Charter cities

The idea of charter cities, originally promoted by Stanford economist Paul Romer, sparked a lively academic debate in the field of economic development. The idea of charter city rests on the premise of creating special reform zones within countries. The reform zone would not be governed by the prevailing system of formal and informal rules within countries. The concept of charter city would serve as an intellectual laboratory of ideas in which governments would be let to quickly adopt innovative system of rules. The purpose of charter cities is the empowerment of incentives in world's less developed countries to develop human capital skills, hence, to increase the level of productivity and real wages that could foster the increase in the standard of living. By and large, the core idea of building a charter city means building a city of about 1000 sq. kilometers in the unoccupied land of the host country and adopting an innovative system of formal and informal rules provided by the source country. The example of charter city include selling Guantanamo to Canada and turning the little piece of Cuban land into Caribbean Hong Kong by adopting a formal system of rules and governance based on limited government, strong rule of law and free market; and turning the new territory into manufacturing hub that could serve as a source of income for workers across Caribbean islands such as Haiti. The charter city would not only provide the opportunity for testing intellectual ideas and innovations but also migrational opportunities for individuals from world's most impoverished countries such as Haiti. The coordination of the charter city is managed by a triangle. First, the host country would provide the piece of land. Second, the source country would provide the infrastructure, human capital and ideas. And third, the guarantor country would provide the assurance that the charter would be respected by both countries.

The concept of the charter city has gained significant attention by development experts in discussing developmental malaise in world's least developed countries in Africa. The empirical evidence on Africa's underdevelopment is striking. It suggests a blinking interplay of corruption, institutional fragility and state failure. According to African Development Indicators, about 75 percent of firms in Cote d'Ivoire identify corruption as the major constraint in doing business. In Ethiopia, less than 2 percent of females enroll tertiary education. Moreover, the average Ethiopian female can expect only 7 years of total schooling. In Liberia, about 11 percent of married women partake a contraceptive use by any method. Hence, one third of young Liberian women, aged 15-19. In addition, 60 percent of Liberians live below $2 per day. In Mozambique and Sierra Leone, only 45 percent of young women are literate. A female at birth in Sub-Saharan Africa can expect to experience no more than 8 years of total schooling throughout her life.

The perennial question in the establishment of charter cities is whether the idea can serve as a source of good rules, promoting good governance through low-cost contract enforcement. Institutional fragility of states across world's least developed countries is largely the economic outcome stemming from wrong development diagnostics, mismatched policy choices and a rigid structure of formal and informal institutional arrangements which resulted in a myriad of bad rules and corrupt political leadership across the specturm of world's poorest countries. The general conclusion from the lessons of development policy is that in the last century, development policy failed to facilitate meaningful prescriptions for a permanent rise of GDP per capita. In particular, the misdiagnosis of essential development dilemma is not a consequence of technical failure in delivering concrete solutions to applied issues of economic development but a consequence of mismatched theoretical foundations which supplied wrong assumptions. Theoretical models of economic growth and development in late 1950s and early 1960s rested on the assumption on output per worker as an increasing and diminishing function of the capital per worker. Although the validity of the neoclassical growth theory remains undisputed, development policy and international aid donors failed to recognize that increasing the amount of aid does not lead to better development outcomes. In fact, the majority of Sub-Saharan countries experienced the relative decline of GDP per capita in the 20th century. In 1913, the GDP per capita of Ghana (in 1990 international dollars) represented 42 percent of the average GDP per capita of European periphery. In 2008, Ghana's GDP per capita represented merely 8 percent of the average GDP per capita of European periphery. By the available statistics, Algeria was the second wealthiest country in Africa, only after South Africa. In 1913, Ghana was the fourth richest society in Africa, only after South Africa, Algeria and Egypt. In 2008, Ghana's GDP per capita was ranked 20th in Africa, in the same range as Angola, Lesotho and Nigeria.

The question surrounding the emergence of the charter city is whether it can serve as a treatment to the contagious sclerosis of fragile institutional structure in failed states, marred by poor governance and the lack of law and order, causing the failure to enforce private contracts as to ensure the rule of law and provide the institutional impetus for sound governance and better formal and informal rules. A notable criticism of the institutional fragility in world's less developed countries pertains to the capture of the state by the political elites. The political elites in world's poorest regions have provided sufficient conditions for the capture of government and judicial system by incorporating a system of powerful informal arrangements through bloated corruption which consequently impaired investment and ultimately resulted in the expropriation of private property rights. The institutional chaos in the most failed states of the world culminated into behavioral adaption to bad rules. The sequence of harmful economic policies eventually seized upon poor development outcomes such as high rates of poverty, stagnating income per capita, low life expectancy and poor health and education indicators.

The foremost task of the charter city should facilitate the institutional decency to enforce private contracts without transaction cost barriers and ensure a robust system of the rule of law since better rules nonetheless depend on how informal institutions such as culture, habits and behavior embrace the virtues of free markets, limited government and the rule of law. Aside from the essential infrastructural arrangements, the provision of institutional conditions for living under a different set of rules does not necessarily imply sufficient prerequisites for the productivity growth that could, in the long run, transform the charter city from low-wage pool of unskilled labor into high-wage urban agglomeration. What is needed for a charter city to flourish is the acceptance of informal institutions of the liberal society such as the freedom of contract and the freedom from corruption. One should not hesitate that economic and personal liberties in world's poorest countries are plagued by predatory rent-seeking political behavior as well as contended against the principles of adherence to formal rules. Without a sensory adherence to these principles, it would be impossible to envisage the charter city as a solution to world poverty and underdevelopment.

For a charter city to provide a clear and cohesive framework of rules, it is essential to provide the credibility and predictability of rules. In early 1950s, Hong Kong was a small island chartered by the British who established a system of credibility over centuries. Hong Kong was the only place where Chinese workers were allowed to migrate from the mainland China. The credibility of the rules, emphasizing limited government over extensive government intervention, free markets over regulated command-and-control economy and the rule of law over political discretion and interest-group politics, proved vital in Hong Kong’s steady economic growth in the 20^th century. In 1950, Hong Kong’s income per capita was around GBP 2,500. By 1997, the average income per capita rose to GBP 20,000.

The idea of building charter cities to boost income per capita by innovative framework of governance is a valuable alternative to the mainstream development policy. First, setting a charter city in regions such as Sub-Saharan Africa and Latin America would encourage seasonal and permanent migration flows from areas with low population density both on domestic and international scale. David McKenzie and John Gibson examined the impact of New Zealand’s Recognized Seasonal Employer program (link), aimed at encouraging seasonal migration from Pacific islands Tonga and Vanuatu to New Zealand, benefitting employers at home. The empirical evidence and policy conclusions suggest that seasonal migration is offering a triple win since a migrant, the sending country and the receiving country benefit from participating in seasonal migration program:

“Nevertheless, there are several caveats to these conclusions. The first is that development is a long-term process, and some of the effects of the RSE may only materialize over many years of community involvement. These could include positive effects such as greater asset-building, investments and skill development if workers return for many seasons, as well as potential longer-term negative effects of continual absence of family members on family and community relations. Secondly, while the gains to households from this seasonal migration are large, they still pale in comparison to the gains from permanent international migration (McKenzie et al, 2010). A key policy issue is therefore the extent to which seasonal migration can or cannot eventually open up avenues for permanent migration. Finally, as with all evaluations, there is the question of how far the policy details and findings can be extrapolated to other settings and that it was developed drawing on lessons from experiences around the world should provide some external validity. As temporary migration programs are increasingly emphasized in policy discussions, there is likely to be plenty of scope for governments and researchers to work together in the future in assessing how well these lessons translate.”

Second, charter cities would nevertheless spur the diffusion of knowledge into the countries of poor regions in the world. In its most distinctive form, charter cities would be similar to the role of small states in the global economy. For instance, consider Mauritius. Back in 1968, when the island gained the political independence from the United Kingdom, the economic prospects of the country were undermined by rapid population growth, rachitic productivity and overdependence on sugar as the only export industry. In addition, trade policy imposed high tariffs and import quotas to protect sugar manufacturers. Since it was impossible to dismantle the barriers to trade, the government of Mauritius responded by creating a virtual special export zone. Any foreign and domestic company could enter and exit the export zone by retaining the profits earned. Companies within the export zone operated under different rules with no trade restrictions such as tariffs, import quotas, voluntary export restraints etc. Hence, the only entry requirement for locating in the special zone was that companies manufacture only for exports as not to compete with domestic markets. The special export zone proved to be a success story. Productivity and employment rates increased sharply, boosting income per capita and standard of living. In 2010, Mauritius’s GDP per capita ($15,500) is the second highest in the region, only behind Gabon ($14,600). The experience of Mauritius with the special export zone and its consequent impact on the economic prosperity of the island, suggests that institutional competition ultimately rewards the institutional structure with better economic outcomes. The entire concept of the charter city is based on encouraging the institutional competition between charter cities and politico-economic systems in poorer countries where charter cities would be most likely to settle. Low initial level of income per capita in charter cities would encourage low-wage employment with unskilled labor. The experience of countries such as Mauritius, Singapore and Hong Kong suggests that favorable institutional features at the beginning stage of development result in better economic policies, ultimately leading to stable economic growth, higher standard of living and better education and health indicators. In Mauritius, the judicial independence from political influence has been enhanced by delegating the highest court of appeal to the British Privy Council, a royal judicial committee (link), full powers of judicial authority.

