Freedom for development

This article was firstly posted at UFM Madrid, due to a research fellowship: madrid.ufm.edu/noticia/freedom-for-development-by-alvaro-martin/

Freedom. Both, political and economic freedom have shown to be two of the main keys to prosperity throughout history. Countries that have embraced freedom have developed faster and promoted poverty reduction and human development at previously unseen levels. No matter how we present the evidence, there will always be hundreds of critics of capitalism blaming economic freedom for higher social marginality, inequality, and finally, for every socioeconomic problem that could be slightly related to the actually predominant economic system. That’s why, throughout this article, I will review the main empirical evidence and academic literature on the issue, trying to demonstrate how liberal democracy and capitalism are the best of the available organizational systems if our main aim is to promote socioeconomic development for all.

The last 40 years have been the greatest proof of it, allowing humanity to experience the greatest and fastest contraction of extreme poverty (established threshold at 1.9 dollars per day) rates in History, in parallel with some of the greatest advances in human development, as measured by the Human Development Index standards. Contrary to what is widely thought, inequality hasn’t exploded either, and international inequality has even been kept stable along the last four decades. If instead of debating about equality of ends, we debated about equality of opportunities, we would need to recall how since the 1980s, equality of opportunity has massively widened, allowing for peak levels in scholarization and literacy, along with access to drinkable water and electricity. But, let’s put some data on the table to back it.

As previously depicted, since 1980 poverty has been summoned in a constant descending tendency, stabilising at a 9.5%  in 2015, down from more than 30% in 1980. Nowadays, humanity is also globally richer, with global GDP skyrocketing since the last decades of the XIXth century. In 1870 the average per capita income stood at 1,260 dollars per year, while nowadays it stands near the 14,600 dollars, measured in 2011 constant prices. At the same time, capitalist countries (the ones located at the top of the table in terms of economic freedom, according to Heritage Foundation), register per capita yearly incomes close to 45,000 dollars. But there’s one particular statistic that demonstrates the huge progress the world has accomplished in terms of human development along the past few decades. Life expectancy has increased from an average of 30 years at the start of the XXth century up to 73 years of average global life expectancy in 2019. Misery, hunger and repression have all descended globally. This doesn’t mean the world is perfect nowadays and no improvement is needed, it just means that due -in a great proportion- to economic and political freedom, nowadays the world is a richer, healthier and freer place to live.

Now, in the following subsections, we will review some of the best academic literature available on topics such as: foreign direct investment, market competition, digitalisation, economic and political integration and protectionism; and how all these factors contribute in promoting or deterring humanity’s socioeconomic development.

Foreign Direct Investment

Foreign Direct Investment (FDI) has shown to be one of the most useful tools when incentivising an efficient allocation of resources and maximisation of productive capabilities in emerging countries. FDI unleashes a full network of incentives and positive externalities that naturally affect citizens’ behaviours and attitudes, as well as generating profound changes in political and economic institutions, contributing in the mean term to lift productivity levels and economic efficiency.

We need to take into account that FDI not only contributes to to the process of building up machinery and factories. Even more relevant than this is the contribution FDI makes to intangible capital volumes in emerging economies. Knowledge and know-how are some of the most important factors of production in developing economies, as any investment plan will require of both when being structured and fully implemented. As Luintel et al. have shown, multinationals play a very relevant role through heavy investment plans in intangibles such as investigation, innovation, development or procedural organization in emerging economies. This knowledge generates strong spillovers which profit smaller local businesses, which now have to confront a smaller entry cost to the market by adhering to the already established know-how networks. According to data from the UN, in 2018 investment in intangibles in developing countries reached its maximum historical point, with the 100 biggest firms investing more than 350 billion dollars in intangibles such as R&D in emerging nations.

As well as knowledge, productivity is also transferred throughout vast networks of spontaneous entrepreneurial connectivity. Arnold et al. have studied this particular issue for the Indonesian case, examining and contrasting productivity levels of local manufacturing plants with productivity levels of manufacturing plants acquired and managed by foreign multinationals. The collected data show a productivity differential of 13.5%, due mainly to technology, equipment and intangible capital transfers from the mother company to its subsidiary. Other authors, as Beata Javorcik, a professor at Yale, show that, according to the available empirical evidence, privatization of publicly owned local businesses in emerging economies by multinationals lead to a greater productivity boost than when these privatizations are executed by local companies. This shows how FDI by multinational firms into emerging economies are nearly synonyms of greater productivity and efficiency levels.

