For Publication in Marc Plattner, ed., International Relations and Democracy (Washington, DC: forthcoming)
“I think that. . . it may be asserted that a slow and gradual rise of wages is one of the general laws of democratic communities.” Alexis De Tocqueville, Democracy in America, 1835.
“The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.” John Maynard Keynes, The General Theory of Employment, Interest, and Money, 1935.
Does economic openness strengthen or weaken emerging democracies? The existing literature provides no clear-cut answer, asserting that the relationship between openness and democracy can take two divergent routes. Along one path, openness promotes growth which, in turn, contributes to the development of democratic institutions.2 Along another, globalization causes economic disruption, income inequality and job insecurity, leading to lower growth and social conflict, which in turn threatens the stability of weak or fledgling democratic states.3
We argue in this article that the key determinant of which path prevails depends on domestic institutional factors; institutions in which the international community should take a strong interest. Specifically, we focus on the effectiveness of institutions for compensating workers whose jobs or incomes are threatened by economic opening, which, as Paul Samuelson argued as early as 1948, has considerable distributive effects on the domestic factors of production, creating new patterns of winners and losers. In developing our argument, we seek to refine Dani Rodrik’s claim that “[s]ocieties that benefit the most from integration with the world economy are those that have the complementary institutions at home that manage and constrain the conflicts that economic interdependence triggers.”4 While we accept that view, it is our contention that the effectiveness of institutions cannot be understood apart from the domestic political context in which they are situated. Drawing on recent empirical work in political economy, we argue that direct transfer mechanisms have provided, at best, only partial compensation to the losers of globalization and that the more effective, from the political standpoint, institution-building in emerging democracies will focus on the development of capital markets, including human capital markets. Increasing and appropriately targeting direct investment in such markets will increase the opportunities available to disadvantaged segments of society to finance their own or their children’s education and to obtain capital for entrepreneurial activities.
These findings, we emphasize, have important implications for emerging democracies and the advanced industrial states that wish to support their development. If these states lack the efficient capital market institutions that enable workers (and, equally importantly, their families) who have been displaced by economic change (e.g. openness) to transform themselves into long-run winners, then the losers are likely to seek redress through rebellion and other activities that threaten the stability of the fledgling democratic states both directly and through creating a climate that is unfavorable to investment and sustained economic growth. In this sense we strongly share the observation made by A. B. Wolfe in 1944 that “democracy can be summed up as equality of opportunity. . . Democracy is perhaps epitomized in the whole modern trend away from rigidity of status to freedom of opportunity. . . Here, economics and ethics walk hand in hand (italics added).”5
The paper is organized as follows. In the first three sections we trace the causal logic associated with the most prominent schools of thought regarding the relationship between openness, growth and democracy. The fourth section examines the argument that efficient capital markets can contribute to the stability of democratic institutions. In the conclusion, we draw some lessons for both the academic and policy communities, focusing on the role of international assistance in promoting capital market development.
Openness, Growth and Democracy
In classic economic theory, the relationship between economic openness and growth is straightforward. Countries that adopt free trade policies and accept the division of labor implied by the principle of comparative advantage will liberate the factors of production and enable them to work with greater efficiency. As a result, these countries will produce and consume more than they could under a protectionist regime. We emphasize that, ceteris paribus, from the standpoint of Ricardian trade theory, the adoption of free trade makes economic sense from a domestic welfare perspective no matter what policy is adopted by potential trading partners.
For additional reasons that were largely overlooked by classical theory, international trade has a positive effect on growth beyond the “one time” efficiency gains associated with economic opening. According to Mancur Olson’s seminal argument, sustained growth in democracies could be stifled by the lobbying activities of special interest groups, which seek to eliminate competition in their efforts to monopolize and cartelize national markets. Professional associations, for example, seek to provide rents to their members, and these small, concentrated groups have a more compelling self-interest in winning profits than diffuse consumers have in preventing them. As a result, such rent-seeking activities lead to the capture of economic activity by quasi-monopolists who thereby rid themselves of the necessity to compete. Over time, the economy inevitably becomes sclerotic, as reflected in falling growth rates. The classic case of this phenomenon, according to Olson, was provided by 20th century Great Britain, though these rent-seeking models have been influential in our understanding of the political economy of transition economies such as Russia, as well.6
The opening of an economy to flows of trade, investment, and people, in contrast, acts to break the power of these special interests. As Olson writes, “if there is free international trade, there are international markets out of the control of any lobbies... Free trade undermines cartelization of firms, and indirectly also reduces monopoly power in the labor market...”7 To be sure, “free trade alone is not enough” to break domestic monopoly power, but in “combination with other policies” it can play a powerful role.8 In sum, free trade promotes growth through its direct effects on the division of labor and its indirect effects on would-be rent-seekers.