Many smaller countries in the 20^th century, known for good development outcomes, have adopted roughly similar institutional impetus for economic growth and development. In Africa, countries with the highest level of economic freedom and the lowest perception of corruption, such as Mauritius, Botswana and Namibia, enjoy the highest level of GDP per capita in the African continent. In spite of the abundance of natural resources, Botswana adopted market-friendly economic policies in the second half of the 20^th century, conducive to private enterprise and investment. According to World Bank, it takes 152 hours to pay taxes in Botswana compared to Sub-Saharan average of 315 days. In addition, a claimant in Botswana can expect to recover 63.7 cents per $1 from an insolvent firm compared to 8.4 cents per 1$ in Angola, 16 cents per 1$ in Niger and 0 cents per 1$ in Madagascar.

And third, charter cities would vastly improve the infrastructure of the residents, choosing freely to enter and exit the city. Households in countries such as Guinea still lack the access to electricity, forcing students to do the homework under streetlights and use the car park lights to review school notes (link). Despite being one of the largest receivers of aid per capita, Guinea still suffers from the lack of widespread access to electricity. One could hardly believe that the efforts pledged by international aid donors to reduce poverty and improve the standard of living across the African continent, were not sufficient. What created the black hole, such as the above in Guinea, is the institutional structure plagued by persistent corruption, political cronyism and bad governance, creating bad rules and wrong incentives. Charter cities would ingeniously cure the widespread persistence of misrule and political misconduct since the system of rules would be defined by the founding charter of the city. Good prospects of charter cities would require free entry and exit from the city as well as transparent and honest oversight of the respect for rules by independent judicial authority, managed by a guarantor country such as the United Kingdom, U.S. or Canada. In the proposed form, a typical charter city would become a manufacturing hub. In particular, it would enable access to low labor costs and significant economies of scale to technology entrepreneurs from rich countries as well as transparent contract enforcement, law and order and the security of private property rights. On the other hand, cities would enable millions of people from poor countries to migrate to chartered cities and seek employment opportunities in an environment, safe from corruption, political restraint, violence and bad governance. Hence, charter cities would provide a necessary input to the intellectual competition of ideas in economics, law and political philosophy and elsewhere to be implemented in chartered cities.

The concept enables social scientists and development experts a real-world experiment of ideas. Hence, charter cities could provide a safe haven for prosecuted individuals in poor countries, suffering from judicial errors, physical and military violence or illicit property expropriation. The UN estimates that, over the next few decades, 3 billion people will move to cities. The inflow exerts a growing pressure on urban agglomerations. The lack of basic infrastructure and the continuity of predatory misrule could cause a rapid growth of slums in larger cities which, by and large, are the main source of infectious diseases, HIV prevalence and youth crime since the absence of access to clean water, electricity and education are the major impediment to the improvement of development outcomes in poor countries. A charter city could flourish to become an impulsive alternative to the current state of overdependence on foreign aid. However, it should be unambiguously clear that adherence to good rules and governance requires a bold and decisive change in the set of informal behavior; in which corruption, crime and nepotism are doomed to the fullest possible extent by the full enforcement of private contracts and the rule of law.

Foreign aid and development economics

The aim of main research agenda of development economics in the last century was to provide an evolving approach to curing the persistence of poverty and underdevelopment in world's least developed and developing countries. High economic growth in developing countries in the last decades has changed many developing nations into middle-income countries. For instance, real economic growth rate in China and India from 1960 onwards averaged 6.67 percent and 3.49 percent, respectively. In 2010, China and India were already classified as lower middle-income countries, belonging to the same income group as El Salvador, Armenia and Philippines. In the recent year, China's GDP per capita was higher than GDP per capita of many high-growing developing nations such as Ukraine, Nambia, Armenia and Bosnia and Herzegovina, and roughly at the same level as Algeria. Over the last decade, the economic growth in developing countries accelerated, driven by an increase in global commodity prices, robust investment rates, expansionary monetary policy and a growing domestic consumption. The economic growth in a majority of African states stagnated, consequently leading to a decrease in the overall standard of living. Between 1960 and 2009, average real GDP growth was negative in countries such as Congo, Democratic Republic (-2.26 percent), Liberia (-1.51 percent), Niger (-1.02 percent), Zambia (-0.52 percent) and Zimbabwe (-0.02 percent) with many other African countries with little or no growth in the second half of the 20th century. The stagnation of income per capita in countries such as Sierra Leone is largely the result of civil war and severe political instability, creating domestic violence and the persistence of poverty, malnutrition and AIDS/HIV prevalence. From the second half of the 20th century onwards, international aid donors have contributed significant amounts of foreign developmental assistance in various forms such as medical care and vaccination against polio, AIDS/HIV, measles and malaria, direct cash transfers and physical infrastructure. Despite significant official and unofficial developmental assitance from international aid donors, dispersion of real income per capita, measuring the level of cross-country convergence or divergence of income per capita, the gap in economic development widened in the course of the last century. In 2010, the percentage of countries with the level of real GDP per capita $1,500 or below equaled almost 20 percent (link).

The rise of development economics in the 20th century was a natural response to growing disparities in income per capita between rich and poor countries. In the framework of neoclassical theory, development economics emerged from a neoclassical growth theory, pioneered by the famous Solow-Swan model. In the simplest possible form, the growth of output per capita depends on the capital per worker and the initial level of output under stable rate of national saving and capital depreciation. Assuming diminishing returns to scale and constant rate of population growth, the increase in capital per worker would increase the output per worker that would, hence, approach its steady-state equilibrium. Theoretical notions of the Solow-Swan model were tested against the empirical data on economic growth. The key assumption of the neoclassical growth model is that poor countries would tend to catch-up rich countries, assuming higher output growth in poor countries. The convergence of income per capita would imply a neg relationship between the initial level of output per capita and output growth over time. Thus, countries with lower levels of output per capita in the initial period would experience faster rates of output growth. Consequently, the output per capita and the standard of living would approach to the level in rich countries. The empirical tests of the Solow-Swan model failed to confirm the theoretical hypothesis since economic growth rates in 20th century in developed countries were higher compared to developing countries. The divergence of income per capita led to the subsequent modifications of the Solow-Swan model. In fact, the main criticism of the model points out that the model itself failed to capture the role of technological progress in determining the level of output per worker. The mysterious growth episode in Japan and other East Asian nations posed a difficult question. How can a country with low initial level of output per worker at the end of the WW2, exceed the productivity level in rich countries? The obvious answer is that Solow-Swan growth model failed to capture the role of technology shocks which violate the assumption of diminishing capital returns, what could explain why initially poor countries subsequently converged to the level of productivity in rich countries and then exceeded the level. The phenomenon, known as growth residual, has subsequently reduced the predictive power of the Solow-Swan model since a considerable share of economic growth was not ascribed to capital and labor inputs but rather to the persistent role of technological change.

Policy implications from Solow-Swan model imply that the essential requirement to boost economic growth in a country with low initial level of output per capita is to increase the amount of capital per worker, namely by boosting public and private investment in infrastructure. From 1950s onwards, World Bank had repeatedly boosted the growth of infrastructure by facilitating developmental assistance into world's least developed countries. According to the neoclassical growth theory, higher capital-labor ratio would provide additional investment stimulus, thereby increasing the employment-to-population ratio. Proponents of the foreign aid provided the rationale for higher foreign aid spending by the analogy of post-WW2 Europe when Marshall Plan provided $13 billion, or roughly $100 billion in today's prices, to Western European economies to recover the physical infrastructure which had been destroyed during WW2. Marshall Plan intervention was rather short, quick and finite. The efficacy of foreign aid in Africa is questionable since little or no growth occured in many African states such as Burundi, Benin, Zimbabwe and Congo. Official forecasts from the United Nations from 1950s onwards, based on the famous Harrod-Domar growth model (link), often assumed a rapid increase in the level of GDP per capita in response to the increase in investment rates. The forecasts, based on the theoretical assumption of diminishing capital returns, predicted a persistent convergence of GDP per capita to the level sustained in richer countries. The fact that the launch of extensive investment in infrastructure resulted in further economic stagnation of many African states, has questioned both the validity and quality of prescriptions laid by the mainstream development economics.

