Oil wealth and democracy

The recent study by Kevin K. Tsui (link) shed some important implications of the relationship between oil wealth and democratic governance. It is a well argued fact that major discoveries of oil hindered rather than encouraged the political transition of less developed and developing countries into well-functioning, stable and mature democracies.

Although oil-rich countries tend to favor political dictatorship, Norway, U.S. and Canada are proven exceptions to this particular pattern mainly because of the evolution of institutional stability safeguarding contract enforcement while imposing strict limits on the executive branch of government. On the other hand, oil-rich non-democratic countries, such as Libya, Jordan and Saudi Arabia may enjoy longer longevity and higher income per capita but, in the long run, the pressure for freedom of the press and greater civil liberties may sooner or later undermine the political power of seemingly untouchable dictatorships. This particular hypothesis can explain recent uprisings across the Arab world.

By and large, the lesson from revolutions in Tunisia, Egypt, Libya and other Arab states is that once oil wealth leads to the improvment of infrastructure, life expectancy and standard of living, the call for political liberties and stronger civil society is irreversible, which can undermine even the most robust dictators.

The Future of the Arab World

The wave of revolutions in the Arab world has withheld authocratic political regimes in Tunisia and Egypt after weeks of violent protests and political turmoil that eventually resulted in overthrowing some of the most bloated and corrupt political leaders in the Arab world. The final departure of Egyptian and Tunisian presidents sparked a series of political demonstrations in countries across the Middle East, from Syria to Yemen and from Algeria to Bahrain. The ongoing pressures for greater civil society and for the establishment of democratic institutions pose a major threat to long standing political dictators in Arab states. Hence, the upcoming democratic change has eventually undermined the political authoritarianism and millitary dictatorship, both of which are incompatibile with the principles of economic freedom and civil society.

After having gained independence from colonial powers in 1950s, Arab countries adopted socialist model of economic development enhanced by heavy government intervention and political nationalism. The adoption of socialist public policies led to economic stagnation, institutionalized authocracy, often marred by millitary violence and civil war as in Algeria in early 1990s. The political and economic model of the typical Arab state is known for very low level of economic freedom even though structural indicators of Arab societies might indicate the opposite. Libya has steadily enjoyed the highest per capita income in North Africa. The country is the 15th largest oil exporter and has 9th largest prooved oil reserves in the World. However, Libya suffers heavily from 30 percent unemployment rate and diminished health and education outcomes. Libya's high GDP per capita is entirely inflated by high oil prices via excessive appreciation of the domestic exchange rate. Thus, as a developing country, Libya posts trade deficit while the country is a net exporter of capital flows. Excessive appreciation of Libyan currency, following high oil prices, is a potential source of Dutch disease - a triangle of slow productivity, weak domestic manufacturing sector and artificial wealth, created by a sudden surge of prices of natural resources without sufficient productivity growth. Therefore, Arab countries, from Qatar to Morocco, will have to undergo a swift transition to a competitive market economies, based on domestic structural change, rather than on artificial wealth increases, resulted from natural resource abundance.

The majority of Arab states suffers from centralized and dysfunctional financial system - a painful legacy of decades of socialist economic mismanagement. Prior to independence from France and the UK, several Arab countries already enjoyed competitive financial systems. Raghuram Rajan and Luigi Zingales examined the reversal of financial development in the 20th century and showed that, by 1913, Egypt's stock market capitalization/GDP ratio amounted to 1.09, far ahead of many of today's advanced economies. By that time, Egypt's financial development was comparable to the UK and Belgium. In 1960, in the midst of socialist revolution, the ratio plummeted to 0.01 - a symptom of severe underdevelopment of financial market.

The Arab world is flooded by widespread corruption. In Transparency International's Corruption Perception Index, the vast majority of Arab states perform badly, hindering institutions of the rule of law and democratic governance as the essential foundation of economic growth and structural change in the long run. The fact that 75 percent of Algerian youth below the age of 30 is unemployed, calls for immediate deregulation of the labor market and better governance in private and public sector.