The second part of the openness argument, and one more relevant for our purposes, holds that the growth generated by openness (among other factors) contributes to the strengthening of democratic states. This insight has its origins in Seymour Martin Lipset’s observation of the correlation between wealth and democracy, a finding that has received strong support in subsequent empirical studies (notwithstanding some important exceptions, including India and Bangladesh).9 Indeed, given the amount of research devoted to this finding, it is surprising that its theoretical foundations--that is, a causal explanation of the relationship between wealth and democracy--still remain weak.
Perhaps the most ambitious attempts to provide empirically supported causal stories for the wealth-democracy connection have been made by Richard Posner and Robert Barro. Posner’s argument purports (with some success) to show that higher levels of median income bring about greater political stability. The key reason for this is that wealthier countries are better able to support a strong criminal justice and internal security system.10 In a similar vain, Robert Barro maintains:
With respect to the effects of economic development on democracy, the analysis shows that improvements in the standard of living-- measured by a country’s real per capita GDP, infant mortality rate, and male and female primary school attainment--substantially raise the probability that political institutions will become more democratic over time. Hence, political freedom emerges as a sort of luxury good.11 The underlying argument, which has strong parallels in economic analyses of the emergence of environmental standards and labor rights, is that with rising incomes people become more willing--and more able--to buy such things as clean air, better working conditions, and democratic governance. It suggests that consumers have a hierarchy of needs, starting with the necessities of life and moving upwards towards such luxury items as political freedom. Joined with the above mentioned arguments for the beneficial effects of free trade on economic growth, this model leads us to believe that we ought to place greater faith in market processes, for over time these will, as if by an “invisible hand,” produce political outcomes in the form of democratic regimes. In sum, free trade promotes democracy.
Free Trade, Domestic Politics, and Social Welfare
Market processes, however, are often mediated by existing political conditions and institutions, and as a result, do not always operate in such a benign manner. Moreover, being a quintessentially utilitarian doctrine, free trade is predicated on the goal of maximizing aggregate output and consumption, irrespective of the substantial distributive effects within or between countries. As we argue below, these features of international political economy produce consequences that are too serious to ignore.
The basic theory underlying the distributive effects of free trade was initially formulated by Paul Samuelson in 1948 with his “factor price equalization” (FPE) theorem. According to FPE, two economies that adopt a policy of free trade will find (given certain assumptions) that the returns to the factors of production in each country will tend towards equalization at some intermediate point.12 This work was built on an earlier theorem, due to Samuelson and Wolgang Stolper, that asserts that if protection is used to raise the domestic price of goods, the return to the factor used intensively in its production will increase. It also follows that if protection is abandoned, the prices and returns will decrease. The important point is that trade between rich and poor countries may result in lower wages for unskilled workers in the rich state.
Pressed further, FPE suggests that economic opening may lead to highly undesirable consequences for both aggregate economic welfare and prospects for democracy. First, the extent to which openness promotes growth will depend on the degree to which countries in the North are able to maintain their commitment to free trade policies over time. The existing welfare transfers in most advanced industrial countries, as generous as they may be, provide displaced workers with only partial compensations for their income losses.13 Indeed, even assuming the best intentions, structuring well-targeted income transfer programs has proven elusive, due to the perverse incentives associated with providing full compensation (e.g. it encourages all workers to identify themselves as “losers”). As a result, threatened by free trade with developing countries, workers (and capitalists) in the industrial states have tended to seek protection in the form of such policy-destabilizing activities as tariffs and non-tariff barriers such as quotas on imports. The case of “tariff escalation” against refined agricultural products from the developing world (e.g. higher tariffs on instant coffee than on coffee beans) or the sugar cane quotas provide particularly egregious examples of this phenomenon.
Second, these barriers, in turn, reduce the growth prospects for countries in the South, since they are unable to enjoy the dynamic gains from trade associated with technological progress and growth. The relationship between such growth reductions and democratization becomes clear when we consider that the empirical evidence strongly supports the existence of an “income threshold” effect, which suggests that countries are considerably more likely to democratize or remain democratic after they have achieved a certain level of average per capita income.14In short, to the degree that trade protection in the North has real income effects in the South, it will slow or prevent the attainment of the level required for democratization.
If the industrially developed countries are to maintain their free trade policies, mechanisms must be found to compensate the losers. This suggests one set of reasons for the emphasis of domestic fiscal policy on capital markets, with their dynamic, inter-temporal effects and potentially greater economic efficiency. Formulated as a working hypothesis, the weaker the domestic capital markets, the more difficult it will be for the governments of the North to promote free trade and hence the dimmer are the prospects of democracy in the South.