The philosophy of the mainstream development economics was sharply criticized in the light of the fact that foreign aid failed to alleviate poverty and made the growth of African economies slower. The efforts by the World Bank have been diverted from correct diagnosis of the developmental issues in African states to repeated initiatives such as the commitment of the international community to increase the share of foreign aid to least-developed countries to at least 1 percent of the GDP. The criticism of the mainstream development economics was already formulated in 1958 when Mont Pelerin Society organized the 9th meeting and development economics seminar where professor Herbert Frankel of the Nuttfield College put forth the criticism of foreign aid and the failure of development economics:

"The lesson that flows from it is that it does pay to go to these remote areas and find out what the problem is, instead of assuming that one knows the problem before one begins. Until recent years, people have simply assumed in many of these territories in Africa, that there were no real, positive signs of enterprise among the indigenous population, which was supposed to be so uninstructed or inert that it was not able to fend for itself, experiment for itself, or improve itself. It was not realised that a reason why there was this apparent lack of initiative in the population was that there were serious customary or legal obstacles to the exercise of ordinary enterprise, even on a small scale."

Given the lack of the comprehensive diagnosis of the causes of underdevelopment in African countries, the mainstream development economics failed to capture the appropriate assumptions in the theoretical models of economic development, upon which developmental assistance was justified. A more reasonable theoretical solution to the economic stagnation and social conflict in Africa has been put forth by the human capital theory. In its broadest and most general form, the theory stated that the economic stagnation of African countries is a consequence of the lack of skills and investment in education that could provide the necessary input to increase the economic growth and, subsequently, alleviate the issues of AIDS/HIV, malaria, child malnutrition and domestic violence. There is no doubt that the growth of education initiatives in Africa has sent many children to school. In addition, many universities in Western Europe and the United States have expanded the initiative and offered students from African states preferential admission criteria in various forms such as graduate fellowships, student grants and lower required standardized test scores, to boost admission rates of African nationals at U.S. universities. The efforts of developed countries to bring educational initiatives to Africa encouraged school participation as well as international opportunities of African citizens to study abroad, even at world's most prestigious and highly-ranked universities. Notwithstanding the importance of education in creating the stock of human capital for the wealth of nations, educational initiatives should address the essential obstacles that creates the failure of African expatriates to return to home countries, hence, bring skills, knowledge and various other forms of human capital, which are essential to the process of long-run growth, the issues of labor market distortions in African countries. These distortions crucially impede the ability of young African graduates to matching jobs in regional labor market.

What the mainstream development economics failed to take into account is the institutional paralysis which prevails in a majority of African countries, plagued by the destructive tribal institutions based on widespread corruption, bribes and domestic violence as means of achieving political power. The prevalence of hybrid institutions, marred by the complete absence of the rule of law and judicial institutions that could facilitate efficient contract enforcement and the protection of private property rights, is not only a severe obstacle to higher economic growth but also the apparent mechanism that captures the set of explanatory features that could possibly account for what caused the misdiagnosis of the African development dilemma. Back in 2002, African Union estimated that each year, corruption costs African economies more than $148 billion or 25 percent of Africa's GDP. The significance of corruption in state structures in Africa manifests itself in poor quality and provision of public services, the absence of judicial independence from political regimes, cumbersome contract enforcement and unprotected private property rights. Such distortions impede the level of trust and provide evolving incentives to subvert the institutional independence into political cronyism, in which corruption substitutes the tax system through bribes and extortion as methods of lowering transaction costs in overcoming the malfunctioning of the judicial system. In 1978, Erwin Blumenthal of the central bank of the Federal Republic of Germany, warned the international community that "Zaire's political system is so corrupt that there's no prospect for Zaire's creditors to get their money back." (link)

The advancement of country's economic prospects requires not only transparent, sound and efficient regulations but, more importantly, highly efficient civil service. In 2010, Transparency International published Corruption Perception Index (link) by measuring the persistence of corruption in public sectors across the world. The findings showed that the vast majority of poor African countries were plagued by extensive and extortionate corruption and ranked in the bottom 20 percent of the distribution. Comparing the level bureaucracy against GDP per capita reveals the amplified evidence of the negative correlation between the efficiency of civil service and the GDP per capita. The ease of doing business in Africa in countries such as Botswana, Ghana, Mauritius and South Africa is remarkably easier with predictable, stable and efficient regulation, compared to countries such as Burundi, Burkina Faso, Côte d'Ivoire etc. where highly burdensome administrative procedures in doing business hamper capital formation and restrain productive investment in health-care, education and private-sector infrastructure that could provide the impetus to economic growth.

The relationship between the amount of foreign aid, received by the least-developed countries, and the scope of corruption as a rough approximation of the institutional quality in the least-developed states, could provide the answer to the question whether international donors consider the scope and significance of corruption in allocating the amount of foreign aid. The experience from the last century of development policy, suggest that international donors actually allocated more foreign aid to the countries, suffering from severe state failure, widespread corruption, government failure and the complete absence of judicial independence that could provide a system of checks and balances and the necessary restraint on the violiation of private property rights, extortion and violence by the political elites. In 1999, Alberto Alesina and Beatrice Weder (see "Do Corrupt Governments Receive Less Foreign Aid," American Economic Review, 92(4), pp. 1126-1137) found that, contrary to arguments of aid supporters, foreign aid is not used to reward good governments since more corrupt governments received more foreign aid and official development assistance from international donors. The most striking evidence, presented by Alesina and Weder, suggests that U.S donors seem to neglect the persistence of corruption in allocating foreign aid to poor countries while, on the other hand, Scandinavian donors deem the persistence of corruption as highly important, hence, rewarding governments with lower extent of corruption.

In the following graph, I estimated the impact of corruption on official development assitance in the sample of 41 least-developed countries in 2008. In the model, I set the official development assitance to be determined by the scope of corruption in least-developed countries. The official development assitance is expressed as a share of representative country's gross national income (GNI) for it provides a better measure of aid dependence than foreign aid per capita since the size of population is controlled by the main assumptions of the model. The data on official development assistance were download from World Bank's World Development Indicators (link). The data on the extent of corruption in least-developed countries were provided by Transparency International's 2008 Corruption Perception Index (link). The extent of corruption varies from 1 to 10, where lower values indicate more persistent corruption. I estimated whether countries with more corrupt governments receive a higher share of foreign aid from international donors. On the basis of 41 least-developed countries, sample estimates suggest that a 1 point improvment in corruption perception index tends to decrease, on average, the share of foreign aid in gross national income, on average, by 2.37 percentage points. Sample estimate of the slope coefficient is statistically significant at 5 percent level. Even though, the variation in corruption perception index accounts for 5.51 percent of the variation in official development assitance, the influence of the extent of corruption on the share of foreign aid in gross national income is not spurious but systematic and persistent.

Corruption and official development assistance

Source: World Bank, World Development Indicators, 2010. Transparency International, Corruption Perception Index, 2008.

The estimate suggests that international donors indeed reward more corrupt governments by increasing the share of official development assitance. In 2002, African Union estimated that corruption was costing the African continent $150 billion per year. The estimates of the total cost of corruption provide an ample evidence that, over the last century, international donors consistently allocated foreign aid to more corrupt governments, creating aid-dependent economies, prone to bloated bureaucracies and extractive institutions which subsequently led to the stagnation of income per capita in the last decades. An ample criticism of foreign aid initiative was put forth by Dambisa Moyo (link) in the WSJ two years ago: "The most obvious criticism of aid is its links to rampant corruption. Aid flows destined to help the average African end up supporting bloated bureaucracies in the form of the poor-country governments and donor-funded non-governmental organizations."

The consequence of rootedness of corruption and extractive political institutions in African tribal cultures can be, in a considerable part, drawn upon the colonial heritage that spread throughout the African continent from 19th century onwards. The colonial experience across the African continent (link) served not only as a conquest of newly discovered areas but, moreover, also as an experiment of developing political and economic institutions on the basis of European influence. The colonial heritage in Africa was mainly derived from the European occupation of African lands. Hereto, the presence of European colonisers in Africa provided a long-lasting foundation of the institutional lessons from which the African states went forth.

