inclusiveness, growth, and political support
TRANSCRIPT
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Inclusiveness, Growth, and Political Support
Richard L. Carson
Department of Economics, Carleton University, Ottawa, Canada
E-mail address:
Abstract: This paper links political support to economic growth. Governments gain support from wealth
creation and income redistribution, and the quest for support links differences in economic systems to
differences in political systems; inefficiencies persist when they raise political support. Depending on how a
government obtains its support, the quest for support can either lower efficiency and raise the consumption
cost of growth or lead to inclusiveness, efficiency, and sustainable growth, a kind of ‘political invisible
hand.’ In order for the invisible hand to work, however, some quite visible institutions must also exist and
be operating effectively.
JEL Classifications: D72, O40, P59.
Key Words: Economic Growth, Insiders and Outsiders, The Inclusiveness Parameter, Political Advantage,
Rent Seeking.
1. Introduction: Political Support, Growth, and the Inclusiveness Parameter
Can diverse economic and political change result from a change in a single underlying parameter? In
this paper, I argue that it can if the parameter measures the ‘inclusiveness’ of a political system in an
environment where governments obtain political support from two basic sources, wealth creation and income
redistribution, and choose combinations of the two that maximize their support. Changes in these
combinations—and thus in the way governments obtain support—cause multiple changes in social and
economic variables that can change the very nature of societies.
To gain political support from income redistribution, a government exploits differences in ability to
supply support. Let ‘insiders’ be those with a relatively high ability to supply political support and ‘outsiders’
be those with a relatively low ability. Then government redistributes income from ‘outsiders’ to ‘insiders,’
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contingent on insiders’ support behavior—eg., by giving insiders monopoly or monopsony power or by taxing
outsiders and subsidizing insiders. We denote this redistributed income by V, which is a form of rent, while
competition for V by supplying political support is a form of rent seeking and represents an alternative use of
resources to wealth creation. Below we interpret the evolution of growth in Japan [Beason and Patterson 2004]
and in the former Soviet Union [Anderson and Boettke 1997], as well as the ‘Great Recession’ in the United
States as consequences of political support from rent and rent seeking.
The more a government relies on insiders for support, the greater will be the support derived from
redistribution and rent seeking. This support, denoted by R, can take many forms—money, resources,
campaign rallies, monitoring, delivery of votes, intimidation and repression of political rivals or opposition
groups, etc., depending on the nature of the political system. The government uses V to pay for R and to
motivate support for itself rather than for a rival. Baker [2015] argues that rent seeking is the main driver of
growing inequality in the U.S. over 1980-2015.
Examples of insiders include the Communist Party elite in nations where it rules and party elites in
other countries, such as Japan, where a single party monopolizes power. In the United States, the upper 1% in
terms of income have outsized political influence owing to their ability to make outsized political contributions
in an environment where money plays an important role in determining political outcomes. Because increases
in rent and rent seeking can raise political support while lowering efficiency, both efficiency and equality can
be low at the support maximum. A political system becomes completely inclusive when the difference between
its insiders and its outsiders disappears, along with the exploitation of outsiders. Then efficiency is high.
Outsiders lose from income redistribution, but can gain from wealth creation. Let be the share of
outsiders in political support, which depends on the nature of the political system. This share is computed like
the share of labor or capital in output, and we can talk about insider or outsider intensive support, depending on
which group a government relies on for most of its support. A political system with = 1—all the support
comes from outsiders—is quite different from one with = 0—all the support comes from insiders—especially
in the role played by competition. Changes in generate a spectrum of political systems. As rises, a
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government will rely less on insiders and income redistribution and more on outsiders and wealth creation,
causing efficiency to increase. Differences in ability to supply support will become smaller and harder to
exploit; expansion of voting rights with secret ballots and the development of a free press are usually part of
this. As rises, the support of insiders becomes less important and that of outsiders more so until the
distinction between the two vanishes, and support depends only on wealth creation.
Thus, indexes inclusiveness. While the value of reflects the institutions and history of a given
political system, governments can often change institutions and erode or augment their effectiveness. This
changes . Because governments maximize their support, the quest for support links efficiency to
inclusiveness and, more generally, differences in economic systems to differences in political systems. In Why
Nations Fail, Acemoglu and Robinson [2012] also link efficiency to inclusiveness, although without defining
inclusiveness in a quantifiable way. We can also think in terms of ‘targeting’ [Lizzeri and Persico 2001]. In
redistributing wealth to insiders, a government destroys part of this wealth by raising inefficiency. However, it
gains political support by targeting wealth to people with a relatively high ability to supply support. Efficiency
will increase if institutional changes make it harder for a government to target in this way, but a government
that gains from doing so will resist such changes.
A government maximizes its political support, U, subject to a short-run production frontier, TR, in R and
useful output, Y. Here wealth creation means production of Y, which we take as numeraire. Only Y can yield
utility from present or future consumption, the way in which ‘useful’ output is useful. We divide Y into profit
from providing political support, G, and all other useful output, (Y – G). Rent extracted from outsiders to pay for
support is V, which equals the cost of support, RR, plus the profit from providing it, or V = G + RR. Here, R is
the price of R in units of Y. To maximize its support, a government can choose R and G or Y and G. Then TR
determines Y or R, along with R, which equals the inverse of the marginal rate of transformation of this frontier.
R, G, and R determine V. As economic growth occurs, U remains tangent to TR as TR shifts outward.
This paper makes two contributions and tries to give a positive analysis rather than a normative one. First,
it derives a specific political support function, U, with as parameter and shows how changes in affect Y, R,
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and G, as well as market and political competition, efficiency, and growth, plus secrecy in government, corruption,
and the rule of law. It also looks at the institutional requirements for inclusiveness to be high. Second, it shows
how the quest for support causes to change and how this affects efficiency and growth. This quest can lead to
an inclusive polity, a kind of political invisible hand, or to a polity that is far from inclusive.