As in the North, free trade may also result in rising income inequality in the South, the direct economic and political effects of which we will consider in some detail later. The reasons, however, do not follow from FPE analysis, but instead focus on the role of technological change. One of the key traditionally lauded effects of opening less developed economies to the world market has been the transfer to such economies of new and more efficient production technologies. These technologies, however, are likely to have a “skill bias,” which rewards workers who possess the skills needed to operate the equipment, while leaving others by the wayside. Indeed, the welfare of the less skilled may actually decrease under the new policies. By virtue of their greater efficiency, the imported technologies increase the supply of output, in turn, driving down its unit price and jeopardizing the livelihood of those who continue to produce similar commodities with the less efficient technologies. Given that opening the country to the global market increases the probability that prices on other goods would move in the same direction, these effects are only exacerbated.
As Donald Robbins shows in a pioneering paper, technology transfers that take place between North and South are, indeed, positively correlated with increased wage dispersion among workers in the receiving country; as technology transfers flow to the South, labor markets become increasingly segmented into winners and losers.15 Robbins’s empirical findings are further echoed by recent economic theories which are more ambivalent concerning the effects of trade on development than neo-classical models. 16
It bears emphasizing that even where trade theoretically contributes to economic growth—e.g. owing to technology transfer—the distributive effects of technology accumulation on factor returns may in fact work to undermine its contribution to good performance. To the extent that free trade causes fundamental changes in the returns received by the factors of production, and especially by labor, the prospects of a backlash against the political-economic policies and institutions that promoted the liberalization agenda in the first place loom progressively larger. The potential of such a backlash, following the one-time eliminations of rents previously enjoyed by labor under protectionism, to degenerate into the sociopolitical instability may be particularly threatening in emerging democracies. It is this rationale that has led numerous analysts (e.g. David Cameron, Peter Katzenstein, and Dani Rodrik) to emphasize, from a positive standpoint, that openness and public expenditure for welfare state policies (e.g. income transfers) are highly correlated in the advanced industrial economies, and scholars like Rodrik to argue, from a more normative perspective, that social safety nets ought to accompany the move toward liberalization in developing countries.17 However, despite its seeming reasonableness, the political-economic difficulties associated with extracting the resources needed for knitting such safety nets, make this recommendation ring hollow in many fledgling democracies around the world. We consider the evidence for and the nature of these difficulties in the following two sections, in the context of a more general discussion of the effects of economic inequality.
Economic Inequality, Democracy and Growth
We have thus far suggested that the shift to free trade may result in greater inequality in both industrial and developing countries, and that, in so far as it actively diminishes the welfare of some segments of the population, it could provoke domestic political resistance leading to the return to protection against imports and even to sociopolitical instability. We have also noted the effects of protection on the rates of growth and hence on democracy. But what are the direct effects of economic inequality on growth and democracy? Because the potential political significance of coalitions opposing free trade may critically depend on the response of those members of the middle and lower segments of the income and wealth distributions whose welfare is not changed or is even slightly improved by economic openness, this question deserves independent attention in the context of our paper, side by side with the consideration of the immediate response of those who are actively disadvantaged. Put differently, in the analysis of its effects on growth and democracy, economic inequality should be seen as both an intermediate cause (itself, in part, an unfortunate consequence of free trade) and an independent intervening consideration which contributes to the determination of the full effects of free trade.
We address the effects of economic inequality through the lens of endogenous growth theory (EGT), which has gained considerable currency in macroeconomics in the last decade and which offers a more balanced approach to the relationship between democracy and growth. A key advantage of EGT models is that they focus our attention on the domestic political-economic response to the effects of economic and technological change. In this way they are in a unique position to help us understand the complex relationships between openness, growth, domestic institutions (especially capital market institutions) and political stability in democratic states. The EGT models we consider below point to the possibility of a negative relationship between economic performance and changes in factor returns resulting in an increasingly unequal distribution of income, which we identified as one of the unfortunate domestic consequences of trade liberalization. Against the background of such consequences, EGT’s strong association of higher inequality with sociopolitical instability, and hence with lower growth, helps explain the unfortunate, if inevitable, conclusion that the “relationship between growth rates and indicators of openness... is weak at best.”18 It also suggests a very sanguine, although, as we argue in the concluding section, potentially constructive, view of the relationship between free trade and democracy.
EGT has yielded two approaches--usually held to be competing, but which we will argue should be seen as complementary--to conceptualizing the relationship between income distribution and economic growth: “endogenous fiscal policy” and “sociopolitical instability.”19 While these approaches are in agreement, supported by extensive empirical work,20 with the basic claim that greater income inequality leads to lower growth, they differ in their analysis of the underlying political mechanisms that generate this outcome.