Given the heterogenity of the European perspectives on institutional development, the colonial period in Africa left a long-lasting impact on the economic and political development in Africa. Africa's richest countries, namely Botswana, South Africa and Mauritius, were influenced tremendously by the colonial heritage. In Botswana and South Africa, the colonial influence of English and Dutch on further economic development was mainly derived from setting strong institutional foundations of economic development such as the rule of law, judicial independence and limited government compared to other African states. Apart from the setting of formal institutions, fostering contract enforcement and the integrity of the political institutions, English and Dutch colonizers provided the establishment of cultural setting not prone to fraud, extortion and extractive institutions. Favorable institutional conditions furthered the advertance of trust and institutional efficiency, which are deemed essential in fostering the development of financial markets. Even the German presence in Namibia from 1884 to 1915 during Deutsch-Südwestafrika (link) fostered, to a certain extent, independent judiciary, relatively sound institutions and cohesive framework of the rule of law. As a result, Nambia retained the status of one of the least corrupt countries in Africa, known for relatively high degree of economic freedom in a regional comparison with other African states.

While the influence of German, English and Dutch colonizers was largely beneficial to African countries from the perspective of economic growth and development over the last century, the presence of French, Italian and Belgian colonizers arises serious concerns over the prospects of economic development across the African continent. The myraid of violence, in countries such as Congo Dem. Rep. and Somalia, which ultimately led to civil wars and the settlement of extractive institutions, largely reflects the innate ability of the colonial policies to provide the necessary conditions for the institutional integrity, the rule of law and stringent property rights that could underline the basis of economic development by restraining the power and domination of political elites and their ability to expropriate private property rights in pursuit of extractive monopoly rents from natural resources. That easily explains why countries such as Congo, Zambia, Nigeria and Zimbabwe, in spite of vast reserves of natural resources, were seized by the state capture of political elites. The colonial presence largely determined the size and scope of aid dependency in African states. The most plausible and persuasive explanation of the impact of European colonial policies in African countries was presented by Daron Acemoglu, Simon Johnson and David Robinson (see "Disease and Development" Journal of European Economic Association, 1(2/3), pp. 397-405):

"European colonists were much more likely to develop institutions of private property, encouraging economic and social development, in places where they settled. In contrast, in places where they did not settle, they were more likely to opt for extractive institutions, designed to extract resources without investing in institutional development. In these places, institutions were highly centralized, with political power concentrated in the hands of small elites and with almost no checks on this elite. The property rights and more general rights of the majority of the population were not protected."

The political and economic circumstances of the European institutional legacy in African states imparted aid dependency on those countries where the combination of tribal institutions, hostile to free enterprise and judicial restraint of political dictatorships, and unequivocally detrimental colonial policies dominated the development of political and economic institutions, setting the rules of the game. Therefore, the inability of many African societies to establish sensible and effective institutions resulted in the political capture of the state by the elites. The monopoly power of the political elites, enforcing anti-growth public policies, led to consistently poor economic outcomes, plagued by high rates of poverty and infectious diseases such as polio, malaria and measles.

The challenge of development economics is not to design aid schemes, which inevitably lead to aid dependency, marred by persistent corruption and political fraud, but to ascertain correct diagnosis of why foreign aid repeatedly resulted in the poor economic outcomes and the consequent stagnation of income per capita in many African states in 20th century. The failure of African societies to establish a rigorous system of incentives, which could significantly improve economic outcomes, is not a response to market failures (which deemed highly of early development economics) but a result of severe government failure to establish effective institutions of the rule of law, contract enforcement and stringent property rights. These institutions are the broadest foundations of economic development and the only viable alternative to political nepotism and the power of elites which, as poor development outcomes in Africa show, ultimately impose extractive institutions, causing the persistence of poverty and underdevelopment.

Artificial states

The question of the artificial states has recently been brought up by the referendum in Southern Sudan on whether the southern part of the country should declare political independence from the northern part of the country. An article in New York Times (link) succintly discussed few notable fact-checked evidence of the increasing ethnic, political and economic North-South division within the country. As a single country, Sudan performed terribly in development outcomes. According to CIA World Factbook (link), the country suffers from high rates of extreme poverty and illiteracy. For instance, the official share of population below poverty line is estimated at 40 percent - almost twice the average of North African states. In addition to poor development outcomes, the country is plagued by significant political and ethnic fragmentation into largely Muslim, Arab-speaking north and predominantly Christain, English-speaking south. The political independence of South Sudan is the only contemporary evidence of the re-establishment of land borders alongside the ethnic division.

In the recent paper entitled Artificial States, Alberto Alesina, William Easterly and Janina Matuszeski presented two formal measures of artificial states. Aside from the measure of ethnic division, the authors constructed the measure of straightness of border lines. The hypothesis suggests that squiggly geographic border lines separate the states alongside the ethnic division. On the contrary, straight border lines suggest increase the probability of the emergence of artificial states plagued by ethnic and linguistic fractioning. The authors presented the empirical evidence, suggesting that fractional land borders are highly correlated with the GDP per capita. In addition, the share of ethnically partitioned population within the country is systematically decreasing the GDP per capita in cross-country comparison. The intuitive ideas behind the empirical evidence suggest that at the end of colonial period, colonizers that set straight borderlines between the emerging countries incured significant economic cost to newly formed African countries in terms of lost GDP. The evidence from Alesina-Easterly-Matuszeski study suggest that a 1 percentage point increase in the fraction of country's population belonging to groups partitioned by the border would decrease the GDP per capita by 1.3 percent. On the other hand, countries with squiggly geographic borderlines enjoy significantly higher GDP per capita.

The post-colonial period in Sudan was characterized by two civil wars which outbroke in 1972 and 1983. In 1956, Sudan gained the political independence from Great Britain. Contemporary borderlines were predominantly determined by the colonial authorities in African states prior to the wave of independence of many African nations. The emergence of the artificial states is rather a consequence of poor colonial policies than of high bargaining cost of ethnic groups within the country in setting country borderlines. Hence, the economic effects of colonial legacy can persist over time. Consider the evidence from Cameroon. The country was originally colonized by Germany. During the World War I, Northern Cameroon was occupied by Germany while the rest of the country was colonized by the French. Between 1916 and 1960, the country was a unique experiment of how the establishment of the institutional setting of European countries affects domestic development outcomes. A recent study by Alexander Lee and Kenneth Schultz (link) suggests that in the areas formerly occupied by the British enjoy higher levels of wealth and improved access to clean water while the rest of the rural country, after having been colonized by the French, suffers from significantly hindered access to clean water and worse provision of public goods. Even though the colonial patterns do not apply to urban areas, lessons from Cameroon suggest that the impact of post-independence public policies and colonial legacy on the level of wealth is of the same importance even when linguistic and ethnic fragmentation persists over time.

In spite of considerable degree of inefficiency, the persistence of inefficient and ethnically fragmented states is continuously marked by poor economic and development outcomes, often accompanied by civil-war conflicts such as military violence and genocide by the Sudanese army in Darfur. An interesting theory has been recently put forth by Daron Acemoglu, Davide Ticchi and Andrea Vindigni (link) who suggest that rich political elites seize state capture and democratic politics by expanding the size of bureaucracy. Hence, to gain political support, the coalition of elites chooses an inefficient structure and organization of the state.

The phenomenon of artificial states is not abridged to least-developed countries and developing world. Even in the group of advanced countries, several countries emerged despite a considerable degree of linguistic, ethnic and cultural fractioning within country borders. The evidence from Switzerland suggests that a continuous transition to a peaceful and stable democracy is possible. Amid highly fragmented linguistic and cultural characteristics such as four official languages and the persistence of GDP per capita divergence between high-income German cantons and low-income French cantons, Switzerland is characterized by envious political stability and economic performance. The genuine feature of federal political system is a consistent fiscal decentralization such as jurisdictional competition between units within the federalized structure in various areas such as taxation, regulation, health care etc. Hence, a decentralized fiscal structure and division of powers require a limited federal government and a high degree of autonomy within the federation. Thus, despite a multilingual population, the Swiss model of federalism is marked by political stability, peace and prosperity.

The phenomenon of artificial states in advanced countries is not confined to Switzerland itself. What distinguishes the Swiss model of federalism from centralist political systems in its neighboring countries is a high degree of political autonomy in Swiss cantons. Competition between jurisdictions within the federation nonetheless generates different economic outcomes. However, the outcomes generated by jurisdictional competition preclude adverse effects caused by either state capture of democratic politics or redistributive taxation between jurisdictions. In Switzerland, cantons with favorable public policies such as low tax rates on labor and capital, sound regulation and competitive provision of health care, have enjoyed persistently higher levels of wealth compared to cantons in the rest of the country. Of course, the coexistence of diverse ethnic and lingual groups within the single state requires common values, integrated into formal institutions.