Questions about inclusiveness and growth recall the long-running debate in the economics literature over
whether democracy raises growth. The most recent entry, as of this writing, is a paper by Acemoglu, Naidu,
Restrepo, and Robinson [2019], which answers with a resounding ‘yes.’ These authors also reference earlier
works on the subject, several of which give negative answers. Here I note that inclusiveness differs from
democracy and is neither necessary nor sufficient for democracy, although most inclusive polities are probably
liberal democracies. Autocracies can be inclusive under internal or external pressure to be efficient. However,
this requires a government to be able to rely on the support of outsiders without giving them guarantees of political
rights in return. Such an arrangement is likely to be temporary. Most democracies are illiberal, rather than liberal
[Zakariah, 1997], and the former are generally not inclusive (see below for the difference between the two). The
basic reason why inclusiveness raises growth is that it increases reliance on wealth creation for political support.
2. The Political Support Function
The political support function gives the demand side of our model. For any given political system,
is assumed to be constant, and a government’s total support, U, is a non-decreasing function of insiders’
support, UI, and outsiders’ support, UO. A constant population is also assumed, regardless of .
Assumptions (i), (ii), (iii), and (iv) then determine the nature of U: (i). Let be the share of outsiders in U
and (1 – ) be the share of insiders. Thus, is the percentage increase in U when UO increases by one
percent with UI constant and (1 – ) is the percentage increase in U when UI increases by one percent with
UO constant. Since is determined by the political system, it is independent of Y, G, and R. For any given
, the government will maximize its support and will try to change in a way that raises U.
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(ii). UI = SIR, where SI indexes a government’s share of total insider support from any given R.
SI(G,R) varies between zero and one and is increasing in G, but decreasing in R. A greater G gives a stronger
incentive to support the government, while a greater R dilutes this incentive by spreading a given G over
more R. If SIG and SI
R are the changes in SI when, respectively, G and R increase by a unit, SIG ≥ 0 and SI
R ≤
0. UI is assumed to be increasing in R and G with marginal products, UIR = SI + SI
RR and UIG = SI
GR. UIR > 0
implies a loyalty requirement on insiders. IfR = (SIRR/SI) is the elasticity of SI with respect to R, R < 1
holds at the support maximum. If R rises by x percent, SI must fall by less than x percent in order for UIR to
be positive. The death of a charismatic leader may reduce loyalty among insiders (or lower SI and raise R at
every R and G), forcing an autocratic government to rely more on outsiders for political support. Such a
government becomes more inclusive, but may continue to govern autocratically, an example of inclusiveness
without democracy.
(iii). Let Q be total political support from outsiders, and let SO be this government’s share of Q, where
SO varies between zero and one. Then UO = SOQ, where SO is increasing in (Y – G), the part of Y that is not
redistributed to insiders, with marginal support value SO(Y – G). U
O is also assumed to be increasing in (Y – G)
with marginal support value UO(Y – G). Since maximizing U requires a government to compare its support
from outsiders to that from insiders, SOQ can be measured in units of R. (iv). G and R show diminishing
returns and complementarity in UI, in that UIG is decreasing in G and increasing in R, while UI
R is increasing
in G and decreasing in R. As a result, UI is strictly quasi-concave.
Assumptions (i), (ii), and (iii) imply that U is a geometric average of UO and UI given by:
U = [UO(Y – G)][UI(G,R)](1 – ). (1).
Here U, UO, and UI are measured in units of R. Let T = QR(1 – ) be total political support over all
contenders for power, and let S = [SO(Y – G)][SI(G,R)](1 – ) be this government’s share of T, so that U = ST.
Except when there is only one contender, T is assumed to be less sensitive to changes in a government’s
policies than is S. As a result, percentage changes in S for a given are numerically greater than those in T
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unless the change in S is zero; then so is the change in T. This causes U to be increasing in S, and in
maximizing U a government also maximizes S.
When takes its maximum value of one, U = UO, and RU = GU = VU = 0, where the U subscript
denotes support-maximizing value. The support maximum on any TR is at point PM where (YU – GU) = YU =
YM, the maximum value of Y and of (Y – G) on TR. Maximizing useful output then maximizes support, as
well as the average living standard. Since VU = 0, there are no exploitable differences in ability to supply
support, suggesting a relatively egalitarian distribution of Y.
When is close to one, support is outsider intensive. When = 0, U = UI, and support is insider
intensive. If V is divided between cost and profit in a way consistent with maximizing support, U is
maximized where V reaches its maximum, say Vm. Let Pm = (Ym, Rm) be the point on any TR at which V =
Vm, and let Gm be the value of G at Pm. We shall see that Gm and Rm are also the maximum values of G and R
that can be consistent with support maximization. Thus, all support maxima along any TR must lie between
PM and Pm. Finally, outsiders will never surrender all their income to rent extraction, implying Ym > Gm.
3. The Production Trade-Off Between Useful Output and Rent Seeking.
For the supply side of our model, let GDPF = W(A,K,N) be the maximum GDP that can be produced
from physical and human capital, K, and labor, N, using the best technology available worldwide, which is
indexed by A. If W has constant returns to scale and Hicks neutral technology, as in Parente and Prescott
[2004]—hereafter P & P—then W(A,K,N) = AF(K,N), where F(K,N) is the production function in some base
period when A = 1. For any nation, relative efficiency, EG, in producing GDP from the same A, K, and N is
EG = GDP/GDPF. Thus:
GDP = Y + RR = (Y – G) + V = EGAF(K,N), (2).
where EGA is total factor productivity in producing GDP. Since Y – G = GDP – V, and Y – G is the income
from producing Y, the same is true of GDP – V, and V is the income from producing R.
