) ≈ South Sudan

South Koreans are roughly 30 times richer than North Koreans!

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Economic divergence

What determined long-term economic divergence b/w two Koreas?

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Economic divergence

What determined long-term economic divergence b/w two Koreas?

• Geography/Natural environment

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Figure: Guns, Germs, and Steel by Jared Diamond

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Economic divergence

What determined long-term economic divergence b/w two Koreas?

• Geography/Natural environment
• Culture/Religion

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Figure: The Protestant Ethic and the Spirit of Capitalism by Max Weber

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Economic divergence

What determined long-term economic divergence b/w two Koreas?

• Geography/Natural environment
• Culture/Religion
• Economic and political institutions

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Figure: Why Nations Fail by Acemoglu and Robinson
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Democracy and Development

Why North Korea so poor and South Korea so rich?

• S. Korea: Inclusive institutions (democratic governance)
• N. Korea: Extractive institutions (nondemocratic governance)

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Democracy and Development

Inclusive and extractive institutions (0:39-1:47)

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Democracy and Development

Inclusive institutions
• Economic institutions (e.g., secure property rights)
• Political institutions (e.g., power subject to constraints)

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Summary

Why do they care about democratic governance?

• Because democracy is good for economic growth.
• Divergence between North and South Koreas.
• S. Korea had inclusive institutions (democratic governance).
• Secure property rights
• Power subject to constraints
• Those institutions help to solve commitment problems.

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Outline

1. Introduction
2. Why Democratic Governance?
3. Commitment Problems
4. Empirical Evidence?
5. Key Takeaway

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Example: Foreign direct investment

• Developing countries need investments from foreign firms

• The possibilities of nationalization =⇒ underinvestment of foreign firms
• They fear that the state will nationalize their investment once it becomes profitable
• Firms will not invest the extensive capital necessary to buy land or build a factory
• Governments cannot credibly commit to not nationalize foreign companies

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Example: Foreign direct investment

(a) YPF (b) Repsol

• In 2012, the government of Argentina nationalized YPF

• YPF was the largest energy company in the country
• A majority of its stake was owned by the Spanish company, Repsol

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Example: Foreign direct investment

• In 2011, Repsol found vast reserves of shale oil in Neuquén province

• Argentina became a net oil importer for the first time in decades
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Example: Foreign direct investment

Figure: President announces the bill to nationalize YPF

• Politicians saw an opportunity to take control of a valuable economic resource

• And, claim credit for turning around the oil industry

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Example: Foreign direct investment

• Extracting shale oil requires both expertise and capital

• The best way for Argentina to do so is through partnership with foreign oil
companies
• But they were reluctant because they were fearful that their assets might suffer
from the same fate as Repsol’s
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Example: Foreign direct investment

• Gov’t’s inability to credibly commit to respect property rights of foreign firms

• It led to slow progress in developing shale oil and gas in Argentina

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Commitment Problem

• Party A: foreign oil companies

• Party B: the Argentine government

1. Party A could take an action that would benefit both himself and Party B
2. However, Party A anticipates that, in the future, Party B will have the power to
exploit him
3. As a consequence, Party A doesn’t ever take the initial action

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Commitment Problem

• This is a social dilemma because of the possibility of a socially efficient outcome

• If Party B could credibly commit not to exploit her future power, Party A would
take the action, and they’d be better off
• Party B’s inability to credibly commit yields a socially inefficient outcome

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Historical contexts

• Commitment problems exist for all investors

• Foreign investors’ fear of nationalization (by autocrats)
• Domestic investors’ fear of confiscation (by kings)
• All investors face such political risks
• Commitment problems exist across different polities with varying degrees

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Historical contexts

Figure: Argentine president who nationalized the YPF

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Historical contexts

Figure: English king who exploited investors/merchants

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Historical contexts

• Those almighty leaders could say whatever they want.

• Suppose investors make fixed capital investments (buildings, machinery, and
equipment).
• Then, the power balance shifts in favor of the leaders.
• Those leaders can always confiscate (nationalize) those hard assets.
• Most importantly, there’s nothing preventing them from doing so.
• The leaders cannot credibly commit not to exploit the investors in the future.
• As a result, investors do not invest as much as they could.

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Historical contexts
What if the hands of Kings were tied? (i.e., power subject to constraints)

Figure: Glorious Revolution (1688)

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Historical contexts

Glorious Revolution in England (1688)

• Absolute monarchy → limited monarchy
• Before 1688, kings had arbitrary and confiscatory power
• After the Revolution, they had to obtain parliamentary consent to those behaviors
• Parliament represented wealth holders (investors)
• The institutional change put a check on the kings’ ability to exploit

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Historical contexts

Glorious Revolution and Economic Development (0:00-2:53)

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Commitment Problem

• The commitment problem exists in all domains of economic activities

• Without constrained power and protection of property rights, you have no incentive
to be “creative”
• Suppose you have the creativity and talents of Thomas Edison
• But you live in a country where dictators can easily steal your creative idea–say, a
light bulb.
• Then, you have no incentive to put your time and effort into a new invention
• Even if dictators promise that they will respect your rights, it is not credible
• In other words, they cannot credibly commit not to exploit your intellectual right

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Contemporary contexts

Rule of Law and Economic Incentives (1:24-3:19)

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Summary

Why does democratic governance lead to economic development?

• Inclusive institutions
• Secure property rights
• Power subject to constraints
• They solve commitment problems!
• Under democratic governance, the hands of political leaders are tied.
• When leaders say “we will respect your property rights,” their commitments are
credible.
• Investors will invest their money and collect its economic return.

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Outline

1. Introduction
2. Why Democratic Governance?
3. Commitment Problems
4. Empirical Evidence?
5. Key Takeaway

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Is there Empirical Evidence?

Stylized facts
• Average growth rate is higher in democracies.

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Figure: Economic Growth Distributions (Besely & Kudamatsu 2007)
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Is there Empirical Evidence?

Stylized facts
• Smaller variation in growth rate across democracies.
• Larger variation in growth rate across nondemocracies.

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Figure: GDP Growth Rate and Democracy (Polity IV) 1960-2008
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Is there Empirical Evidence?

Stylized facts
• Among autocracies, there are extreme cases on both sides
• Highly successful: China, Singapore and a few others.
• Highly unsuccessful: Many more.

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Is there Empirical Evidence?

How about other welfare outcomes?

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Is there Empirical Evidence?

Stylized facts
• Democracies do much better in providing healthcare.
• Democracies do slightly better in providing schooling.

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Figure: Life Expectancy Distributions (Besely & Kudamatsu 2007)
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Figure: School Enrollment Ratio Distributions (Besely & Kudamatsu 2007)
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Key takeaway

• On average, democracy does better than autocracies in economic growth.

• Higher level of economic growth.
• More stable and predictable growth.

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Summary

• In theory, democratic governance solves commitment problems

• We expect that it would promote economic development.

Do we have empirical evidence that democratic governance leads to economic

development?

• Average GDP growth rate is higher in democracies (with smaller variation).

• Democracies do much better in providing health care.
• They do better in providing schooling.
• No famine has ever taken place in a functioning democracy.

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Outline

1. Introduction
2. Why Democratic Governance?
3. Commitment Problems
4. Empirical Evidence?
5. Key Takeaway

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Key takeaway

• Why do they care about democracy? → It’s good for economic development.
• Why do we expect its positive effect? → It solves the commitment problems.
1. Economic actors will realize their full potential
2. This is because of the protection of property rights and constrained power
• Do we have empirical evidence? → Yes, evidence supports the expectation.
1. Democracies show a higher economic growth rate
2. Democracies promote the well-being of their citizens

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