Contrary to common perception, the artificial state may not be characterized exclusively by ethnic and linguistic fragmentation. To a large extent, Germany and Belgium could be classifed as artificial states. In Belgium, Flemmish-speaking north of the country consistently outperformed French-speaking south on various indicators and outcomes, including income per capita, international test scores and employment-to-population ratio. The political and linguistic division of Belgium into high-income Flemmish part and less developed French part reflects the essential dilemma of artificial states - should a single country with fragmented and heterogenous population be abandonded and whether ethnicity borders should represent country borderlines. In fact, linguistic fragmentation of Belgium to the extent that Flemmish and French part of the country adopted different administrative and education systems, led to persistent inability of two majorities to form a government. In 2007, The Economist opined that Belgium should cease to exist. The unification of Germany (Wiedervereinigung) integrated two parts of the country with vastly different institutional setting into a single political unity. However, Eastern and Western Germany were known for completely different political and economic system. The unification has incured many adverse effects. A significant difference in wage and price levels between East Germany and West Germany caused continuous migration of East German labor into West Germany, thus decreasing the productivity growth in East Germany. Consequently, the unification of the country led to the adoption of West Germany level of prices and wages in Eastern part of the new country. The artificial increase in price-wage level increased the unemployment rate in Eastern Germany to double-digit level, not least triggered brain-drain and capital flight. Hence, the unification of Germany as an artificial state resulted in persistent income per capita divergence between high-income West Germany and low-income East Germany. The unification of Germany into a single country should indeed never happen. In fact, adverse effects of the unification on East German productivity and wages would not lead to continuous increase in unemployment rate. If East Germany maintained a high degree of political autonomy, the transition to market economy would not be restrained by the adoption of West German price-wage level that could not be sustained by low productivity level in East Germany. To avoid the pitfalls of the artificial states, West and East Germany would be better off, had the countries never been reunified.

Recent national referendum in South Sudan on whether the southern part of the country should declare political independence from Sudan again pondered over the persistence of artificial states. The empirical evidence on poor development outcomes in several African countries suggests that borderlines, disregarding the ethnic distribution of the population within the country, are highly correlated with low income per capita. The unique solution of the artificial states is the adoption of political federalism. Under fiscal decentralization and limited government, federalism enables peaceful and prosperous existence of fragmented ethnic and linguistic structure in a single state. For instance, former Yugoslavia, known for highly fragmented ethnic, linguistic and economic disparities, ceased to exist not because federalism would not be a genuine political system but, ultimately, because of severe economic mismanagement, powerful and centralized government that disdained the principles of political autonomy and market economy, causing severe hyperinflation and the collapse of the federation that eventually resulted in a decade of civil wars and military violence. The evidence from Yugoslavia suggests that between 1950 and 1990, drastic economic divergence occured. The lesson suggests that the essential condition for the efficiency of federalism as a political system is high political autonomy and fiscal decentralization, both of which enable the competition between public policies.

Amid linguistic fragmentation, the competition between jurisidictions rewards competitive public policies by higher income per capita which ultimately boost the inception of public policies in less developed parts of the federation. Hence, without jurisdictional competition and political autonomy, ethnic and linguistic fragmention of the country may ultimately result in political instability which, in addition, generates poor economic outcomes.

Student performance and economic growth

The 2009 PISA test study (link) of students' proficiency in reading, mathematics and science is a highly successful method of evaluating student performance across countries. In fact, the creation of human capital is the main endogenous feature of the long-run economic growth since the quality of schooling and education system are essential to the creation of human capital. The difference in GDP per capita across countries is both intuitive, theoretical and empirical challenge to search for the causes of the gap between the economic performance of nations.

PISA test scores are aimed mainly at the evaluation of student knowledge at primary and secondary level in the fields of reading, mathematics and science. The assessment of knowledge in a particular field is subdivided into six different proficiency levels, ranging from 1 to 6. For instance, students at the 1st reading proficiency level are characterized by innate recognition of simple ideas reinforced in the text while students at the 6th reading proficiency level are characterized by a full capability of making multiple inferences, comparisons and contrasts and integrating the ideas presented in the text into a coherent conceptual framework of abstract ideas, sound evaluation and reflection. While 98.6 percent of OECD students can perform reading tasks at level 1, only 1.1 percent of students across OECD countries can perform reading tasks at the highest proficiency level. In addition, 28.4 percent of students in OECD countries exceeded the 4th (mid-range) reading proficiency level.

The reading scale has been further divided in reading continuous and non-continuous texts. However, the evidence suggest no systematic difference in reading scores between the two fields. Countries with the highest performance, measured as mean score, in reading rank are Korea (89.8 percent), Finland (89.3 percent) and Canada (87.3 percent). Countries with the largest student populations such as United States, United Kingdom and France were ranked in the upper-middle range while percent, and Israel (79 percent), Luxembourg (78.6 percent) and Austria (78.3 percent) are the lowest-ranking high-income countries on the reading scale in the 2009 PISA assessment. In the field of mathematics, 8 percent of students in OECD countries perform below level 1, 31.4 percent of students can perform mathematical tasks at 4th (mid-range) proficiency level while 3.1 percent of students perform at the highest proficiency level. In the country distribution, the percentage of students in the 6th proficiency level is the highest in Korea and Switzerland (8 percent), Japan, Belgium and New Zealand (5 percent). In a regional distribution, more than 25 percent of students in Shanghai perform at the highest level of mathematical proficiency. The proportion of students in the 6th proficiency level is very high in Singapore, Chinese Taipei and Hong Kong - 15.6 percent, 11.3 percent and 10.8 percent respectively. In addition, performance disparity in mathematics varied significantly across countries. Less than 1 percent of students in Mexico, Chile, Greece and Ireland reached 6th proficiency level A brief overview of the main empirical findings suggests a rather rigorous disparities in country ranking and performance.

The assessment of student performance in science is similar to the distribution of mean scores in the field of mathematics. About 5 percent of students perform below 1st proficiency level. In addition, only 29.4 percent of the students in OECD countries is proficient at 4th (mid-range) proficiency level in science while an average 1.1 percent of students in OECD countries can perform at the highest level of scientific literacy. In addition, the percentage of students below the lowest level of scientific proficiency is highly negatively correlated with country ranking since the proportion of students below the 1st level is the lowest in Finland (8.3 percent), Korea (6.3 percent), Estonia (8.3 percent) and Canada (9.6). Higher country ranking would thus indicate a lower proportion of students below the 1st proficiency level. All of the aforementioned countries ranked in the highest 10 percent of the distribution. If Shanghai, Hong Kong, Macao and Taipei were independent countries, their respective ranking in the field of scientific literacy would be in the top 10 percent of the distribution.

The empirical data on the distribution of mean scores in reading, mathematics and science are highly relevant to the measurement of human capital since the impact of mean scores on economic growth would differ to the certain extent from other measures of human capital. Recent attempts to capture the effect of human capital on economic growth were aimed at the definition of human capital as total years of primary, secondary and tertiary schooling. For instance, Robert Barro and Jong Wha Lee have collected disaggregated data on the total years of schooling for 146 countries between 1950 and 2005 at five-year intervals (link). The empirical evidence from the country panel suggests a strong linkage between schooling and long-run economic growth and institutional country features (link). In addition, Barro and Lee estimated the implicit return from an additional year of schooling ranging from 5 percent to 12 percent.

Gary Becker (link) and Richard Posner (link) recently discussed the 2009 PISA findings and the impact of cultural, genetic and demographic disparities on mean test scores in the United States. United States ranked in the middle of the mean score distribution. The rank of the United States (17th out of 79 countries) is above average in reading and average rank in mathematics (31st out of 79 countries) and science (23rd out of 79 countries). As Becker and Posner indicate, the relative performance of the United States should be evaluated with the consideration of cultural and demographic differences since the mean score of White and Asian students is significantly higher than the mean score of African American and Hispanic students. Disparities in mean scores between different demographic groups are typical in largely heterogenous populations. In Belgium, the regional disparity in mean scores between French and Flemish communities is even more striking. While the mean score in mathematics in 2006 in Flemish community had beenabove the OECD average, the mean score in mathematics of students in French community had been 18.56 points below the OECD average while the mean score of students in Flemish community had been 30 points above the OECD average. In 2009, such a relative difference would place French community in the rank of Italy, Portugal and Spain. On the other hand, student performance in Flemish-speaking community would reach the rank of Canada, Switzerland and Japan.