We can re-write (2) as:
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Y = EGAF(K,N) – RR = EAF(K,N), (3).
which is also the equation of TR for any given K, N, and A. Here E is the economy’s efficiency in producing Y,
with E = (1 – sR)EG = sYEG, where sR = RR/GDP is the share of R in GDP and sY = Y/GDP is the share of Y. Thus,
E depends on R and if R > 0, then E < EG. With R on the vertical axis, the inverse slope of TR is YR = ERAF(K,N),
where ER is the change in E when R rises by a unit. Since TR slopes downward, ER < 0, and E is therefore
maximized at PM along any given TR. The loss of efficiency as R rises has two components. First is the direct
loss or amount of Y that the resources used to produce R could produce instead. Second is an indirect loss, or the
efficiency cost of the interventions used to generate V. This is also the cost of protecting and subsidizing insiders
and giving them market power. Total factor productivity in producing Y is EA. Because of constant returns to
scale, dividing both sides of (3) by N gives:
y = EAf(k), (4).
where y = Y/N is useful output per unit of labor, k = K/N is capital per unit of labor, and f(k) = F(K/N,1). In this
paper, we are mainly interested in the growth of y and Y.
Let YK(K/Y) be the share of human and physical capital in Y, where YK is capital’s marginal product,
defined as the percentage increase in Y when K increases by one percent with N fixed. Then YK = Y/K = y/k =
yk. The value of A is common across economies, and for simplicity, I assume that A is independent of changes in
K or N by any one economy. P & P suggest (p. 38) that the annual trend growth of A is about .8%. By contrast, E
and EG are economy specific. For any given A, K, and N, the maximum value of Y worldwide is YF = AF(K,N).
This is the frontier value of Y where E = 1 = sY = EG. Over time, Y moves closer to YF when E is rising and further
away when E is falling. If E and EG correlate positively over time, moving away is not uncommon [eg., Salinas-
Jiminez and Salinas-Jiminez, 2011, van Ark, O’Mahoney, and Timmer, 2008], keeping in mind that YF is
increasing as A rises.
P & P argue that differences in GDP per capita result largely from differences in total factor productivity.
At a point in time, these reflect differences in EG from nation to nation. In their view, growth ‘miracles’ occur
when political or other changes cause EG to rise rapidly. Efficiency levels affect growth by affecting the marginal
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products of capital and labor. Since YK = (Y)/K = (EYF)/K, YK is increasing in E for any given , YF, and K. The
lower is E, the lower YK will be and the greater will be the increase in saving required to raise Y by a unit (= 1/YK).
Thus, the consumption cost of growth, defined as this savings increase, is decreasing in E. The lower is E, the
lower Y will be for any given A, K, N, and YF; a high level of R also implies relative poverty, since many resources
will not be producing useful output, and the level of protectionism will be high.
We can write E = YU/YF = (YU/YM)(YM/YF), where YM is the maximal value of Y (where R = 0) on the same
TR as YU. Without rent seeking, YU = YM would hold. If this economy were on the worldwide frontier, YM = YF
would hold. Thus, YU/YM is the rent-seeking ratio, and YM/YF is the technology ratio. However, rent seeking
depresses YU in part by protecting rents on obsolete technologies and associated work skills, which suppresses
innovation and entrepreneurship. This suppression may be the biggest part of the long-term cost of rent seeking,
contrary to the claimed tiny ‘welfare loss from monopoly’ by economists in the 1950s [Del Rosal, 2011, pp. 298-
99; see also Freeland, 2012, pp. 277-286].
In this context, E also depends on J, the capital used in innovation, and on L, the capital used in copying
technology from other countries. These are distinguished from K, the capital used in production. At the support
maximum, the value of marginal product of each kind of capital must be the same. Thus, YJ = YL = YK, which
implies YJ = (EJ/E)Y = Y/K or EJ = E/K, and likewise for EL. I view K as being many times larger than E < 1.
To all intents and purposes, EJ = EL = 0 therefore holds at the support maximum. EJ will be decreasing in R since
preservation of rent and rent seeking suppresses innovation. EL may be increasing in R since non-market
interventions that also generate rent can speed up the copying of technology. However, the positive effect on EL is
limited to the technology ratio and is constrained by the willingness of other countries to share their technology.
4. The Support Maximum
If we take a snapshot of an economy at a point in time, the government maximizes U for any given ,
subject to TR and to Y = G + (Y – G). If we first maximize U subject to Y = G + (Y – G) for any given and
Y, the support-maximizing division of Y into G and (Y – G) occurs where UG = U(Y – G) whenever G > 0. Here
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UG and U(Y – G) are the changes in U when, respectively, G and (Y – G) increase by a unit. When UG = U(Y – G)
at each value of Y, U can be re-written as a function of Y, R, and , with UY = UG = U(Y – G). For simplicity,
we ignore the error that arises because a unit increase in G is also a unit increase in V, which has an indirect
effect on Y.
Let MCR be the marginal cost of R, defined as the fall in Y when R increases by a unit. Then any TR
is strictly concave from below if MCR is rising as R increases along TR. The rationale for rising MCR is that
a government will try to minimize the loss of Y resulting from any given increase in R, but that these efforts
are subject to diminishing returns as R/Y increases. Given our concavity assumptions, there will be one local
maximum of U, which is also a global maximum. If MRT and MRS are the marginal rates of transformation
and substitution of Y for R, and R is plotted on the vertical axis, the first-order conditions for maximizing U
on any given TR when < 1 are EJ = EL = 0 and:
MRT = (MCR) –1 = MRS = UY/UR = UG/UR = U(Y – G)/UR = (R) –1 = UIG/UI
R, (5).