For their part, proponents of endogenous fiscal policy approach21 argue that income inequality induces the median (decisive) voters, located in the middle quintiles of income distribution, to affect the policy redistributing the income away from the upper income groups who, in open economies, generally correspond to the immediate winners of the open-borders policy. From an economic perspective, however, since it is the wealthy who have the highest propensity to save (and thus to invest), taxation will have distortionary effects inhibiting investment and hence the resulting rates of economic growth. We might further note that, in a “global economy,” any significant effort to “soak the rich” is also likely result in capital flight, again with the effect of reducing domestic resources for investment. The model thus posits that income inequality leads to redistribution, which in turn leads to lower economic growth.
The sociopolitical instability approach associated with EGT,22 which posits a direct link between economic inequality and the sort of political violence just mentioned, provides a mirror-image perspective to endogenous fiscal policy. It states that instability, captured in such indicators as politically motivated protest demonstrations and deaths from political violence, is the inevitable and immediate consequence of sharply skewed income distributions--as may result, for example, from the sudden opening of a country to free trade. Sociopolitical instability, in turn, creates an environment of uncertainty, discouraging investment in the country. Not only does it lead savers to withdraw their funds and send them abroad (capital flight, as occurs today in many developing and transition economies), but it causes the government to invest in police and military forces, which are economically inefficient. Again, the net result of inequality is instability leading to slow or negative growth and hence, given the above-mentioned relationship between growth and democracy, to weaker democracy.
The causal link between economic inequality and political instability is almost certainly mediated by the differing expectations of future income streams held by the rich and poor. Specifically, the poor in developing countries have relatively low expectations regarding their ability to acquire greater human capital over time, and thus of their capacity to adjust to economic change, owing to the high wealth elasticity associated with education and with the ability to borrow liquidity to invest in an entrepreneurial venture. In the absence of efficient capital markets which tend to be considerably less wealth-elastic, for the poor, the prospects for the future associated with the pursuit of regime-preserving strategies differ little from their grim current conditions. As a result, we are more likely to see them resorting to the politically destabilizing strategies culminating in political violence. This fact distinguishes the developing countries from the advanced industrial democracies, where public access to capital markets is significantly more open, offering wider career choice (and opportunities for children), economic efficiency and-- we would argue-- greater political stability.23
It is interesting to note in this context that John Maynard Keynes, in writing of 19th century Europe, observed the phenomenon that might be construed as quite the opposite of the predictions of either type of the endogeneous growth theories mentioned above, stating that “it was precisely the inequality (italics in original) of the distribution of wealth that made possible those vast accumulations of fixed wealth and of capital improvements which distinguished that age from all others.” What prevented domestic revolution, he argued, was a tacit social contract between rich and poor, in which the wealthy saved and invested for the benefit of the community as a whole.24 What he did not say, however, is that in 19th century England (and elsewhere in Europe), there was a considerable degree of social unrest, which ultimately provoked political reforms that gave workers the franchise and increasing access to educational opportunities.25 The tacit social contract, therefore, was enforced in part by the threat (and indeed the presence) of violence.
The macroeconomic literature has treated endogenous fiscal policy and sociopolitical instability as two logically distinct approaches, and thus their respective empirical tests have been interpreted as at once a wholesale refutation of one and a vindication of the other.26 But their conceptual implications are linked to one another in a way that, in the context of examining the relationship between democracy and the open economy, places a high premium on their consideration in tandem.
Indeed, the most plausible rendering of sociopolitical instability is as a conditional complement to the redistributive policies envisaged by the defenders of endogenous fiscal policy. That is to say, the one outcome (instability) is most likely associated with the absence of the other (redistribution). Which of these two outcomes prevails in practice will be determined by the extent to which government policies are responsive to the demands of the median voters. The available data, which strongly indicate that governments’ decisions to redistribute income away from the upper quintiles do not correspond in any significant way (in either most developed or developing countries) to changes in the distribution of income, should thus be taken as a statement about the extent to which political regimes may be relied on to forestall internal sociopolitical instability.27 Note that this fact suggests that governments may successfully label themselves “democracies” without providing equity of opportunity to the majority of their citizens.
