Financial integration in autocracies: Greasing the wheel or more to steal?


This paper analyzes the influence of financial integration on institutional quality. We construct a dynamic political-economic model of an autocracy in which a ruling elite uses its political power to expropriate the general population. Although financial integration reduces capital costs for entrepreneurs and thereby raises gross incomes in the private sector, the elite may counteract this effect by increasing the rate of expropriation. Since de facto political power is linked to economic resources, financial integration also has long run consequences for the distribution of power and for the rise of an entrepreneurial class.

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  1. 1.

    Chinn and Ito (2008) show that the industrialized countries have steadily liberalized their financial markets since the 1970s, whereas in the less developed and emerging countries a massive deregulation took place from the 1990s onwards.

  2. 2.

    The ICRG index is provided by Political Risk Services (2005) and ranges from 0 to 6, with a higher value indicating a lower extent of corruption. Capital inflows per capita were computed by dividing the financial account balance, as documented in the IMF’s International Financial Statistics, by total population size.

  3. 3.

    See also recent contributions by Lagunoff (2009), Ticchi and Vindigni (2010) on the dynamics of political institutions.

  4. 4.

    Henry (2003, 2007) provides empirical evidence that financial liberalization results in a decline of capital costs. In addition, Bekaert et al. (2011); Bonfiglioli (2008); Kose et al. (2009b) show that financial integration has a direct positive effect on productivity. See also Alfaro and Charlton (2007), who find empirical evidence for a rise of entrepreneurial activity as a result of a better access to foreign capital markets.

  5. 5.

    See also Rajan and Zingales (2004) for a more extensive elaboration of this argument. Albornoz et al. (2012) analyze the incentives to expropriate foreign investors in a Heckscher–Ohlin-framework, in which foreign capital facilitates international trade. In their model, the expropriation risk depends—among other things—on sectoral factor intensities. Aizenman and Yi (1998) analyze the incentives for an autocratic regime to liberalize financial markets. They show that the ruling elite chooses a regime which enables it to control the inflows of foreign capital and thus its income gains from the taxation of the private sector.

  6. 6.

    Besley and Ghatak (2009) present a formal exposition of this argument. Guriev et al. (2011) theoretically explain and empirically verify that expropriations in the oil industry are more likely to occur in periods with a high oil price. See also Robinson et al. (2006); Bulte and Damania (2008); Myerson (2010) or the rent seeking models of Lane and Tornell (1999); Baland and Francois (2000); Mehlum et al. (2006).

  7. 7.

    This approach has been extended to analyze various dimensions of autocratically ruled economies, such as different types of dictators (Shen 2007), information asymmetries concerning the beliefs of citizens about the type of government (Azam et al. 2009), or time horizons of the rulers (Acemoglu 2005).

  8. 8.

    Unlike in Acemoglu (2006a, b) or Parente and Prescott (1999), the elite is not directly involved in the production process. Hence, it has no interest in the expansion or contraction of a given sector for the purpose of raising the returns from its own economic activities. While this framework may fail to capture some historical cases in which the elite was defined by the ownership of specific factors—e.g., land ownership in Argentina—it appropriately describes a situation in which the elite achieves and sustains its political dominance mainly by controlling an oppressive apparatus.

  9. 9.

    As we consider a small open economy for which goods prices are determined by world markets, distinguishing between goods produced in the traditional and the modern sector would blur our key argument without yielding additional insights.

  10. 10.

    This assumption implies that the traditional sector does not generate any profit or capital income.

  11. 11.

    Whether the assumption of a complete depreciation is realistic depends on our definition of a “period”, but also on our interpretation of “capital”: if we broadly interpreted \(K^M(t)\) as representing the sum of all fixed costs—covering expenses on machinery, but also on a firms’ administrative overhead, rents, customer relationships etc.—the idea that these costs have to be incurred in every period seems more plausible.

  12. 12.

    For an alternative framework with convex costs of trading capital goods, see, e.g., Castro et al. (2009) or Ševčík (2012).

  13. 13.

    In principle, the decision to liberalize the financial market is a policy choice made by the domestic elite and should, therefore, be also treated as endogenous. Yet, as mentioned in the introduction, most liberalizations in developing countries took place under strong pressure from international organizations like the IMF. They were hardly avoidable for most developing countries, such that our choice to treat financial liberalization as exogenous appears to be more appropriate for these situations.

  14. 14.

