What reverses economic collapse and leads to rapid economic growth?
1 August 2016
Better economic and political institutions matter in reversing growth collapse. Democratisation and improving state bureaucracy can help to take a country out of negative growth episodes. But for a country to transition from stable to rapid growth, economic institutions matter more than political. Specifically, improving the quality of property rights institutions – the rules and arrangements that determine how property is used and owned – can bring about rapid growth episodes.
A large literature has examined the role of institutions in explaining economic growth. While the earlier literature has examined the role of institutions in determining long-run per capita income, a new literature examines the determinants of growth accelerations and deceleration episodes – which are large discrete changes in medium term growth rates that are common in developing countries. Some of these studies examine the onset of growth accelerations while others examine the onset of growth decelerations. However, these studies look at only the timing of the shift in the growth rate (either as an acceleration or a deceleration), and the econometric methodology they use are probit models (where the year of the break is taken as one, with other years as zero) to study the likelihood a growth break occurring in a given year, for a set of correlates. An important limitation of these studies is that they do not differentiate between the different growth episodes that a country is transitioning from or to. For example, when a country moves from a growth collapse to rapid growth, it is a different growth transition qualitatively than when it moves to an episode with slightly positive but slow growth rates.
In a forthcoming ESID paper, Sabyasachi Kar, Lant Pritchett, Kunal Sen and I investigate the role of economic and political institutions in determining the likelihood of a country transitioning from one growth episode to another. In contrast to the previous literature, in this paper, we provide a richer characterisation of the growth process where a country may move between six different types of growth episodes, ranging from growth collapses to rapid growth episodes. By doing so, we are better able to capture the episodic nature of growth and that many countries tend to switch frequently between growth collapses to slow growth episodes to rapid growth episodes.
We differentiate between six types of growth episodes – from growth collapses (where the episode specific per capita real GDP growth rate, g, is -2 per year), to negative growth (g between -2 and 0), stagnation (g between 0 and +2), stable growth (g between +2 and +4), moderate growth (g between +4 and +6), and rapid growth (g over +6). Using multinomial logit models, in the context of a panel dataset of 125 countries from 1984 to 2010, we examine the likelihood of switching from one growth episode to another growth episode. We examine the role of contract viability (as a measure of the quality of economic institutions) and the role of democracy and bureaucratic quality (as measures of political institutions) in explaining the switches that countries experience between different types of growth episodes. The data on contract viability, democracy and bureaucratic quality are derived from the ICRG database (www.prsgroup.com).
We find that though bureaucracy quality has a positive effect while switching from negative growth episode to positive growth episodes, it doesn’t matter in most of the cases while switching from lower order growth episodes to higher order growth episodes. Both contract viability and democratisation can explain the switching from negative growth episode to positive growth episodes. Contract viability and democracy can also explain the movements from lower positive growth episodes to higher positive growth episodes. However, while contract viability is important for moving from stable growth episode to rapid growth episodes, democracy is not important in explaining this switch. This suggests that while better economic and political institutions matter in taking a country from growth collapses to stable growth, economic institutions matter more than the political institutions for the switching from stable growth to rapid growth.
Our results suggest that democratic episodes do not necessarily witness transitions to rapid growth episodes from moderately positive growth episodes. However, democratic episodes do witness a transition from negative to positive growth episodes, indicating that democratisation does prevent the worst type of growth episode that a country can experience. We also find that improving state capacity in the form of the quality of the bureaucracy can help in taking a country out of negative growth episodes, but that higher state capacity does not increase the likelihood of rapid growth episodes. This finding suggests that previous research that has found a positive role of bureaucratic quality in fostering economic growth needs to differentiate between phases of growth, and that the relationship between bureaucratic quality and economic growth may not be monotonic.
We find that the most important institutional determinant of switching to higher order growth episodes from lower ones and, in particular, to rapid growth episodes, is the nature of property rights institutions – that is, the extent to which investors trust the viability of contracts. In contrast to the previous literature on the determinants of growth accelerations, we find that not only does institutional quality matter in bringing about a growth acceleration, it is the case that the greater the quality of property rights institutions, the higher is the likelihood of a transition to a rapid growth phase.
Our findings have clear policy implications. For a country in a growth decline or collapse, it is important to stress improvements in both political and economic institutions, such as bureaucratic quality, viability of contracts and democratisation to move into an episode of positive growth. However, once the country is in a stable or moderate positive growth episode, further movements into rapid growth episodes need larger emphasis on improving the quality of property rights institutions than enhanced democratisation or state capacity. Economic institutions trump political institutions in bringing about rapid growth episodes, though they both matter in reversing growth collapses.