The revolution and civil unrest across the Arab world is nevertheless calling for greater civil liberties and for the shift from corrupt authocratic regimes into political freedom, freedom of association and democratic institutions, safeguarding free elections and a cohesive adoption of non-authocratic political governance. Without restoring a sound protection of human rights for women and men and freedom of the press and speech, the economic future of the Arab world is doomed to gradual stagnation behind fast-growing emerging markets.

Corruption and bribes

The chart below shows the percentage of respondents in selected countries who willingly paid bribes to different service providers. The frequency of offering bribes for personal gains is strongly associated with the level of economic development. The highest percentage of paid bribes accures in those countries where the quality of institutions is very poor. The absence of judicial independence leads to the lack of trust, spread of uncertainty and costlier contract enforcement. In such conditions, corruption increases network and transaction costs. Thus corruption is a substitute for tax system. In terms of economic costs, corruption reduces economic growth by increasing the cost of transparent contractual relations. If corruption is persistent to a lesser extent, corrupt behaviour such as paying bribes is costlier since the probability of being caught is higher. Property rights and the rule of law together with judicial independence play an essential role in fighting corruption. Poorly defined property rights increase the risk of expropriation and therefore provide an incentive to pay bribes. Establishing a robust system of the rule of law is the best safeguard in tackling the persistence of corruption.

Source: The Economist (link)

The Strength of Corruption

The Economist summarized the findings of the 2010 Corruption Perception Index. Corruption is still one of the main obstacles to prosperity and good governance. Many governments around the world are reluctant to tackle corruption because it is a rewarding political behavior abusing the quality of institutions. Nevertheless, persistent corruption causes high transaction costs of contract enforcement. Thereby it is creating wasteful allocation of resources. On the other hand, developed countries are not immune to corruption. The key to high quality institutions in developed world is to find the way how to eliminate the presence of legal corruption.

According to the Index, the perception of corruption in the world is the lowest in New Zealand, Denmark, Singapore and Sweden. Scandinavian countries still remain a benchmark for the nations around the world in adopting the best practices in fighting corruption. One of the main reasons is that these countries have adopted first-class institutions in formal and informal dimension. The highest perception of corruption was found in Somalia, Myanmar, Afghanistan and Iraq. It is time for undeveloped countries to recognize that corruption is the central drawback that keeps them poor and underprivileged; because it leads to economic stagnation, moral crises, wars and social unrest.

Source: The Economist, The usual suspect (link).

Natural resources and prosperity

Does natural resource abundance lead to more wealth and higher growth? This is an ample question of economic growth theory. In addition, many episodes of economic consequences of resource abundance suggest there is no single relationship between resources and growth. Many countries around the world are economically dependent on the supply of natural resources, especially in least developed and developing countries. In spite of significant amount of resources such as oil, coal, natural gas, gold and other commodities, many developing nations remain undeveloped and vastly dependent on foreign aid.

Countries such as Iran, Libya and Venezuela are among the largest oil-producing developing countries. In spite of vast supply of commodities, the data and experience do not suggest a positive impact of resources on economic growth. Prior to the 1979 Islamic revolution, Iran used to be one of the most developed countries in the Middle East. After 1979, Iran underwent an overhaul of its economic system and a beginning of large-scale state intervention in the economy. The theocratic government regime de facto suppressed private property rights and imposed strict government control over the economy. Even though Iran's oil reserves have been among the largest in the world, country's GDP per capita and structural indicators have stagnated since 1979.

Venezuela is a brilliant textbook example of how resource-abundant economy can stall as a consequence of socialist political dictatorship and unlimited constitutional power of the dictator. Libya is attributed with the largest supply of oil in Africa. Country's oil sector accounts for 95 percent of export earnings, 60 percent of public sector wages and 25 percent of GDP (link). Even though the country is the largest oil exporter in Africa and despite a GDP per capita in the rank of Russia and Lithuania, the unemployment rate is estimated at 30 percent which is the 21st highest unemployment rate in the world. In addition, Libya's business environment is marred by the lack of economic freedom resulted from high degree of corruption in public sector and judicial system. According to Heritage Index of Economic Freedom (link), Libya is the least free economy in North Africa and Middle East which is nonetheless unsurprising since in 1978 all private property rights for private businesses were eliminated.