    For expositional convenience, and without loss of generality we set the subsistence level of a member of the general population equal to zero such that a confiscatory expropriation of this kind is feasible.

  15. 15.

    An alternative interpretation of \(\tau \) would be that of an “expropriation tax” that reduces expected incomes.

  16. 16.

    Note that \(A > 1\) implies \(\alpha > 1\), which indicates that, if the total general population were employed in the modern sector, it would produce a greater quantity of output than if it were employed in the traditional sector. Nevertheless, \(L(t) > 0\) in equilibrium, since output per worker in the traditional sector is decreasing in employment and exceeds \(\alpha \) at low levels of \(L(t)\).

  17. 17.

    We assume that the state bureaucracy is staffed with members of the ruling elite. The term \(c\) reflects the costs for the facilities and the equipment that are used to monitor and enforce rent extraction, and that are assumed to be purchased on the world market. Note that Besley and Persson (2009, 2010) endogenize the decisions of the incumbent to invest in fiscal capacity, which determines the amount of the collected tax revenues. The costs of these investments are also assumed to be increasing and convex.

  18. 18.

    See also Besley and Kudamatsu (2008) for a framework in which an autocratic leader, in addition to policies for own private interests, also implements benevolent policies in order to stay in power.

  19. 19.

    Note that workers and entrepreneurs get the same income in equilibrium, such that we can drop the index \(M\) and \(T\), and interpret \(y\) as the per-capita income of the general population.

  20. 20.

    The literature has suggested different ways to link political power to economic resources. Here we follow Acemoglu (2006a, b) and Acemoglu and Robinson (2008), who model political power as a function of the absolute income level. We also analyzed the case in which a change in relative incomes affects the de facto power of the general population. Our qualitative results did not change fundamentally.

  21. 21.

    Note that we neglect the collective action problem among the general population and that we concentrate only on material resources as the driving force that determines political power (a similar assumption is made in Acemoglu et al. 2005).

  22. 22.

    While we allow the elite to save and to choose an optimal time path for \(\tau \), we keep assuming that there is no saving and lending by the general population. This can be motivated by refering to the poor financial infrastructure, which characterizes most developing economies. For example, the population share of depositors with commercial banks and the number of commercial bank branches relative to the population size, which are published by the World Bank (2012), can be shown to be significantly lower in poor and repressive countries. We argue that, in such an environment, access to financial institutions is likely to be reserved for the ruling elite.

  23. 23.

    If the political costs of expropriation are purely monetary, we can interpret \(U^E\) as the elite’s income in period \(t\). In this case, the elite maximizes the present value of its income.

  24. 24.

    Given the linear utility specification, this solution is not unique—which, however, does not affect the elite’s choice of the rate of expropriation. Note furthermore that our specification assumes away transaction costs associated with international borrowing and lending by the elite. In a framework that also accounts for this type of capital market imperfection, the effects of financial integration on expropriation would be comparable to an exogenous change in \(\rho \).

  25. 25.

    This follows from comparing (15) with (20).

  26. 26.

    Setting the numerator of (21) equal to zero, we obtain the following critical values of \(\underline{\psi }\) and \(\overline{\psi }\):

    $$\begin{aligned} \underline{\psi },\overline{\psi }&= \frac{(\delta +\rho )(2c\delta -A(2\delta +\rho ))}{2A(2\delta +\rho )}+/-\\&\quad \frac{\sqrt{[(\delta +\rho )(2c\delta -A(2\delta +\rho ))]^2+4Ac\delta (\delta +\rho )^2(2-\frac{c}{A})(2\delta +\rho )}}{2A(2\delta +\rho )}. \end{aligned}$$

    Taking the derivatives of the difference \(\overline{\psi }-\underline{\psi }\) with respect to \(A\) and rearranging terms shows that \(\frac{\partial (\overline{\psi }-\underline{\psi })}{\partial A}>0\).

  27. 27.

    For this numerical exercise, we have chosen the following parameter values: \(\rho =0.11,\,\delta =0.9,\,A=1,\,c_{low}=2.2,\,c_{high}=2.6\).

  28. 28.

    Since workers in the traditional sector are paid their average product instead of the marginal product, the modern sector is inefficiently small.


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Correspondence to Philipp Harms.

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Dadasov, R., Harms, P. & Lorz, O. Financial integration in autocracies: Greasing the wheel or more to steal?. Econ Gov 14, 1–22 (2013).

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  • Institutions
  • Capital mobility
  • Political economy

JEL Classification

  • F21
  • O16
  • P48