In Figures 1(a) and 1(b), four maxima are shown, at A and B in Figure 1(a) and at B and C in Figure
1(b). The flatter are the isoquants of U for any given TR—and thus the higher is (MRS)–1, the demand price
of R, at each (Y,R)—the higher RU and the lower YU will be. This is shown in Figure 1(b), where UB leads to
higher RU and lower YU than UC. Likewise, for a given support function, U, a steeper TR, and thus a lower
MCR, implies a higher ratio, RU/YU. A steeper TR implies higher past investments in political support, R,
relative to investment in useful output, Y. This helps to entrench a system that relies on insider-intensive
political support by making it harder to raise Y in the short run by lowering R.
5. The Effect of Inclusiveness on the Political Support Maximum
5.1. How Inclusiveness Affects Wealth Creation, Rent, Rent Seeking, Efficiency, Secrecy in Government,
Corruption, and the Rule of Law.
When < 1, (1) implies:
U(Y – G)/UG = [(1 – )](UI/UIG)(UO
(Y – G)/UO). (6).
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Since U(Y – G)/UG = 1 is necessary for dividing Y into (Y – G) and G in a support-maximizing way, suppose
that UG = U(Y – G) holds initially at each (Y,R), so that MRS = UIG/UI
R. From (6), if then increases, the ratio,
U(Y – G)/UG, must rise at each point ((Y – G), G, R). This requires G to fall and (Y – G) to rise at each (Y,R) in
order to restore UG = U(Y – G). By assumption (iv), the fall in G raises UIG/UI
R, while the increase in (Y – G)
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does not affect UIG/UI
R. Thus, an increase in raises UIG/UI
R, and therefore MRS, at each (Y,R). The
isoquants of U become steeper in (Y,R) space, as in the shift from UB to UC in Figure 1(b).
Along any TR, therefore, the increase in lowers RU and raises YU and E. Despite the rise in
YU, GU must fall, for otherwise the support maximizing value of UIG/UI
R would fall, by assumption (iv).
Thus, GU is decreasing in . Viewed as the supply price of R, R correlates positively with R along any
given TR so that VU is also decreasing in ; markets become more competitive as rises, and it follows that
VU, GU, and RU all reach their maxima at Pm. As rises, governments rely less on insiders for support and
therefore extract less rent to pay for this support, which implies less protectionism and concentration of
economic power and greater market competition.
Since utility comes only from consuming Y, a government will be more secretive when is lower to
hide the loss of Y from rent seeking and extraction of rent. Secrecy also provides a favorable environment
for the politics of identity and victimization—key elements of populism—and for corruption, defined here as
the use of public office for personal gain. A polity with low inclusiveness will have relatively high
corruption, and governments will award positions with opportunities for corruption in return for political
support. The support of a corrupt official, who is an insider, is more valuable to a government when is low
than when is high, while the support of outsiders who bear the cost of corruption is less valuable. Salinas-
Jiminez and Salinas-Jiminez [2011] find that corruption negatively affects both the level and the growth of
total factor productivity where GDP is concerned. The transfer of V also limits the extent to which a
government can be impartial between insiders and outsiders and subordinate itself to an impersonal rule of
law that treats them equally. This constrains the rule of law.
5.2. Institutions Necessary for Inclusiveness to be High
A ‘liberal’ democracy combines institutions of representation, which translate popular preferences
into government policy, with institutions of restraint that uphold basic rights and freedoms, including civil
liberties and minority rights, and limit exploitation, including by government [Rodrik, 2014]. Effective
institutions of restraint reduce differences in ability to supply political support and make it harder to exploit
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the differences that remain by restraining contenders in the ways they can compete for power, including by
extraction of rent. They also make it easier to vote for opposition candidates and to provide them with other
kinds of support. Institutions of restraint include an independent police and judiciary to enforce and interpret
the law, institutions that protect voting rights and competition in the market, an independent civil service,
and a free press—publicity limits the ability of politicians to extract rent [Chang, Golden, and Hill, 2010].
An autocracy may lack both kinds of institutions, whereas ‘illiberal’ democracies lack effective
institutions of restraint, which make institutions of representation easier to undermine via measures such as
voter suppression, voter deception, ballot box stuffing, non-secret ballots, etc. An illiberal democracy may
choose its governments in periodic elections with universal suffrage, but still have low inclusiveness if the
cost of evaluating voting alternatives is high or if voting is not free and fair with secret ballots. In such a
society, government often captures institutions such as the courts and police that might be effective
institutions of restraint if they were independent.
Institutions of restraint are the backbone of an inclusive political system [Zakaria, 1997]. While
inclusiveness is possible without democracy, owing to its efficiency properties, such an arrangement is likely
to be temporary, as noted earlier. Institutions of restraint can promote democracy by making it easier for a
political opposition to organize and publicize its positions and to compete for power. They can also lower
the cost of losing elections or other forms of political competition. In these ways, they raise the number of
competitors for power—which causes greater fragmentation of political support among contenders—and
give insiders and outsiders more options and useful information. Governments will therefore stay in power
longer, on average, when is low. When is high, losers of political competition will be more willing to
leave office. This helps to establish conditions for institutionalizing political competition in periodic and
peaceful elections that enable power sharing via rotation of power over time.
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6. How Changes Over Time
A support-maximizing government will try to change the political system in a way that raises its
support. Supposing it succeeds, let U* be the maximum value of U over all values of for this government
and let * be the value of where U = U*. Whether UO > UI or UI > UO holds for a government at any
point reflects the nature of this government’s skills, as well as the values of R, G, and Y at that point. Let ln
denote natural log. Differentiating ln U partially with respect to gives U = U(ln UO – ln UI). U is
positive at any (Y,R) if UO > UI, in which case the government gains support from a small increase in .