Resource abundant countries also used to be expropriated by the colonizers in the age of colonization. Early colonizers of a vast majority of African resource-abundant countries did not focus on the permanent establishment of sound property rights and contract enforcement but solely on the extraction of natural resources. This created huge political instability and intense war conflicts on the African continent. On the other side, there are countries with abundant natural resources and high prosperity at the same time such as Norway and Canada. The political history of these countries suggests an entirely different institutional setting, based on the protection of private property and contract enforcement. Such a structure and origin of the legal system ensured low transaction costs and sound contract protection by the judicial system as the basis of economic development.

After centuries of socialist political and economic mismanagement, dictatorships in Africa and the Middle East resulted in the artificial wealth illusion demonstrated by relatively high GDP per capita and poor structural indicators such as high unemployment rate. Therefore, one should be cautious in examining the relationship between natural resources and economic growth in the longer run. Nevertheless, institutional, historical and political background of resource abundance should not be neglected.

Italian Big Government

The figure from The Economist showes that the number of official cars on the streets in Italy is 6 times as much as in the average European country. The figure doesn't seem to reflect the terrible state of the Italian economy. In 2009, Italy's public debt grew up to 115.3 percent of the GDP. Given the worrying state of public finance, Italy's one of the riskiest countries in the Euroarea. It is a country of an enormous contrast between the developed North and the agrarian South. The country also has one of the largest shadow economies and widespread corruption perceptions in the developed world. Because of reginal income per capita disparity, Italy is a country of significant differences in youth and adult unemployment across the country. According to the OECD, Italy has one of the highest youth unemployment rates in the EU (26.3 percent). In the last year, youth unemployment rate in Italy grew by 5 percentage points. The proportion of youth in employment is 20 percentage points below the OECD average.

Source: The Economist

Corruption and economic welfare

I collected data on GDP per capita and Corruption Perceptions Index (CPI) for 50 countries in the year 2009, disregarding the level of GDP per capita. The sample consists of developed, developing and least developed coutries. I discovered significantly negative relationship between GDP per capita and perception of corruption. CPI ranges from 1 to 10. Higher index implies lower corruption perception.

Corruption and economic welfare across nations

Source: IMF (2010), Transparency International (2009), own estimate

In general, countries with higher GDP per capita have significantly lower corruption perception and better institutional governance as well as the rule of law. The main finding is that if GDP per capita increases by 1000 USD, Corruption Perceptions Index will, on average, increase by 0.2 index points, all other remaining constant. It means that the persistence of corruption drops when countries become wealthier. GDP per capita is a good predictor of corruption perception. In general, 74 percent of the variability of corruption perception in the sample is explained by GDP per capita variation.

The least corrupt countries in the sample are New Zealand (9.4), Denmark (9.3), Sweden (9.2) and Switzerland (9.0). The highest perception of corruption was found in Haiti (1.8), Venezuela (1.9), Russia (2.2) and Belarus (2.4).

As we can see, fighting corruption is an important policy measure of encouraging economic development on the road to prosperity.

Corruption eruption

The Economist wrote an interesting article about corruption where it discussed the problematics of corrupion and why does it exist. The answer is simple. The chances of being cought are small while the temptation of bribery is too high as benefits are so great. According to "When in Rome act like a Roman" argument, bribery is the price the you have to pay to enter the world's most difficult markets. Bribery can also speed up the bureaucratic procedures. On the other hand, tackling corruption can make your way a bit more difficult as in the case of IKEA when the company entered the Russian market and decided to fire managers who were paying bribes to local officials. Ethics is the only weapon that can overtake the corruption.

Ethical principles are the ones that can make people, firms and govermnents change the why they deal with the situations. Moreover, in the US, the Department of Justice is prosecuting far more cases than ever before. In 2001, only eight cases were prosecuted. Now there are 150 cases, which confirms that things are improving. As the likelihood of being cought is dramatically higher than few years ago, firms are not taking on more risk that before. That is why not so many firms tend to do their work in the corrupt way. Internet as well makes it easier to control firms' activities. Thus, it is easier to reach the information. There is still a lot to be done with the help of a watchful eye.