This finding, of course, is perfectly consistent with the literature on collective action. Assuming that median voters prefer signaling their attitudes via the “usual channels of political representation” than by costly protest activity (participation in which is highly correlated with the income of the median voter), we may infer that the better organized interests of the upper income strata have generally been successful in counteracting the pressure from lower-income groups to redistribute their wealth. The realities of pluralist politics, which reward the better organized and the better resource-endowed groups, thus hardly warrant the confidence of the international community in the ultimate willingness of domestic political institutions in fledgling democracies to compensate the immediate losers of such potentially welfare-enhancing policies as free trade. Note that this inference is only strengthened by the realization that governments, at best, have a short-term electoral horizon and therefore would prefer immediate fixes to their political problems (such as income transfers) to long-term investment (such as in human capital markets).
Given this political-economic constellation, it appears that the forces acting against the development of “good policy” in emerging democracies are, indeed, quite powerful. As the World Bank has observed, “Although the recipe for good policies is well known, too many countries still fail to take it to heart, and poor performance persists. This often signals the presence of political and institutional incentives for maintaining ‘bad’ policies. Policies that are bad from a development perspective are often highly effective at channeling benefits to politically influential groups.”28 Efforts to redistribute income away from the upper quintiles are thus likely to prove frustrating, while taxing the poor is fruitless. But to leave the story here would be to provide little more than a counsel of despair.
As we argue below, escaping from this trap probably requires significant assistance from the international community, particularly for supporting human capital markets. Before asserting this policy conclusion, however, it is important to review briefly the current state of knowledge regarding the relationship between openness, growth and human capital markets in the developing world. After all, if no case can be made for a correlation between education, labor market performance and economic growth, then our call for greater investment in this sector will obviously ring hollow.
Openness and the Development of Capital Markets
While today it may be widely accepted today that educational attainment and growth (and thus democracy) are causally linked, that has not always been the case in the economics literature. As Gary Becker has written, “The early literature on human capital did not formalize the relationship between development and human capital investment.” In contrast, recent work is paying significant attention “to human capital as an engine of economic growth.”29 As our discussion of EGT suggests, we would argue that such claims must be mediated by an understanding of domestic political factors.
In economics, discussions of the role of trade and education in development have a near identical ring to them. For example, trade has also been called an “engine of economic growth” by economists. But the effects of trade and education on development and democratization are neither simple, straightforward, nor mutually independent. As we noted in our discussion of the effects of sociopolitical instability--caused by inequality--on democracy and growth, political and economic outcomes in fledgling democracies are best seen as being mediated by access to capital markets. Indeed, owing to the critical role of this mediation, we may say that the degree of investment in and access to capital markets, especially human capital markets, plays a determinative role in a country’s trade and growth prospects, and hence its likelihood of strengthening its democratic institutions.
We note that the empirical evidence suggests the presence of very different country experiences in this regard. According to the World Bank, “Some countries have successfully combined openness and investment in learning and education, forming a virtuous circle: openness creates demand for education, and learning and education make a country’s export sector more competitive.”30 Examples of this positive trend would be drawn most prominently from East Asia, at least prior to the financial crisis of 1997-98 (and it is interesting to note that the countries least touched by the crisis, such as Taiwan, would seem to be those where this relationship holds most strongly). Yet in other countries, especially those in Africa and Latin American, it appears that the relationship between openness, education, and growth has become vicious rather than virtuous.
For example, the Inter-American Development Bank states that the “low returns to basic education” in regions like Latin America “may reflect the influence of globalization through a number of conduits. The incorporation of China and other less developed countries into world trade may have exerted adverse pressure on earnings for workers with only a basic education...And combined with macroeconomic policies, trade liberalization in Latin America seems to have fostered the adoption of technological change that has displaced labor demand...”31
From our perspective as political-economic analysts of democratization, the tragedy is that it is precisely these “blue collar” workers who have the least access to the higher education they so desperately need if they are to remain competitive in the global economy. This provides a chilling example of how globalization and education might fuel a vicious circle. But the answer to breaking this circle will not be found in simply throwing money at the education establishment; to the contrary, “the distribution of education matters.”32
Unfortunately, the available data on educational expenditure in developing countries do not give much reason for optimism from either the perspective of absolute effort or from the distributive angle. To take some country cases where the statistics are available, educational expenditures fell between 1980 and 1992 in El Salvador (from 3.9 to 2.2 percent of GNP), Bulgaria (4.5 to 4.2), Malaysia (6.0 to 5.3), Mali (3.8 to 2.2), and Zambia (4.5 to 1.8). Of all developing and transition economies, only three (Kenya, Ukraine, and Yemen) spent more than 7 percent of GNP on education; for the world as a whole the figure was 5.2 percent, or only slightly more than the 4.4 percent spent in 1980; these figures hardly indicate a major commitment of public expenditure. Incidentally, education has obviously not been the big winner of the post-Cold War peace dividend, which saw military expenditures for the world nearly halve from 5.2 to 2.8 percent of GNP during the 1980-1995 time horizon.33
From the distributive perspective, the evidence to date from developing countries, especially in Africa and Latin America, suggests that the benefits of education are being captured by a relatively small number; that is, by the “winners.” That, we would emphasize, is not a promising finding for those concerned about democracy qua equity of opportunity. There appear to be significant differences in levels of educational attainment depending upon one’s income level and one’s gender. Further, UNICEF reports that public expenditure is not targeted at basic education, despite the evidence that this delivers the highest economic returns. Instead, “many countries continue to focus on higher (tertiary) education to the detriment of primary and secondary levels.”34
Who are the beneficiaries of that spending on tertiary education? Certainly not the most needy. For the developing world as a whole, the poorest fifth of the population receives only 3 percent of public expenditure in tertiary education, while the richest fifth receive almost 70 percent. In short, the incidence of education, especially as one reaches higher levels of attainment, offers no evidence of redistribution; to the contrary, it is clearly the rich who benefit from public spending.