After raising , a government can increase U further by adjusting Y, G, and R to their new support-
maximizing values, which will raise UO UI, as we saw above. Also U < 0 if UI > UO. Here the
government gains support by lowering and then adjusting Y, G, and R to their new support-maximizing
values, which will lower UO UI. Suppose that UI = UO, which would have to be at a point between Pm and
PM where U = UI = UO. Then UO = U will be higher at PM where R = 0.
Thus, no point between Pm and PM can give a maximum of U; * is either zero or one, and U* is the
higher of UI at Pm or UO at PM. Because U* occurs at a political extreme, economic and political systems
that are similar to begin with can become quite different in time, as can per-capita Y. If a government
reaches = 1 through its efforts to raise its support, it will maximize efficiency and per-capita income by
following its own self-interest—a political ‘invisible hand’ is at work. However, this hand will only work
well when supported by visible and effective institutions of restraint.
The above assumes that SI and SO are independent of , which may be true if an economy can
achieve inclusiveness without democracy. However, such an arrangement is likely to be temporary, as noted
earlier. With democracy, SI and SO will be decreasing in because of rising fragmentation of political
support as rises, which causes political competition to increase and change in nature. Two-thirds of all
leadership changes under autocracy result from non-co-operation—coup, regime change, assassination,
popular uprising, or foreign intervention [Svolik 2012, p. 5]. This is more like competition to be a
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monopolist—in which losers disappear from the market—than competition in price and quality, in which
several suppliers can survive.
Because of rising fragmentation of political support, SI and SO are decreasing in . The same will be
true of UI and UO if total support, T, is less sensitive than S to changes in . While R falls as rises, Q
would plausibly increase as outsiders become more important to political outcomes. For an incumbent
government, an increase in causes SI and SO to fall as more options and useful information become
available to insiders and outsiders. Rent, protection, and secrecy will also fall as increases, and greater
openness makes it harder to blame economic malaise on others.
When SI and SO are decreasing in , UI > UO still implies U < 0, but UO > UI does not necessarily
imply U > 0. Differentiating ln U partially with respect to now gives:
U = U[(ln UO – ln UI) + (UO/UO) + (1 – )(UI
/UI)]. (7).
Here UO and UI
are the changes in UO and UI per unit of a small increase in , with Y, G, and (Y – G)
constant. Since UO/UO and UI
/UI are negative, UO must exceed UI by a positive margin in order for an
increase in to raise U. Moreover, an intermediate value of * becomes possible where U = 0. This
would occur where a negative value of (UO/UO) + (1 – )(UI
/UI) just offsets a positive (ln UO – ln UI),
thwarting the movement of to = 1—a possible explanation for the existence of illiberal democracies.
While * = 1 is still possible, this requires a government with a skill set that more strongly favors UO over
UI than when SI and SO are independent of .
When is high, one or more political parties or coalitions is likely to benefit from effective
institutions of restraint, which enable them to survive and to compete successfully for power. The parties or
coalitions in question will therefore promote and defend such institutions. But if is low, UI > UO is likely.
If institutions of restraint do not already exist, a government lacks an incentive to adopt them because they
lower its political support. An exception can arise if the incumbent government is already facing a struggle
for power, which causes UI to be less than UO. If this occurs when is low, a crisis is likely to be underway
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in which UI and U are low, and the government is facing an existential threat. Without such a threat, the
political reforms needed to raise and institute liberal democracy are unlikely to be forthcoming.
7. The Effect of Inclusiveness on Growth
7.1. Types of Growth and the Interaction between Extensive and Intensive Growth
We define extensive growth of Y or of y to be growth from increases in inputs, notably capital, with
total factor productivity, EA, held constant. Intensive growth is growth from increases in EA, with K and N
held constant. The three types of growth are then: (a). extensive. (b). intensive and based on technology
catch-up —on imported technology that is new to the importing country, but already in use elsewhere. (c).
intensive and based on innovation—that is, on technology that is new worldwide.
If the g superscript denotes rate of growth, y = EA(f(k)) implies:
yg = Eg + Ag + kg. (8).
Thus, yg is the sum of extensive (kg) and intensive (Eg + Ag) growth rates of y, although the two types of
growth are complementary, since increases in EA raise YK = Y/K = yk = y/k = EA(f(k))/k for any given k,
thereby offsetting diminishing returns to capital. Since f(k)/k = F(1,1/k), which is decreasing in k, increases
in EA also raise the value of k that goes with any given yk, thereby creating new possibilities for extensive
growth. Likewise, decreases in E resulting from increases in R reduce these possibilities.
Let yk)g be the rate at which yk = y/k changes. Then:
kg = yg + g– (yk)g. (9).
The physical capital share of GDP has been gradually rising since around 1980 in developed economies, the
result of a relative decline in the price of capital goods [Karabounis and Neiman 2014], leading to a
substitution of capital for labor. Karabounis and Neiman suggest that this share is rising at about .14% per
year. If the human capital share is also rising at .14%, g = .14%, which I shall assume for illustrative
purposes. Substituting (9) into (8) gives:
(yk)g = [(Eg + Ag] + g (yg. (10).
16
Any growth of y above [(Eg + Ag)grequires the consumption cost of growth
to rise. When yk and E are constant, equation (10) becomes yg = kg + g = [Ag/(1g If Ag =
.8%, = .65—since K includes both physical and human capital—and g = .14%, y will grow by 2.54% per
year and k by 2.4%. Over 60% of the growth of y is extensive (kg = 1.56%), from capital deepening, the
reason why all nations that have achieved modern economic growth have dramatically raised their capital-to-
labor ratios. Yet, from (10), if y grows at a constant rate in an economy unable to generate technological
progress, yk will be falling at (1 = 54% of this rate. The intensive part is crucial to sustaining yk (or in
keeping down the consumption cost of growth) and giving an incentive to increase k.