In the U.S, the demographic disparities in mean scores in reading, mathematics and science do not reflect the quality of the American education system. While the overall quality of the public and private American high school education system raised considerable concerns in previous performance of U.S. students in international mathematics and science ranking, the ranking of U.S. universities in science, mathematics and social sciences is the highest in the world. The output U.S. universities resulted in the highest number of Nobel laureates in physics, chemistry, medicine and economics as well as into cutting-edge accomplishments in R&D and technology. The emphasis on creativity and innovative thinking embodied in the American education system has enabled the United States to emerge as a world leader in technology, R&D, innovation and entrepreneurship.

The openness of the U.S. education system to international students, ideas and creative thinking could account for the remarkable achievements and academic quality of top American universities. On the other hand, poor teacher quality in American high school system is detrimental to the reading and quantitative literacy of American high school graduates, as a consequence of what Becker calls "teaching-to-the-test" syndrom where many public school teachers teach students topics not relevant to the command of knowledge but to the tests since test scores presumably determine teacher pay. Eric Hanushek of Hoover Institution recently found (link) that replacing bottom 5-8 percent of high school teachers with average teachers could near the United States on top of the international mathematics and science ranking. In addition, the measure is worth $100 trillion according to Hanushek (2010).

In the international perspective, student performance has been viewed as a significant determinant of the difference in cross-country economic performance. Recent paper by Atherton, Appleton and Bleaney (2010) found that higher mean test scores in mathematics, reading and science significantly improve per capita GDP. The authors showed that holding per capita income constant, average years of schooling is less important than mean test scores in predicting the economic growth. The 2009 PISA study highlighted the relationship between international test scores and economic growth. The evidence suggests almost non-existent correlation between reading performance and GDP per capita and cumulative education expenditure. The evidence simply suggests that socioeconomic variables matter more for reading performance than simple and often inconclusive aggregate indicators. In analysing the impact of various social and economic variables on reading performance, the results suggest a high correlation between parents' education and children's reading performance. For instance, 1 percentage point increase in the percentage of the population aged 35-44 with tertiary education returns 1.36 point increase in average reading performance where parents' education accounts for 44 percent of the variation in children's reading performance. The impact is shown in the following graph.

Parents' education and student reading performance

Source: OECD, PISA 2009.

A brief look also reveals another striking implication: cross-country reading performance is strongly affected by social and cultural status of the child's parents. A simple estimate of the relationship between reading performance and socio-economic status suggests that 1 percentage point increase in the share of students with very low social, cultural and economic status tends to decrease the average reading score by 1.13 points. Hence, social, economic and cultural status explains about 46 percent of the variation in student reading performance.

A considerable improvement of primary and secondary education system is vitally essential to the long-run economic growth. International test scores are an important method of evaluating international disparities in student performance and the subsequent impact on economic growth. Modern knowledge-driven economy requires not only intelligence, attentiveness but also comprehensive, integrated and developed social skills. Low reading, mathematics and science performance is generally attributed to student's low social, cultural and economic status. Genetic, cultural and socioeconomic variables, rather than education expenditure and GDP per capita, tend to play a major role in early childhood development as a basis of future student performance.

The economic and social future of countries requires considerable investment in children and student. Professor James Heckman of the University of Chicago brilliantly argued in Heckman equation (link) why the most gainful benefit of early childhood development is increased social productivity, greater motivation and developmental stimulation that every child needs. Our society should be not neglect an indisputable fact that early childhood development is a major determinant of student performance which sets the conditions for future advantage in school, college, career and life in general. Without these essential measures, student performance would suffer heavily from the spread of crime, teenage violence and high dropout rates.

The evidence from the 2009 PISA study suggests that higher quality of the education system is a necessary condition for higher test scores in reading, mathematics and science. As the evidence suggests, that the quality of human capital is strongly associated with higher standard of living. Without a prudent step towards improving developmental stimulation of students, considerably low student performance may seriously harm the prospects of future generations.

Economic growth and democratic institutions

Professor William Easterly recently presented (link) an intriguing empirical evidence on the relationship between nation's politics and economic growth. In particular, professor Easterly presented data on long-run economic growth and the scope of democracy for a majority of countries between 1960 and 2008. Professor Easterly identified that the highest-growing countries in the world were those with autocratic political regimes. Among ten highest-growing economies between 1960 and 2008, all of them, except for Cyprus, have been characterized by hybrid and autocratic political regimes. On the other hand, ten countries with the lowest growth rates of real GDP per capita between 1960 and 2008 were equally known for authocratic political systems or flawed democracies.

Presumably, the evidence bodes against the recent prediction by Dani Rodrik that authoritarian political regimes ultimately create economic systems vulnerable to external shocks and structural change, thus hampering the prospects of structural change as a neccessary condition for economic development.

To estimate the general pattern of the relationship between economic growth and the nature of political system, I reviewed real per capita GDP growth rates between 1970 and 2007 for a group of 134 countries across the broad spectrum of different levels of GDP per capita. Based on Summers-Heston dataset of real GDP per capita growth rates (link) between the stated time period, I estimated average rates of growth of GDP per capita and collected data from Economist Intelligence Unit on the level of democracy across the world in 2008 (link). The intuition behind this approach is the identification of endogenous and casual direction between the two variables. From the theoretical perspective, it is nonetheless difficult to establish a relationship between the form of government and long-run economic growth. There are at least two possible directions of casuality.

First, the underlying assumption of the relationship could be that systemic changes in political environment are essential to the structural change and, hence, are the main mechanism behind the enforcement of constitutional changes and public policies. The assertion of the underlying theory is that autocratic and authoritarian political system hinder structural changes and the establishment of institutions and democratic governance that is crucial for economic growth. This particular view has been asserted by Dani Rodrik (link), Andrei Shleifer, Florencio Lopez de Silanes and Rafael La Porta (link). While Dani Rodrik's perspective heavily relied on the importance of institutions for long-run economic growth, Shleifer, Lopez de Silanes & La Porta captured the essence of economic development in the legal origins of nations.

Second, the casuality in economic growth and political system could also stem in the opposite direction. The basic underlying assumption could be that higher rates of economic growth encourage systemic changes in the political system and enable the adoption of democratic institutions. The notion of economic growth as the engine of democratic changes has deserved a strong empirical support.

Robert Barro's analysis of long-run economic growth across the world (link) has examined the relationship between the level of democracy and long-run economic growth rate. The empirical evidence suggests a non-linear, inverted-U relationship between democracy and 10-year growth residuals, both coefficients in partial quadratic equation and the partial correlation coefficient being statistically significantly different from zero.

The notion would suggest that as countries depart from a low level of real GDP per capita, the adoption of democratic institutions accelerates economic growth but only up to some point. After the tipping point, the economic outcome of further democratization results in lower growth of real GDP per capita, partly because a high level of democracy tends to promote public policies that diminish growth prospects such as higher tax rates on labor and capital and the redistribution of income, all of which exert a somewhat negative effect on productivity growth and incentives for labor supply and investment.

The first table portrays the distribution of real per capita GDP growth rates across 134 countries between 1970 and 2007. The distributive pattern resembles the properties of normal distribution curves. In fact, the estimated coefficients of skewness and kurtosis suggest a rather very mild departure from the assumption of normality which is of the high importance, especially in testing hypotheses about the effects of explanatory variables on long-run growth dynamics. The normality assumption of normally distributed errors was not tested via normality tests.

Ten highest growing countries in terms of real GDP per capita between 1970 and 2007 are Equatorial Guinea (8.39 percent), Taiwan (5.98 percent), China (5.97 percent), St. Kitts & Nevis (5.49 percent), Botswana (5.45 percent), Bhutan (5.38 percent), Maldives (5.38 percent), Hong Kong (5.37 percent), Macao (5.30 percent) and Singapore (5.29 percent). In real terms, the estimated average real per capita GDP growth rates suggest that it took only 13 years for Singapore's real GDP per capita to double and 21 years to triple. In China, where the estimated average growth rate exceeded Singapore's growth rate only by 0.69 percentage point, it took roughly 11 years for real GDP per capita to double and only 19 years to triple. In the lower tail of growth distribution are mostly countries from Sub-Saharan Africa such as Democratic Republic of Congo, Liberia, Somalia, Central African Republic and Niger. Average real growth rates of GDP per capita of these countries were negative. The negative average real GDP per capita growth rate occured in 11 percent of country observations.

Distribution of economic growth across 134 countries between 1970 and 2007

Source: own estimate based on Summers-Heston dataset

The following graph illustrates the relationship between long-run average growth rates and the level of democracy in 2008 for the entire sample of 134 countries. The attempt to analyze the effect of democracy level on long-run economic growth is based on the notion that democratic institutions elevate economic growth in the longer run. The estimated slope coefficient (0.2277) suggest that a one-point increase in democracy index increases the average long-run per capita GDP growth rate by 0.2277 percentage point controlling for other factors.