With respect to Africa, the data show that “the gains in access to education have been unevenly distributed.... In many countries the poor get much less than their fair share of government spending on education.” As examples, in Ghana, the richest 20 percent of households receive 45 percent of state subsidies to tertiary education, while the poorest fifth get only 6 percent. In Malawi the distribution is even worse, with the corresponding figures being 59 percent and 1 percent.35
Latin American provides similar if slightly less dramatic evidence. According to the Inter-American Development Bank, “In most countries of the region, education is more poorly distributed than one might expect...”36 This becomes especially apparent as the level of education increases. For example, whereas 94 percent of poor children in South American complete their first year of primary education, only 63 percent make it through the fifth year and less than 15 percent through the ninth year. As a result, the IADB concludes “Latin America’s poor educational distribution is not the result of problems of initial access for the poor to the education system. It results instead from high and more rapid dropout rates among the poor. Latin American school systems are quite stratified as a result, and do not constitute a mechanism for social mobility or for reducing income differences...” (italics added).37 That is not a promising finding for those who card about the democratic future, defined in terms of equity of opportunity.
The Role of the International Community
So what is to be done? We would argue that foreign assistance can and should play a critical role in promoting investment in capital market development in fledgling democracies, and that this investment should be targeted at the “losers” from economic and technological change--those who are least advantaged. Indeed, these programs should be part and parcel of international economic policies designed to promote greater opening; for as we have seen opening that produces inequality will threaten growth and the strengthening of fledgling democratic regimes. In short, trade policy must become sensitive to the domestic politics of the emerging democratic states.
That will obviously require both an increase in aid funding and a redirection of allocated amounts. While we recognize the immense political challenges that face both these developments, we believe that a strong case for this strategy can be made. After all, to the extent that the advanced industrial states are truly committed to promoting democratization around the world, for reasons of both economic self-interest and national security, then this investment should be seen as both moderate and prudent.
Clearly, the spending trend for foreign assistance at present is not promising. Official development assistance (ODA) by the major industrial countries reached its postwar high of $70 billion in 1991. Since that time, it has tumbled to insignificant proportions, largely because of decreased spending by the United States; while the U.S. Economy constitutes 30 percent of the industrial world total, its aid contributions represent less than 17 percent of all official flows traveling between “North” and “South.” As a result, the member-states gathered in the Development Assistance Committee (DAC) of the OECD recently judged “the current level of American aid as inadequate...”38
Overall, the advanced industrial democracies now allocate less than 0.25 percent of their Gross National Product on foreign assistance, or fifty percent less than they provided at the outset of the 1990s. It is hard to think of any other program, domestic or international, that has suffered such reductions. The end of the Cold War on the one hand, and renewed fiscal pressure on the welfare state on the other, have basically doomed aid budgets everywhere.
At the same time, perceptions about the utility and effectiveness of aid spending will need to be changed before there is any significant shift in public support. The polling data taken by the aid organizations themselves reveal widespread skepticism about the efficacy of aid programs; the belief that such funds “go down a rat hole” is widely held by the public. With that in mind, a major step in the right direction by the aid community is provided by the World Bank’s recent report, Assessing Aid. That report is brutally honest about the errors that have been made in the past, and circumspect about future promises. Nonetheless, the report provides clear evidence that it is possible to target aid and make it more effective in supporting the goal of greater opportunity, especially for the least advantaged.
Specifically, the World Bank has found the following with respect to program effectiveness:39
First, foreign aid succeeds when it compliments domestically sound economic policies. That is, it can help promote overall growth and the expansion of individual opportunities in those countries that pursue macroeconomic stabilization and structural adjustment measures. It should be emphasized that the effect of such assistance “is large...1 percent of GDP in assistance translates into a 1 percent decline in poverty and a similar decline in infant mortality.”