7.2. Type (b) Growth
Let us say that a government has a political advantage in UI when it raises U by lowering and a
political advantage in UO when it raises U by raising . A political advantage in UI leads to a low value of
and to dependence on R and G, and therefore V, for political support if support-increasing political changes
are adopted. An advantage in UO leads to a high value of and to dependence on (Y – G) for support.
In type (b) growth, adopting technology already in use in other economies is often less costly than
inventing this technology. Familiarity with the experience of others in developing and using it can speed up
adoption and raise the growth of Y. Such knowledge can enable a government to hasten the movement of
resources to priority projects and get these projects started more quickly. This implies non-market
allocation. If this government has a political advantage in UI, it will subsidize firms involved in these
projects (and grant them rents)—eg., by keeping input prices below equilibrium, as in credit rationing. In
addition, a government can protect firms that are denied priority access to resources from competition,
thereby granting them rent as well.
Recalling Section 3, let E* be the rent-seeking ratio, (YU/YM), and E** be the technology ratio,
(YM/YF). Then E = (E*)(E**), and type (b) growth can do no more than keep E close to E* by keeping E**
high. With a political advantage in UI, this comes at the cost of a low E*. With a political advantage in UO,
E* will be higher, but E** may be lower for a time. However, rent seeking depresses YU in part by
17
protecting rents on obsolete technologies and associated work skills, which suppresses innovation and
entrepreneurship. Since a political advantage in UO encourages the latter, the technology gap can disappear
at some point, and, more generally, an economy can have a higher E* and an E** that is at least as high as
with an advantage in UI. Once a low is established, however, and government has the skills needed to
make such a system work well, there is little incentive to raise absent a political crisis, as we have seen. A
high consumption cost of growth could produce such a crisis, but there is no guarantee of this.
7.3. Type (c) Growth and Growth Slowdown
With an advantage in UO, a government will rely more on market competition to implement new
technology and less on state intervention that replaces market outcomes. A transition from type (b) to type
(c) growth as opportunities for the former decline may then prevent growth from slowing. Such an economy
will have a lower growth of type (b)—because it relies less on non-market interventions that can temporarily
speed growth—and a higher growth of type (c) since R will be falling if it is not already zero. Reliance on
non-market interventions that generate rent causes both the higher growth of type (b) and the subsequent
growth slowdown. In addition, the higher is , the more leeway a support-maximizing government will
have to allow sectors within Y to decline when demand falls and to shift the released resources into more
efficient uses. Insiders will resist the decline of sectors they represent because this lowers their ability to
supply political support [Acemoglu and Robinson, 2001].
With a political advantage in UI, type (c) growth conflicts with the support need to raise V and keep it
high. In addition, the technologies to be imported in type (b) growth are understood and have known
requirements for effective utilization. But in type (c) growth, the technologies are new worldwide. Much of the
knowledge needed for their effective utilization is either yet to be discovered or else is scattered among various
agents—producers, consumers, researchers, etc.—and remains tacit. An advantage of markets originally noted
by Hayek [1945] is that they can work well without having to centralize this information.
Type (c) growth requires competition, well-developed financial markets, and freedom from market and
trade distortions. Supply restrictions, such as those associated with credit rationing, which are endemic to type
18
(b) growth, are a major barrier to the entry and expansion of small firms and thus to innovation and the
development of technically sophisticated products [Aghion, Harmgart, and Weisshaar, 2008, esp. pp. 50-54].
Supply restrictions can work in type (b) growth when the authorities have a good idea of what to restrict and
how and what to promote and how in order to make the best use of technology they are newly adopting. In type
(c) growth, they are less likely to have this knowledge.
8. A Brief Look at post-WWII Growth in the Soviet Union and Japan and at the ‘Great
Recession’ in the United States.
8.1. Inefficiency and Stagnation of the Soviet economy.
Mainly extensive growth outside the space and defense sectors was a feature of the state-managed
Soviet economy, a planned and controlled system with many quotas, restrictions, and subsidies and therefore
many rents and opportunities for rent seeking. See Anderson and Boettke [1997]. These controls raised the
growth of Y initially by creating large forced savings, rapid accumulation of capital from a low base, and
strong incentives for labor to migrate from agriculture to industry. But high initial growth petered out during
the ‘years of stagnation,’ Brezhnev’s rule from 1964-1982. Soviet GDP per capita rose over 1928-1990 by
an annual average of 2.6% to 5 times its original level [Ofer 2008], but nearly all the sustainable growth had
occurred by 1970. A key problem was diminishing returns to capital, documented by Weitzman as early as
the 1960s, owing to a low rate of technological progress, and a low and declining elasticity of substitution,
S, between labor and capital [Bleaney 1991]. Because it was hard for planners to substitute capital for labor
in old facilities while they were building new ones, diminishing returns to capital became high. Under
constant returns to scale, (ykk/yk) = (1 – )/Sk. The lower is S, the faster yk will fall as k rises.
Relative to the U.S., Soviet GDP/capita peaked at 37.5% in 1970 [Ofer 2008]. After 1970, the Soviet
capital-to-labor ratio soared, while the marginal product of capital in terms of GNP plunged [Easterly and
Fischer 1995, p. 358]. During the Gorbachev years, 1985-1991, GNP/capita fell, and total factor
productivity growth was negative, according to some estimates (eg. Bleaney 1991). According to Easterly
and Fischer [2008], TFP growth remained positive, but was falling over 1950-1987, reaching near zero in
19
1987. Since A was rising, EG was falling before the end of the Soviet Union. Resource allocation was also
poor. For example, some production capacity lay idle for want of labor, while at the same time, there was
widespread overstaffing of firms.