Although the cross-country variation in the level of democracy explains only about 9 percent of growth rate variance, and even though the direct effect of democracy on economic growth seems minor and almost non-existent, the estimated sample regression coefficient is statistically significant at 5 percent level. It suggests that the effect of democracy on growth is persistant and evident in the particular sample.

Democracy and average long-run growth rates in a sample of 134 countries

Source: own estimates

Hence, to account for different degree of variation in average real GDP per capita growth rates, I divided the sample into quartiles. The goal of the pursued empirical strategy is to see whether the difference in variance composition between countries with similar growth rates persists. I divided the total sample into four groups: high growth performers (average growth rate higher than 3 percent) moderate growth countries (average growth rate below 3 percent and above 2.05 percent) and low growth countries (average growth rate below 1.09 percent). The next graph shows the relationship between democracy and average real GDP per capita growth rate in high-growth countries between 1970 and 2007. The parameters suggests a different relationship. The estimated slope coefficient is negative (-0.1638), suggesting that a one point increase in democracy index decreases the average real GDP per capita growth rate by about 0.1638 percentage point.

The share of variance explained by the democracy variable increased by 22.5 percent. In the statistical sense, the effect of democracy on economic growth in high-growth countries has been more powerful compared to the total sample. The estimated slope coefficient is statistically significant at 5 percent level. I also estimated beta coefficient (-0.338) to account for the effects of standard deviation increase on the average growth rate in real GDP per capita. The estimated beta coefficient suggests that a one standard deviation increase in democracy level (2.4 points) would, on impact, decrease the average real GDP per capita growth rate by 0.338 standard deviation or 0.394 percentage point in real terms.

From a theoretical perspective, the enforcement of democratic policies in high-growth countries would have a minor negative effect on economic growth, holding all other factors constant. Surprisingly, authortarian regimes previal in 44 percent of countries in the high-growth sample. Thus, the hypothetically negative effect of democracy on economic growth is evident but it is far from significantly negative.

Democracy and average long-run growth rates in high-growth countries

Source: own estimates based on Summers-Heston and EIU datasets

The next graph portrays the relationship between democracy and average real GDP per capita growth rates in low-growth countries. Contrary to the sample estimate in high-growth country group, the effect of democracy on real GDP per capita growth rate is positive and persistent. The correlation coefficient is positive and moderate (0.458) and statistically significant at 1 percent level. The beta coefficient (0.458) from the regression specification suggests that a one standard deviation increase in democracy level (cca. 1.497 points) would raise the average real GDP per capita growth rate on impact by 0.458 standard deviation or 0.382 percentage point, ceteris paribus. In fact, the variability in level of democracy explains 21.1 percent of the variance of average per capita GDP real growth rates. The estimated slope coefficient is statistically significant at 2.1 percent level and 0.6 percent level, suggesting a very low probability of rejecting the null hypothesis and a strong influence of democratic institutions on economic growth in the long run.

Democracy and average long-run growth rates in low-growth countries

Source: own estimate based on Summers-Heston and EIU datasets

In the next subsample, I jointly added high-growth and low-growth countries in the single sample and changed the casual direction. The underlying assumption is that democracy level is endogenously determined by the long-run average real GDP per capita growth rate. In real terms, I assumed that the public choice of political institutions across the world depend on the real GDP growth rate. Hence, I estimated the relationship by including the squared term in the regression equation. The estimated slope coefficients suggest a typical inverted-U relationship between real GDP per capita growth rate and the level of democracy. The real GDP per capita growth rate alone explains 30.6 percent of the cross-country variaton in the level of democracy. Intuitively, the results suggest that there exists an optimum level of real GDP per capita growth that maximizes the level of institutional democracy.

Differentiating the conditional expectation function of the level of democracy with respect to the real GDP per capita growth rate yields the partial derivate dy/dx = -(ß2/2ß3). Plugging the two coefficients in the partial derivate yields 3.65. Thus, the growth rate of real GDP per capita that maximizes the level of institutional democracy is 3.65 percent. Hence, both coefficients are statistically significant. The p-values are 0.000 suggesting a zero probability of rejecting a null hypothesis when it is, in fact, true - and a strong predictive influence of both variables on the expected level of democracy.

The effect of long-run economic growth on democratic institutions in high-growth and low-growth countries

Source: own estimates based on Summers-Heston and EIU datasets

Countries with the comparable growth rate are Iceland, Ireland, Trinidad & Tobago and Spain. Except for Trinidad & Tobago, none of these countries is either flawed democracy or an authoritarin political regime. Therefore, the expected level of democracy is low in countries where the average growth rate of GDP per capita is either very low or negative or very high.

Hypothetically, the conditional pattern of real per capita GDP growth supports the notion that the highest-growing countries in the 20th century such as Singapore, Taiwan and Botswana had a relatively low level of democracy and a significant degree of political authoritarianism. In addition, countries with the lowest growth rate of real GDP per capita such as Liberia, Sierra Leone and Somalia were also authoritarian political regimes. The predictive power of the regression equation is reasonably high since more than 30 percent of the variance of the level of democracy is explained by a non-linear shifts in the long-run average real GDP per capita growth rate.

Democracy is a controversial question of the modern theory of economic growth. Indeed, the empirical evidence suggests that the highest growth rates were achieved in those countries with a considerable degree of political dictatorship. However, the lowest long-run growth rates of real GDP per capita were achieved by countries in which political dictatorship prevails. The pattern suggest that the quality of institutions such as the rule of law, judicial independence and a constitutional democracy complement the significance of human capital which is the essential engine of long-run economic growth.

The most important growth engine of the highest growing countries such as East Asian tigers and Ireland has been the emphasize on human capital that resulted in a high level of knowledge intensity and high productivity growth rate. These countries were known for heavy doses of state interventionism aimed towards the implementation of industrial policy conducive to economic growth. However, the conclusion should be taken with caution. Political dictatorship or authoritarianism were detrimental to least-developed countries since it encouraged predatory political behavior and resulted in the political environment with a complete absence of the rule of law, judicial independence, protection of private property rights, institutional integrity and constitutional democracy.

The question which set of growth policies is essential to high long-run growth of real GDP per capita involves two answers. First, the primacy of institutional quality alongside the investment in human capital is by far the most important engine of long-run economic growth. Without first-class institutions and human capital, the vicious circle of poverty and social deprivation for less developed nations can be endless. And second, the components of constitutional democracy such as electoral rights and pluralism, good functioning of government, high level of political culture and civil liberties can deliberately increase the prospects of economic growth.

However, if the power of state is left unrestrained by the absence of the rule of law and a coherent set of checks and balances on the coercive strenght of redistributive interest groups, even a high level of democracy would not alleviate the persistence of poverty and weak structural indicators. On the contrary, it would only worsen the prospects of long-run economic growth.

CHINA'S GROWTH MODEL

According to some preliminary estimates (link), China's trade balance is on the course for a significant surplus this year. IMF's annual forecast of current account balance predicted China's trade surplus at $334 billion in 2010 or roughly 6.2 percent of China's GDP. The IMF's medium-term forecast suggests a growing trade surplus by 2015 when the surplus is estimated at a little more than 8 percent of GDP.

Recently, Dani Rodrik questioned (link) the persistence of China's mercantilism based on persistently low exchange rate. The partial fixation of the exchange rate then stimulates export-led growth model and, consequently, results in a large trade surplus which translates into foreign exchange reserves, thus enabling China's central bank to foster exchange rate intervention to defended the targeted yuan exchange rate against the U.S dollar. The implications of China's growth model extend beyond the scope of effects on country's economic growth, investment and current account balance. China's export-led growth model has tremendously affected the macroeconomic performance of developing nations. The exports of developing nations in the European, Japanese and U.S markets basically substitute, not complement, China's exports to the markets of advanced countries. The persistent lack of the appreciation of renmimbi thus forced the economic policymakers of other developing nations to either adopt the same model of exchange rate intervention or lose the export share in developing countries. This intuition is underlined by the theoretical and empirical support.

In 2007, Hausmann, Hwang and Rodrik demonstated (link) that the pattern of specialization by developing countries predicts the subsequent economic growth, suggesting that the share of exports in advanced countries is highly positively correlated with the rates of economic growth. If China shifted the main source of economic growth from export-led model to domestic consumption, the renmimbi would have to appreciate considerably. Contrary to the assertion that China's exchange rate undervaluation hampers the economic growth, industrialization and development prospects of developing nations, the OECD recently stated that developing countries would be hurt significantly if the renmimbi exchange rate were allowed to appreciate. There is also an empirical support for the particular assertion. The OECD recently estimated (link) that, if China's output grew by 1 percentage point, the output of developing countries would decrease by 0.3 percentage point.

