T C A Srinivasa-Raghavan: The limits of cross-country analysis

OKONOMOS/ Does democracy really lead to greater macroeconomic stability?

A couple of years ago I was invited to a dinner at which a famously acerbic and highly respected professor from the Delhi School of Economics was also present. Talk floated around to methodology in modern economics.

The professor expressed the view that the cross-country stuff that the International Monetary Fund (IMF) and the World Bank did was a "cartload of high-grade manure". He then went on, very eruditely, to explain why.

This paper* by Shanker Satyanath and Arvind Subramanian, both of the IMF, suggests that he may well have been right. It is not that their use of econometrics is wrong. It is just that they are stepping far beyond what econometrics was designed to do, namely, measure things that makes sense to measure.

The authors say that they "examine the deep determinants of long-run macroeconomic stability in a cross-country framework and find that conflict, openness and democratic political institutions have a strong and statistically significant causal impact on macroeconomic stability. Surprisingly, the most robust relationship of the three is for democratic institutions. A one standard deviation increase in democracy can reduce nominal instability nearly fourfold."

Well, well, well, who'd have guessed that, you cunning boys.

The message is that if you are looking for macroeconomic stability, better get yourselves a democracy. But then Iraq used to have excellent macroeconomic indicators, as does China. And India with its excellent democracy has pretty disquieting macroeconomic indicators.

Satyanath and Subramaniam claim to have "established a strong empirical regularity in the cross-section evidence relating to another, less recognised, instrumental value of democracy: its strong and robust role in promoting long-run nominal macroeconomic stability." Ouch!

True, they admit, that sometimes democracy results in low levels of growth. But never mind because "it has a strong causal impact on stability."

It follows from this that more foreign capital should flow to democracies than to autocracies. But China attracts a very tidy sum, nearly $50 billion annually.

So did the Tigers of East Asia when they were not democracies because by any yardstick, they were very stable macroeconomically. If anything, their macro-stability has gone for a six only after they became democratic.

Having made their discovery, the authors go on to ask just how effective IMF's policy advice to ensure macroeconomic stability can be. "Should the policy community accept that it has perhaps only a modest role in trying to improve macroeconomic stability?"

They conclude that, to the extent that democratic institutions also play a large role in ensuring such stability, the IMF has perhaps better be less certain because as they cleverly point out "even the IMF cannot do much to increase its influence over stability outcomes. IMF conditionality on policies is considered intrusive enough. It would be difficult to imagine any appetite for extending conditionality to a country's fundamental political institutions."

The authors also subscribe to the comforting view that there are "two mechanisms through which political institutions can contribute to macroeconomic stability. One is through checks on the power of politicians, and the second is through greater accountability of politicians."

Such naïveté is touching. But it simply isn't true that the check on political power results in better macroeconomic policies. Just look at the Employment Guarantee Bill, not to mention the myriad subsidies that we dole out and the way the politicians raid the banks.

The authors clearly have no clue about the nature of political power.

At one place the authors write that the panel data "shows that democracy is a significant determinant of the central bank independence measure that is associated with greater stability, while openness and inequality are not."

Having just finished working on the third volume of the RBI's history covering the years 1967 to 1981, let me assure the authors that democracy has nothing whatsoever to do with central bank independence. The length of the central bank's leash in different countries may vary, but it is decided by governments, not by the countries' political systems.

One final question: can this causality be reversed? That is, democracy leads to greater macroeconomic stability, will macroeconomic stability lead to democracy? If so, China had better begin to worry.

*What Determines Long-Run Macroeconomic Stability? Democratic Institutions. International Monetary Fund WP/04/215, November 2004