Tax revenues depended on the profitability of state firms and therefore on the productivity of
capital. Falling productivity caused growing budget deficits, which were largely monetized, leading to rising
nominal incomes and aggregate demand, as well as and rising differences between official and demand
prices, which generated rising rents. In Russia, the freeing of consumer prices in January 1992 caused them
to more than double from official levels at the end of 1991.
The Soviet economy left a legacy of resistance to market reforms in successor transition economies
by those whose rents were threatened [Aslund, 2002, ch. 9]. This weakened the impact of economic reform,
except where new, Western-oriented governments were able to gain enough support (largely in the Baltic
states) to come to power. Because the institutions of a Soviet-type economy and those of an efficient market
economy are quite different, the change from one to another would potentially have destroyed many rents,
and the support cost of this to an incumbent government helped the Soviet economy to survive for nearly 75
years despite poor performance. It also helped crony capitalism, with its own rents, to emerge afterword.
Over 1970-91, there was hardly any net growth of GDP per capita in the Soviet Union, and in Russia, GDP
plunged by nearly 40% in 1992, the first year of transition [Ofer 2008].
8.2. From ‘Miracle’ Growth to Stagnation in Japan.
For many years, Japan provided the growth model for much of East Asia. Japanese experience and
the subsequent experiences of smaller East Asian ‘tigers’ suggested that government intervention in the form
of industrial policy could permanently raise the growth of GDP. This was largely growth of types (a) and
(b), in which government played a leading role—in facilitating technology imports, in disseminating
technologies to domestic producers, in assisting their learning to use these technologies, and in channeling
resources into targeted growth sectors.
20
Japan and other East Asian nations also promoted export-led growth, building efficient export
industries and achieving an economic ‘miracle,’ using an approach that included large public investments in
infrastructure and technical education, as well as targeting of growth sectors. Targeted sectors were
subsidized and protected and received large public and private investments. This required credit rationing
that channeled loans to favored borrowers—who were initially not competitive on world markets—as well as
barriers to imports, which were often tightly controlled. Japan and other East Asian economies also built up
their human capital and shifted comparative economic advantage within Y toward higher value-added
products that were physical or human capital intensive. Their cost advantage often rested on inexpensive
human capital.
Many inefficient firms also benefitted from this protection. One consequence is that the high-growth
era is now a distant memory. A large volume of resources is tied up in protected and subsidized firms,
including ‘zombies’ that only continue to operate because of this protection and assistance. The peak of the
Japanese economic miracle occurred between the mid-1950s and the early 1970s. By 1970, Japan had the
highest per-capita GDP in Asia, using purchasing power parities [APO, 2015, p. 29]. But then, growth
slowed, and in the early 1990s, stagnation set in, from which Japan has yet to recover. Annual growth of real
GDP per capita in Japan averaged 8.2% over 1960-73 during the economic miracle, but then fell to 1.2%
over 1990-2007 [U.S. Department of Labor, 2008].
Using purchasing power parities, Japan had fallen to second place in Asia in terms of per-capita GDP by
1990, behind Singapore, and by 2015, to fourth, with less than half the GDP per capita of Singapore, 71% of that
of Hong Kong, and 86% of that of Taiwan [APO, 2017, p. 29]. South Korea, which had only 17% of Japan’s per
capita GDP in 1970, had about 85% in 2010 and 90% in 2015. Relative to the U.S., Japanese per capita GDP
peaked in 1991, at 87%, according to the IMF, from which it fell to 71% in 2015. In Japan, EG grew over 1970-
90, since annual TFP growth averaged 1.37% [Sanchez and Yurdagul, 2014]. However, annual TFP growth was
just .44% over 1990-2007 and .33% over 2007-2011, so that EG fell over 1990-2011. All the Asian countries
21
that moved ahead of Japan in per-capita GDP over 1970-2015 had faster TFP growth, if we take into account the
corrections suggested by Hsieh [2002] for Singapore and Taiwan.
Other East Asian nations are potentially vulnerable to forces that cause political support to rely too
heavily on insiders. But both Taiwan and South Korea became democracies during this period and therefore
plausibly acquired more inclusive political systems. Singapore faces strong external pressures to be efficient (as
does Taiwan) and to maintain racial and religious harmony. Japan is a democracy, but one in which a single
party, the LDP, is usually in power and in which many small and mid-sized firms and some large ones continue
to survive because of government largesse. See Beason and Patterson [2004].
8.3. Rent Seeking in the U.S. Financial Crisis and ‘Great Recession’ of 2007-2009.
Government efforts to grow the economy rapidly in Soviet-type economies, Japan, and elsewhere
worked for a time, but then gave way to longer-term growth slowdowns or stagnation. In this paper, I have
offered an explanation based on the distinction between growth of type (b) and growth of type (c), as well as
on linkage between the political and economic systems and government maximization of its political support.
The main culprit is a political advantage in UI, and the antidote is a strengthening of institutions of restraint
to make a political advantage in UO become more likely.
However, supporters of a minimal economic role for government drew a quite different lesson from
the Soviet, East European, and Japanese experiences, which reinforced their belief in the ‘magic’ of the
market. Faith in self-regulating financial markets replaced older views, including that of Adam Smith, who
had argued for government regulation to avoid ‘endanger[ing] the security of the whole society [Smith, p.
324].’ The combination of reduced regulation and government largesse for insiders created rents, which
became a source of political support, and paved the way for the Financial Crisis and Great Recession of
2007-2009 in the United States.