Furthermore, FDI incentivizes global value chains’ integration in developing countries, consequently opening new markets for emerging nations to export those goods and services in which they have some kind of comparative advantage. Harding et al. studied how FDI poses incentives for further internationalisation of global value chains, and concluded that out of a varied list of 77 emerging countries for which full data were available, between 1984 and 2006, the volume of local goods and services sold internationally, increased exponentially, following great FDI influxes, as is reflected in the differences in differences models used in their paper.

Market competition effects on goods’ prices and quality

Recently, a vast range of economic literature has shown how government outsourcing of certain public services can help to achieve, not just lower prices, but also greater quality if market competition is ensured.

In some developing countries, the government still plays a big role in the retail sector, supposedly to guarantee a minimum supply of basic goods, but an outstanding body of empirical literature has shown how market responses to these issues tend to be cheaper and more efficient. For example, Busso and Galiani, in a recent paper asses the effect of a large entry of private retail firms on prices and quality of goods in developing countries. For this empirical investigation, they develop a randomized controlled trial (RCT), by conducting a conditional cash transfer (CCT) programme in the Dominican Republic. In this programme, the authors provided monetary transfers to families located in the lowest deciles of income distribution, amplifying in this way the volume of consumers in the market and incentivising the entry of new firms. The cash was transferred to special cards that could only be used in grocery stores. Along with this CCT programme, entry requirements for grocery stores to enter the market were vastly lowered by the Dominican Republic government, increasing market flexibility and competitive pressure levels.

The RCT was developed in 72 districts of the Dominican Republic, where 61 new grocery stores entered the market, which represents an increase of more than 26% in the number of suppliers. The time lapse of the study is six months, since the treatment group of citizens started receiving the CCTs, and the main variables measured were product variety, prices and product quality (according to consumers’ revealed preferences before and after the study). For this empirical investigation, and particularly for their theoretical prediction, the authors employed an imperfect competition model, which included differentiated-product characteristics and spatial-competition features.

The main conclusions of the paper were that increased competition, even in an environment of greater aggregate income levels (due to the CCTs), price reductions ranged between 2% and 6% in every single case, along with a noticed large improvement in product quality. On top of it, stores didn’t replace one set of goods for other, but increased the range of available products, amplifying product variety and supply diversity. The paper concludes by saying that, as in previous empirical investigations on the subject, as the ones developed by Bresnahan and Reiss, market competition in emerging economies is effective for lowering prices, and increasing variety and product quality, with significant effects that can be extrapolated to some other nations.

Digitalisation

Digitalisation and globalisation of ICTs have recently shown to be one of the newest and most disrupting keys to economic development in emerging economies. But ICTs are not productive by themselves, as along with them, they require an extensive knowledge of their use, which contrary to what many people think, is not an obstacle nowadays for their implementation in developing economies.

In two recently published studies on the subject, A roadmap for digital-led economic development & Do poor countries really need more IT?, by some of the greatest experts on these matters, as Maya Eden and Paul Gaggl, they present a compilation of papers answering several questions on ICTs’ implementation and their relationship with surges in productivity levels.

In developed countries more than 90% of citizens have access to the internet, while this percentage goes down to 20% in developing nations. This contrast of data could lead us to think that the unique viable solution is increasing their interconnectivity by greater direct investment in technological capital. This could in some way lead to serious increases in total factor productivity (TFP), due mainly to the positive spillovers of technological capital, when the required know-how is already established, as authors like Hjort and Poulsen describe.

But technology, as we might expect, doesn’t increase productivity levels just by itself, but due to the effects it has on the whole economy. Economic digitalisation creates greater connectivity networks, facilitating new exchanges and transactions, which previously were not viable due to greater connectivity and cost barriers. We just need to have a look at the vast technological development of global value chains since the 90s, and how this has created new ways for economic development, with a specially relevant effect by organizational technologies, which have led to an ampler international division of labour and greater specialization levels, with their corresponding effects on efficiency and productivity.

In the following graph we can observe how nations with lower income levels tend to present a smaller technological capital intensity and concentration. These differences are even amplified when using real GDP per capita levels as independent variable. These data can be introduced in a logarithmic scale graph representing the correlation between real GDP per capita levels and ICT concentration levels per unit of non-ICT capital. While in 1995 the correlation was strong and statistically relevant, with time that has ceased to be the case, as we can observe when reproducing the same comparison with 2011 data.