Second, in such reform-oriented settings, aid and private investment are mutually supportive; contrary to commonly held beliefs, there is no evidence that aid “crowds out” the private sector. There are several reasons for this positive relationship between aid and investment. For foreigners, the presence of official development assistance often provides “comfort” that donor nations are engaged with governments in the reform process, and will put pressure on any government that seeks to extort funds from private investors or to nationalize their holdings. For domestic investors, aid that supports infrastructure and institutional development makes the local setting more attractive and promising over the long haul.
Third, aid in the form of technical assistance can increase the capacity and capability of state actors. Not only can it be used to help countries import effective policies in such areas as health care, education and environmental management, but by providing advice about how to make more efficient use of inputs it can also expand the range of outputs. As a result, higher quality public services end up reaching more and more citizens.
What these points suggest is that, going forward, aid must be better targeted both with respect to recipients and feasible projects. Aid should be targeted not only at those countries that are committed to economic reform, but more specifically at governments that are also committed to expanding education and work opportunities for the least advantaged. All too often, as the World Bank admits, educational expenditure in developing countries has “not always reached groups that have traditionally had low levels of education (the poor and girls, for instance).”40
One strategy the Bank advocates in this respect is further decentralization of educational expenditure. Indeed, this is associated with the broad movement toward fiscal decentralization around the world. This strikes us as a promising development only to the extent that the case can be made that local governments are more responsive to the needy than are central governments. The jury on that particular question is still out.
Still, the evidence to date bears careful examination. According to a study of three World Bank programs of decentralized educational expenditure in El Salvador, Pakistan, and Brazil, the results have been impressive. “In each case decentralizing and involving civil society led to improvements in public services--specifically the broader availability of schooling to disadvantaged groups.”41 Whether these gains are “one-shot” or sustained remains to be seen; and in this respect we would emphasize that, while giving “civil society” a greater voice in policy-making is certainly consistent with democratization as we define it, some non-governmental organizations that pose as representatives for women, the poor, or other groups are often less transparent than governments themselves!
More broadly, our discussion leads to the conclusion that the World Bank, International Monetary Fund, World Trade Organization and major bilateral donors ought to reexamine their economic programs and policies in light of the connections we have drawn between openness, growth, and democracy. The received wisdom provides an optimistic view about the evolution of the political economy, teaching that open markets promote efficiency, which produce growth and, ultimately, democracy. But that outcome, we have sought to demonstrate, is critically mediated by domestic political institutions which may capture the gains from trade for an elite, denying the majority of citizens equity of opportunity. That is not substantive democracy as we have defined it, and in all too many countries a “vicious” as opposed to a “virtuous” circle of economic development has been established. Breaking that circle, and transforming the former into the latter, will certainly require the good work of courageous leaders within domestic societies, but without foreign assistance their best hopes for the democratic future are unlikely to be realized.
1 Ethan B. Kapstein is Stassen Professor of International Peace, and Dimitri Landa is a Ph.D. Candidate, in the Dept. of Political Science, University of Minnesota.
2 See, for example, Robert Barro, “Democracy and Growth,” Journal of Economic Growth 1: 1-27, 1996.
3 See, for example, Dani Rodrik, Has Globalization Gone Too Far? (Washington, DC: Institute for International Economics, 1997).
4 Dani Rodrik, “Globalization, Social Conflict and Economic Growth,” processed, 11 December 1997, p. 8.
5 A.B. Wolfe, “Economy and Democracy,” American Economic Review 34 (March 1944): 1-20, at 5.
6 Mancur Olson, The Rise and Decline of Nations (New Haven, Ct.: Yale University Press, 1982); on the transition economies, see Anders Aslund, Peter Boone, and Simon Johnson, “How to Stabilize: Lessons from Post-Communist Economies,” Brookings Papers on Economic Activity 1 (1996): 217-291.
7 Olson, Rise and Decline of Nations, p. 142.
8 Looking at the recent wave of cross-border merger and acquisition activity, however, not to mention the history of cross-border cartels, one might argue that Olson was overly optimistic about the competitive powers unleashed by free trade.
9 For a review, see Samuel P. Huntington, The Third Wave (Norman, OK: University of Oklahoma Press, 1991), pp. 59-72.
110 Richard Posner, “Equality, Wealth and Political Stability,” Journal of Law, Economics and Organization 13 (1997).
111 Barro, “Democracy and Growth,” pp. 23-24.
112 For a good review of the debate over FPE, see William Cline, Trade and Income Distribution (Washington, DC: Institute for International Economics, 1997), pp. 40-41.
