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Does democracy dampen the effect of finance on economic growth?

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Abstract

Although a large empirical literature seeks to explain the effect of financial development in promoting economic growth, there is surprisingly little evidence for the impact of political institutions on the growth–finance relationship. This paper finds that political institutions condition the effect of financial development on economic growth. Using a dynamic panel estimator and a sample of 78 developing and emerging economies for the years 1982–2011, the paper investigates the impact of democracy on the relationship between financial development and economic growth. The paper finds that democracy does not enhance the effect of financial development on economic growth. This finding is consistent with a view that democracy can be captured by political elites or other special interests in developing and emerging economies, where institutions are relatively weak.

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Notes

  1. These potentially omitted fixed factors are cross-country differences in geography, colonial heritage, and other historical factors that jointly determine the interaction between financial development and democracy and growth.

  2. The data on debt to GDP ratio have extensive gaps for most of the countries in the sample: To maintain the dataset, the paper uses debt to GNI ratio. But the main focus of this paper is the impact of democracy on the growth effect of finance.

  3. As \(T > 15\) the bias becomes negligible and converges to 0.

  4. Studies on the finance–growth relationship use 5-year averaged data, and do not consider this additional source of bias.

  5. This number is computed: \(0.5(0.17) + (-0.18 \times 0.15 \times 0.50\)) for China; Rica.

  6. With 5-year averaged data, the estimates are very similar to columns 1 and 3. The estimates for liquid liabilities, Pol2, and the interaction term in column 2 are qualitatively similar, though they are statistically insignificant at conventional levels with averaged data. Column 4 estimates are different with averaged data, but this is not surprising, as Aghion et al. (2005) and Levine et al. (2000) find that private credit by deposit banks is the most robust predictor of growth.

  7. According to the private interest view of financial deepening, ‘politicians do not intervene into the financial system to further public welfare but to divert the flow of credit to politically connected firms’ (Beck 2013: 19).

  8. Acemoglu et al. (2008) use the Freedom House Political Rights Index as their main measure of democratic political institutions to investigate the modernization hypothesis. Cavallo and Cavallo (2010) use the Polity2 subindex of democracy to examine the impact of democracy on the growth effect of crises.

  9. Five-year averaged results are similar to fifth year data for the main estimates, and the results for the control variables are stronger with 5-year averaged data. But, again, we prefer our data to 5-year averages, because of the additional serial correlation it introduces in the regressions.

  10. Data on total population are from the World Bank, World Development Indicators.

  11. Data on remittances are from the IMF and include: current transfers by migrant workers and wages and salary earned by nonresident workers.

  12. Gross capital formation is from the World Bank, World Development Indicators.

  13. These results are available upon request.

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Acknowledgments

I thank Sophia Preston, Zachary Williams, an anonymous referee, and the editor, Robert Kunst, for helpful suggestions and comments. All errors are, of course, my own.

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Authors and Affiliations

  1. Department of Economics, The University of the West Indies, St. Augustine, Trinidad, Trinidad and Tobago

    Kevin Williams

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Correspondence to Kevin Williams.

Appendix

Appendix

1.1 Sample

Algeria, Argentina, Bahrain, Bangladesh, Bhutan, Bolivia, Botswana, Brazil, Burkina Faso, Burundi, Cameroon, Cape Verde, Central African Republic, Chad, China, Colombia, Congo Democratic Republic, Costa Rica, Cote d’Ivoire, Dominica Republic, Ecuador, Egypt, El Salvador, Ethiopia, Fiji, Gabon, The Gambia, Georgia, Ghana, Guatemala, Guinea Bissau, Guyana, Haiti, Honduras, India, Indonesia, Iran, Jamaica, Jordan, Kenya, South Korea, Kuwait, Lesotho, Madagascar, Malawi, Malaysia, Mali, Mauritius, Mexico, Mongolia, Morocco, Mozambique, Nepal, Nigeria, Pakistan, Panama, Papa New Guinea, Paraguay, Peru, Philippines, Rwanda, Senegal, South Africa, Sri Lanka, Sudan, Surinam, Swaziland, Syria, Tanzania, Thailand, Togo, Trinidad and Tobago, Tunisia, Turkey, Uganda, Uruguay, Zambia, Zimbabwe.

1.2 Definition of variables

1.2.1 Financial development variables

  • Bank private credit to GDP (private credit): The financial resources provided to the private sector by domestic money bank as a share of GDP. Source: Ćihák et al. (2013).

  • Liquid liabilities to GDP (liquid liabilities): Broad money or M3. Source: Ćihák et al. (2013).

  • Private credit by deposit banks and other financial institutions to GDP (Pcdbfin). Source: Ćihák et al. (2013).

  • Bank deposit to GDP (Bankdeposit): The total value of demand, time and saving deposits at domestic deposit money banks as a share of GDP. Source: Ćihák et al. (2013).

1.2.2 Democracy variables

  • Polity2 Index (Pol2): A composite index of autocracy and democracy, where the autocracy scores are subtracted from the democracy scores. The index ranges from -10 (strongly autocratic) to 10 (strongly democratic). This index is transformed to range from 1 to 0, where 1 is most democratic. Source: Marshall et al. (2011).

  • Polity2 subindex (Dem2): Institutionalized democracy. The democracy scores range from 0 to 10 and is transformed to 1–0, where 1 is the most democratic. Source: Marshall et al. (2011).

  • Freedom House Political Rights Index (FH): Ranges from 1 to 7 and transformed to 1–0, where 1 is the highest freedom. Source: Freedom House.

1.2.3 Other variables

  • GDP per capita (Lagged[logGDPpc]): GDP per capita in constant 2000USD lagged one period. Source: World Bank, WDI.

  • General government final expenditure to GDP (Govconsumption). Source: World Bank, WDI.

  • Consumer price index (Log[1+inflation]). Source: World Bank, WDI.

  • Imports and exports to GDP (Trade openness). Source: World Bank, WDI.

  • Foreign direct investment to GDP (FDI, net inflows). Source: World Bank, WDI

  • Remittance inflows to GDP (Remittance). Transfers by migrant workers and wages and salaries earned by nonresident workers. Source: IMF.

  • Total population (Log[population]). Source: World Bank, WDI.

  • Total debt service to GNI (Debt). Source: World Bank, WDI.

  • Gross capital formation to GDP (Investment). Source: World Bank, WDI.

1.3 Summary statistics

See Table A1.

Table 7 This table contains summary statistics
Full size table

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Williams, K. Does democracy dampen the effect of finance on economic growth?. Empir Econ 52, 635–658 (2017). https://doi.org/10.1007/s00181-016-1089-1

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