Form these graphs we can conclude that the main cause of lower technological capital concentration in emerging economies is precisely their lower productivity levels and high labour intensity production schemes. One of the most relevant conclusions we can obtain from this comparison is that apart from real GDP per capita levels, one of the most tightly related variables to ICT abundance is the sole productive structure of each nation, which allows us to extrapolate some of these conclusions from the cited empirical research.

Economic integration and democracy

Globalisation and global economic integration are not just desirable to promote economic growth and social development, but also to enhance democracy and political freedom. Global economic integration, according to recent empirical investigations, has proven to promote transition from autocratic and dictatorial political systems to liberal democratic political schemes in the mean term. This process has expanded massively along the last 60 years, when recent modern economic globalisation started gaining strength.

Over the last 60 years, more than 48 countries transitioned from autocratic systems to recognized democracies. The number of democratic countries has passed from being 48 in 1960 up to 121 in 2015, out of the countries recorded by the Polity IV index. Some authors as Acemoglu or Rodrik have studied the existing correlation and causality between greater economic integration (measured as Trade/GDP) and political democracy (measured by the Polity IV Democracy Index). The results have been plotted in the graph below, and the conclusions reached by the authors point to a significant correlation and causality between economic integration and political democracy. 

Building on these results, recently Magistretti and Tabellini studied the causal effect of economic integration on democracy levels using a wide panel dataset of countries, enlarging the time period from 1950 up to 2014. One of their main predictions was that lower “effective distance”, understood as the real existing distance between countries when accounting for available technologies and faster means of transportation which help to reduce physical distance between countries, contributes to a faster diffusion of economic and political spillovers between nations. We should add this to the significant reduction in shipping and freight costs over the last half century, which has outstandingly contributed to a greater diffusion of goods and services all over the world, affecting, even indirectly, certain political trends. A very positive fact discovered through these investigations, is that, as Acemoglu shows in a recent paper, negative temporary GDP shocks do not contribute to a backlash in democratic levels, being upward trends much more effective than downward ones in affecting political dynamics.

Furthermore, economic integration also greatly affects multiculturalism through the promotion of global transmission of cultural values, which have empirically shown to have large positive effects on society’s socioeconomic development. This is caused by a process of institutional adaptation and cultural transmission, during which cultural values are circulated through countries due mainly to trade. This multiculturalist tendencies have contributed to the solidification of democratic capital in countries which were previously autocratic and dictatorial regimes, according to an empirical research programme developed by Persson and Tabellini.

So, as we can observe from the above cited evidence, political and cultural values’ transmission greatly depend on economic integration, bringing great positive effects for material, humanitarian and political development of emerging nations.

Protectionism

Protectionism isn’t something new. It has been there since the first mercantilist political trends in the late XVI century, but it has recently, over the last three years, surged with a force unrivalled to any trend previous to the last century, going back to the Smoot-Hawley tariff atmosphere. One of the main promoters of these new protectionist tendencies in the West has been the United States, lead by Donald Trump. Different theoretical arguments have developed around this issue, but can we quantify the real effect of protectionist policies on economic growth and wellbeing?

In 2018 the US implemented tariffs on a total of 12.7% of its imports, raising the average applied tariff rate from 2.6% to 16.6% of the value of imports. Overall, trade partners started a retaliatory process, headed by China, introducing tariffs on a total of 8.2% of US exports, and raising the average tariff on US exports from 7.3% up to 20.4%, according to data from the World Bank.

Authors as Fajgelbaum, Goldberg, Kennedy and Khandelwal in a recent paper estimated quantitatively the impact of the US trade war on the real economy. Their first and most important findings were that tariffs had a large effect on present and future trade flows, as well as on FDI levels. They also estimated that the pass-through of tariff costs would be almost full to imported goods’ prices. Nominally, tariffs could have imposed a 51 billion dollars loss to US consumers and firms due to higher imported goods prices and consequent higher costs of production. Even accounting for some gains in concentrated sectors of the economy due to higher tariffs and trade restrictions, the aggregate net loss caused by protectionist policies would still be around 7.2 billion dollars. The most important part, and the one in which we should concentrate are aggregate impacts of tariffs and protectionist policies on the US economy.