The empirics supports the argument I mentioned earlier - China's exchange rate misalignment inevitably hinders the growth prospects and industrialization of developing countries. The essential question in the course of economic development is what is the best model of growth for developing countries to boost industrialization and development frontiers.

One possibility is the so called surplus model. Historically, growth models of low-income countries were primarily based on exporting natural resources to the rest of the world. Countries such as oil-rich gulf states, Botswana and Argentina became wealthy. Such growth model heavily depends on export demand in other countries. The most notable failure of this growth model is that it doesn't encourage the diversification of economic activity. Thus, countries such as Libya have sustained relatively high levels of GDP but, at the same time, rather depressing domestic indicators. For instance, Libya's GDP per capita is at almost the same level as Chile's GDP per capita, but Libya's unemployment rate is 30 percent - almost three times the average unemployment rate in countries with the same level of GDP per capita. When foreign demand deteriorates, these countries experience the Dutch disease - an overheating economic activity and overvalued exchange rates that discourage investment, entrepreneurship and typically result in higher unemployment rates.

Industrialization and economic development mostly depend on domestic structural change based on the adopting the institutions of macroeconomic stabilization and the rule of law. China's exchange rate policy of renmimbi undervaluation is a failed temporary growth model that is set on the unsustainable course. Without shifting the major engine of growth from export-boosting exchange rate undervaluation to consumption-based growth, Chinese economy will no longer be able to sustain high productivity growth rates. Letting the renmimbi appreciate by free floating could significantly boost the potential for institutional change in China and other developing nations. Therefore, the systemic abuse of macroeconomic policy by exchange rate undervaluation would no longer be feasible and the costs of failed exchange rate regime for developing countries would diminish substantially.

AFRICAN SUCCESS STORY: BOTSWANA

An intriguing empirical finding from the institutional perspective of economic development from Daron Acemoglu, Simon Johnson and James A. Robinson (link):

"Botswana has had the highest rate of per capita growth of any country in the world in the last 35 years. This occurred despite adverse initial conditions, including minimal investment during the colonial period and high inequality. Botswana achieved this rapid development by following orthodox economic policies. How Botswana sustained these policies is a puzzle because typically in Africa, ‘good economics’ has proved not to be politically feasible. In this Paper we suggest that good policies were chosen in Botswana because good institutions, which we refer to as institutions of private property, were in place...

Why did institutions of private property arise in Botswana, but not other African nations? We conjecture that the following factors were important. First, Botswana possessed relatively inclusive pre-colonial institutions, placing constraints on political elites. Second, the effect of British colonialism on Botswana was minimal, and did not destroy these institutions. Third, following independence, maintaining and strengthening institutions of private property were in the economic interests of the elite. Fourth, Botswana is very rich in diamonds, which created enough rents that no group wanted to challenge the status quo at the expense of ‘rocking the boat’. Finally, we emphasize that this situation was reinforced by a number of critical decisions made by the post-independence leaders, particularly Presidents Khama and Masire."

AUTHORITARIAN POLITICS AND ECONOMIC GROWTH

Dani Rodrik argues (link) that political dictatorship is damaging to economic growth since democracies not only outperformed countries with flawed political regimes in the dynamics of economic growth but also in terms of greater civil, economic and political liberties and investment in education that help enforce better public policies and yield better prospects of economic development.

"Democracies not only out-perform dictatorships when it comes to long-term economic growth, but also outdo them in several other important respects. They provide much greater economic stability, measured by the ups and downs of the business cycle. They are better at adjusting to external economic shocks (such as terms-of-trade declines or sudden stops in capital inflows). They generate more investment in human capital – health and education. And they produce more equitable societies."

POVERTY, INCOME INEQUALITY AND ECONOMIC DEVELOPMENT

Financial Times reports (link) on the new measure of poverty proposed by economists from Oxford University. The authors suggested the modification of current measure of poverty which, defined by the World Bank in annually published World Development Report, is currently set at the thresold of $1.25 per day or less. The new measure proposed by economic researchers from Oxford University sets the definition of poverty in a more sophisticated framework based on the household availibility of access to clean water, education, health care and other durable and non-durable goods. The new method, called Alkire-Foster approach, incorporates the qualitative elements into the measurement of poverty.

Using the new method, the authors examined poverty rates in four Indian provinces and evaluated the approach in comparison to the existing income method which had been used in economic and policy analysis by the World Bank and other institutions of economic development. The authors found a significant divergence of poverty rates when measured in both methods. For instance, under Alkire-Foster approach, the poverty rate in Indian state Jharkhand is 50 percent higher compared to the rate of poverty measured under the income method. On the other hand, the authors of the new poverty measure have shown that in some Indian provinces such as Uttaranchal (link), the official measure of poverty highly over-estimates the effective poverty measure as defined by Oxford's Poverty and Human Development Initiative. The multidimensional worldwide poverty index is also availible on the web (link).

The intuitive question arising from the data and empirical research on poverty is whether higher economic growth in less developed countries boosts the growth of income per capita and what is the role of institutional characteristics in economic development. The authors of the abovementioned measure of poverty have shown that despite abundant economic growth in past years and falling income poverty rates, the share of population without access to clean water, sanitation and minimum required nutrition remained unchanged. The percentage of malnourished children in India decreased from 47 percent in 1998-98 to 46 percent 2005-06.

The theoretical and empirical literature on economic growth suggests that there is an inverse U-relationship between inequality and income per capita known as Kuznets curve (link). The intuition behind the relationship is simple. At the very low levels of income per capita, income inequality is low. Alongside the course of growing income per capita, income inequality steeply increases and, after reaching a maximum, it decreases as countries achieve higher levels of income per capita. The rate of income inequality is closely related to the evolution of economic policies over time. Wagner's law, discussed in one of the previous posts, states that government spending over time increases due to long-run income elastic demand for public goods and capture of the democratic system by the particular interest groups that pose a permanent pressure on the growth of government spending and resist the reversals of government expenditures by trading votes.

There's a wide array of disagreement among economists on the effect of income inequality on economic growth. Back in 2001, Joseph Stiglitz re-examined the East Asian economic miracle and concluded that the evidence from the period of high economic growth in East Asian countries suggests that income redistribution has a positive effect on economic growth (link). Stiglitz's argument is based on the income distribution in East Asian countries during the economic miracle. East Asian countries have been known for relatively even distribution of income demonstrated by high Gini index and relatively high income tax rates.

On the other hand, the empirical investigation of the initial conditions in East Asian countries before the economic miracle shows that the political influence of interest groups had been relatively weak compared to Western Europe after the World War 2 when the productivity growth stalled from early 1970s onwards. The relative weakness of interest groups and a stable judicial system, inherited from English common law tradition, enabled high economic growth in the longer run given an enduring stability of property rights protection and the rule of law. In such conditions, income redistribution had relatively little effect on economic growth since the empirics of East Asian miracle suggests that the sizeable proportion of growth in East Asian countries (Malaysia, Singapore, Korea and Taiwan) had been driven by technological progress, investment and export orientation. Considering export orientation, Rodrik et. al (2005) provided the evidence (link) on the positive effect of high-quality export orientation on economic growth. The productivity growth in East Asian countries between 1975 and 1990 had been a pure example of economic miracle defined by the share of growth that could not be explained by the contribution of labor and capital input. In Taiwan and Hong Kong (link), total factor productivity accounted for about 60 percent of output per capita growth. Between 1975 and 1990, in Singapore, output per capita had increased by 8.0 percent. Consequently, the resulting outcome of almost two decades of robust productivity growth had been a significant decrease in national poverty rates (link). The lowest poverty rate, as defined by the measures of home authorities, is in Taiwan where 0.95 of the population live below the poverty thresold.

The basic set of policies that alleviate extreme poverty such as providing access to clean water, nutrition, medical protection against HIV/AIDS and basic sanitary standards have a positive effect on the economic growth and the standard of living. However, the major cause of persistent under-development in Subsaharan and Tropical Africa is mostly the lack of institutional enforcement of property rights, the rule of law and independent judiciary. In spite of billions of USD of direct foreign aid, countries such as Zambia, Sierra Leone, Mali and Rwanda endure in persistent poverty and under-development. Esther Duflo, this year's recepient of John Bates Clark Award, has shown in several studies how field experiments can enlighten the understanding of incentives in least developed countries (link). Understanding the significance of incentives in reducing poverty is crucial to further examination of the relationship betwen income inequality and economic growth.