113 For a recent review of the evidence, see Louis Jacobson, “Compensation Programs,” in Susan Collins, ed., Imports, Exports and the American Worker (Washington, DC: Brookings Institution, 1998), pp. 473-523.
114 Huntington, Third Wave, pp. 59-72.
115 Donald Robbins, Evidence of Trade and Wages in the Developing World (OECD Development Center Technical Papers, no. 119), December 1996. See also Inter-American Development Bank, Facing Up to Inequality in Latin America (Washington, DC: IADB, 1998), p. 46.
116 Dani Rodrik, The New Global Economy and Developing Countries: Making Openness Work (Washington, DC: Overseas Development Council 1999), p. 25.
117 Rodrik, The New Global Economy and Developing Countries, p. 98. In what follows we express some skepticism, however, about the proposition that effective compensation to the “losers” (e.g. workers) actually takes place. Domestic political realities constrain government policy, while international efforts to assist the liberalization process (e.g. through foreign aid) in emerging states tend to support the domestic status quo, meaning the “winners.” See Peter Boone, “The Impact of Foreign Aid on Savings and Growth,” processed, London School of Economics, 1994.
118 Rodrik, The New Global Economy and Developing Countries, p. 1.
119 This terminology is adopted from Roberto Perotti, “Growth, Income Distribution and Democracy: What the Data Say.” Journal of Economic Growth 1 (June 1996), pp. 148-187, at 151-152. We observe that this body of work tends to contradict the assertion of a “Kuznets curve,” which posits a strong relationship between the early stages of economic development and a sharp increase in income inequality.
220 See, for example, Robert Barro, “Economic Growth in a Cross-Section of Countries,” Quarterly Journal of Economics 106 (May 1991), Roberto Perotti, “Political Equilibrium, Income Distribution and Growth,” Review of Economic Studies 60 (October 1993), Alberto Alesina, Sule Ozler, Nouriel Roubini, and Philip Swagel, “Political Instability and Economic Growth,” Journal of Economic Growth 1 (1996).
221 Torsten Persson and Guido Tabellini, “Is Inequality Harmful for Growth?” American Economic Review 84 (June 1994); Alberto Alesina and Dani Rodrik, “Distributive Politics and Economic Growth,” Quarterly Journal of Economics 109 (1994).
222 See, most prominently, Alberto Alesina and Roberto Perotti, “Income Distribution, Political Instability, and Investment,” European Economic Review 40 (1996): 1203-1228, Yannis Venieris and Dipak Gupta, “Income Distribution and Socio-Political Instability as Determinants of Savings,” Journal of Political Economy 96 (1986): 873-883.
223 For the argument similar to ours and the discussion of the evidence, see Klaus Deininger and Lyn Squire, “A New Data Set of Measuring Income Inequality,” World Bank Economic Review 10 (1996): 565-592.
224 John Maynard Keynes, The Economic Consequences of the Peace (New York: Harcourt Brace, 1920), p. 19.
225 On the history, see Ethan B. Kapstein, Sharing the Wealth: Workers and the World Economy (New York: W.W. Norton, 1999).
226 See, for example, Roberto Perotti, “Income Distribution, Democracy, and Growth: What the Data Say,” Journal of Economic Growth 1 (1996).
227 See, inter alia, the findings in Perotti 1996, who controls for democracies.
228 World Bank, World Development Report: 1997 (New York: Oxford University Press, 1997), p. 49.
229 Gary Becker, “Human Capital and Poverty Alleviation,” World Bank, Human Capital Development and Operations Policy Working Papers, n.d., www.worldbank.org/html/extdr/hnp/hddflash/workp/wp_00052.html.
330 Ramon Lopez, Vinod Thomas, and Yan Wang, “Addressing the Education Puzzle,” World Bank, processed, 1998, pp. 7-8.
331 IADB, Facing Up to Inequality, p. 46.
332 Ramon Lopez, Vinod Thomas, and Yan Wang, “Addressing the Education Puzzle,” World Bank, processed, 1998, p. 1.
333 World Bank, World Development Report 1998/99 (New York: Oxford University Press, 1998), pp. 200, 202.
334 UNICEF, The State of the World’s Children: 1999 (New York: UNICEF, December 1998), p. 63.
335 World Bank, World Development Report 1998/99, p. 45.
336 IADB, Facing Up to Inequality in Latin America, (Washington, DC: IADB, 1998) p. 42.
337 IADB, Facing Up to Inequality, p. 43.
338 Development Assistance Committee, Development Cooperation Review of the United States (Paris: OECD, 1998), p. 1.
339 World Bank, Assessing Aid (New York: Oxford University Press, 1998), pp. 2-4.