To calculate the aggregate impact of the trade war on the US economy, the previously cited authors calculate import demand and export supply elasticities, not rejecting a fully horizontal foreign supply curve. Later on, the authors calculate the pass-through of tariffs to imported goods and services prices, even across products with heterogeneous characteristics. So, to calculate the real income loss to US consumers and firms due to the higher price of imports, authors compute it as the product of: import share of value added (15%), portion of US imports affected by new Trump Administration’s tariffs (13%), and average increase in tariffs of targeted products (14%). Their conclusion, when computing for the available data is a loss of real income of 51 billion dollars. The different studied scenarios can be depicted in the table below, where the authors compare the effects of a full trade war with those of a no-retaliation scenario.

We need to take into account that this empirical investigation doesn’t introduce into the model the effects of protectionist policies on economic uncertainty, productivity or innovation, which makes us think that the long-run effects of protectionist policies, not only in the US, but on the global economy, could be even larger.

Conclusion

Through this review of economic development and international trade academic literature, we have learned several things. First of all, we saw how FDI constitutes one of the main engines for growth in emerging countries, guaranteeing an efficient allocation of resources and unleashing a vast network of positive externalities, boosting mainly intangible capital, and affecting workers as well as institutions. Secondly, we discovered how through outsourcing certain public services and promoting competition in the retail sector in emerging economies, prices of goods can decrease notably while quality increases, at least according to consumers declared preferences.

Furthermore, we saw how economic digitalisation can help boost productivity in developing countries when these have the required knowledge and capacity of adaptation of their productive structure. In fourth place, we studied how global economic integration and political freedom, associated to democracy, are nearly naturally related. Finally, we presented academic evidence of how protectionism damages economic growth and socioeconomic development in those nations where it is applied, even without retaliatory effects, having studied the particular case of the recent US-China trade war.

REFERENCES:

• Our World in Data (2019), Oxford University.
• UNO Population Division (2019)
• Heritage Foundation (2020), Index of Economic Freedom.
• Luintel K.; Khan, M., “R&D, Scale Effects and Spillovers: New Insights from Emerging Countries”, WIPO.
• UNCTAD (2019), World investment report: Special Economic Zones
• Arnold, J and B Javorcik (2009), “Gifted kids or pushy parents? Foreign direct investment and firm productivity in Indonesia”, Journal of International Economics 79(1): 42-53.
• Blalock, G and P Gertler (2008), “Welfare gains from foreign direct investment through technology transfer to local suppliers”, Journal of International Economics 74: 402-421.
• Harding, T, B Javorcik and D Maggioni (2019), “FDI promotion and comparative advantage”.
• Busso, M and S Galiani (2019), “The causal effect of competition on prices and quality: Field experimental evidence”, American Economic Journal: Applied Economics 11: 33-56
• Bresnahan, T and P Reiss (1991), “Entry and competition in concentrated markets”, Journal of Political Economy 99(5): 977-1009.
• Phillip, T (2020), “A roadmap for digital-led economic development”, Voxeu.org
• Hjort, J; Poulsen, J (2019). “The Arrival of Fast Internet and Employment in Africa.” American Economic Review, 109 (3): 1032-79.
• Eden M, P Gaggl (2015), “Do poor countries really need more IT? The role of relative prices and industrial composition”, Policy Research Working Paper Series 7352, The World Bank.
• Acemoglu, D and J Robinson (2006), Economic origins of dictatorship and democracy, Cambridge University Press.
• Acemoglu, D and J Robinson (2012), Why nations fail: The origins of power, prosperity, and poverty, Crown Books.
• Acemoglu, D, S Naidu, P Restrepo and J Robinson (2019), “Democracy does cause growth”, Journal of Political Economy 127(1): 47-100.
• Magistretti, G, and M Tabellini (2019), “Economic integration and democracy: An empirical investigation”, Harvard Business School Working Paper, 19-003, July 2018 (Revised, January 2019).
• Persson, T and G Tabellini (2009), “Democratic capital: The nexus of political and economic change”, American Economic Journal: Macroeconomics 1(2): 88–126.
• Rodrik, D and R Wacziarg (2005), “Do democratic transitions produce bad economic out- comes?”, American Economic Review 95(2): 50–55.
• Fajgelbaum, P, P Goldberg, P Kennedy, and A Khandelwal (2019), “The Return to Protectionism,” NBER Working Papers 25638, National Bureau of Economic Research, Inc.