Financial institutions controlled by insiders avoid regulation more easily than those controlled by
outsiders, and the former have higher access to government bailouts. This gives them an incentive to seek
out higher yields by making riskier loans, since they do not have to absorb this risk. In this way, rent seeking
22
can lead to a systemic crisis. Prior to the Great Recession, de-regulation led to a lending frenzy that caused
rapid increases in the ratio of debt to borrowers’ incomes, as well as rapidly rising property values.
Borrowers were willing to take on more debt because high asset prices raised their perceived wealth.
According to Mian, Sufi, and Verner [2017], increases in the ratio of household debt to GDP over 2002-2007
by region are a good predictor of unemployment increases by region over 2007-2010.
Prior to the financial crisis, rising property values increased demand and household borrowing. Easy
money and credit intensified this boost, and big lenders were able to sell low-quality mortgages at little risk
to themselves. A ready market for these ‘sub-prime’ and ‘non-prime’ mortgages allowed lenders to pass on
the cost of borrower default to buyers of mortgages and mortgage-backed securities. As a result, low-quality
mortgage lending grew rapidly, and low-quality mortgages came to comprise over half of all mortgages.
After issuing such mortgages, the issuing bank or shadow bank would either sell them or cut them into pieces
to be pooled with pieces of other mortgages to produce securities that they sold.
The quasi-public mortgage giants, Fannie Mae and Freddie Mac, stood ready to buy mortgages at
high prices, which they then securitized and sold. Ultimately, the lending frenzy depended on the generosity
of Fannie and Freddie and on buyer over-valuation of mortgage-backed securities. Their quality was not
transparent, and capture of bond-rating agencies by securities issuers resulted in ratings that were too high.
The bull market spawned by easy credit and home ownership promotion also contributed to the over-
valuation. Rising property values led to rising prices of mortgage-backed securities, which provided good
returns to securities buyers—as long as property values kept rising. Rising asset prices also raised the supply
of collateral for loans, which made lending appear less risky.
At first, monetary policy accommodated the process described above, but in 2004, the Fed abruptly
changed course and began tightening money and credit. It raised interest rates 17 times over 2004-2006—
the discount rate rose from 1% to 5.25%—and then began lowering rates again, the discount rate falling
almost to zero in December 2008. House prices peaked in mid-2006 after rising for 15 years and then began
to fall. When this fall speeded up over 2007-2008, borrowers often found that they owed more on their
23
mortgages than their properties were worth, in addition to which sub-prime borrowers faced low initial
payments that subsequently escalated. Many mortgage holders defaulted, revealing the riskiness of securities
based on these mortgages. The demand for them imploded, causing the sub-prime mortgage market itself to
collapse in 2007. The home ownership rate went up and back down [Callis and Kresin 2014, 2015].
Prices of real estate and securities soared initially, but these were on a bubble, which burst when
mortgage borrowers began to default in numbers. The subsequent fall in values of real estate and mortgage-
backed securities, aided by the Fed’s temporary tightening of money and credit, put the wealth effect into
reverse and reduced the supply of collateral for loans. Lending became riskier, especially to small
borrowers, many of whom were by now carrying large amounts of debt. The fall in demand for durable
goods by households and small firms, which was intensified by higher borrowing costs and the virtual
drying-up of credit, became the main cause of general economic decline and subsequent slow recovery. The
crisis lowered employment in financial services, where rent seeking had been intense, and in sectors,
especially construction, where rent seeking had buoyed demand.
The shadow banking system grew during the housing bubble to become larger than the banking
system. Shadow banks avoided regulation by selling securities to access savings instead of accepting
savings deposits, but also lacked the public insurance that supported banks. When the bubble burst, the
shadow banks suffered the equivalent of bank runs and became the part of the financial system that shrank
the most. Fannie and Freddie received government bailouts, as did private ‘too big to fail’ financial
institutions. (Most of the bail-out funds were later paid back, however, and the government has taken far
more in profits earned by Fannie and Freddy than the latter received during the financial crisis.) Interest
rates have since remained low, at high cost to savers. The combination of boom and bust provided a net
benefit to Americans in the top 1% of the income distribution, with most of the cost of the recession falling
on small lenders and mortgage holders. According to Saez and Piketty, the top 1% received nearly all the
income gains from the 2009-10 recovery [Lowery, 2012]. For further discussion of issues surrounding the
Financial Crisis and Great Recession, see Krugman [2009] and Mian, Sufi, and Verner [2017].
24
9. Conclusion
Efficiency requires inclusiveness and therefore effective institutions of restraint, without which
outsiders’ ability to constrain the behavior of politicians is weak. When is low, however, a support-
maximizing government has a low incentive to adopt such institutions. Such a government is likely to have a
skill set that favors UI rather than UO, and institutions of restraint increase the fragmentation of political
support, which lowers the support of an incumbent government. With an advantage in UI, type (c) growth is
hard to achieve. Type (b) growth can be rapid initially, but then growth slows once the technology ratio
becomes high, if not earlier.
Efficiency and growth are not the only issues here. The ability to extract rent and to use it to buy
political support goes hand-in-hand with secrecy in government, corruption, inequality, and barriers that
constrain social mobility and the rule of law. In addition, this ability promotes greater economic opportunity
for some than for others plus concentration of economic power, persecution of political opponents, reliance
on scapegoats for poor economic performance, and departures from free, fair, and informed voting with
universal suffrage and secret ballots. This is why a change in inclusiveness implies changes in the very
nature of a society.
Note:
*I am indebted to an anonymous referee for helpful insights and criticism and to Sarah Aboul-Magd for
drawing the diagrams.
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