Democracy and Free Markets

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Observing many developed and developing countries across the globe we can observe that rapid economic development has been achieved both by democracies and authoritarian regimes on the political axis and both by free markets and by state-guided economies on the economic axis. An interesting question to pose in light of this observation is whether there is any reliable relationship at all between the choice of political regime, the choice of economic regime and the resulting economic performance.

Fortunately, almost all possible combinations of economic and political regimes have been tested across the world since World War II, providing us with plenty of data. Without getting into a lot of detail, we can make some basic observations:

- In Latin America, democracy plus state-guided economics resulted in failure,
- In Asia, authoritarian regime plus state-guided economics resulted in success,
- In Africa and the Middle East, authoritarian regime plus state-guided economics resulted in failure,
- In India, democracy plus state-guided economics resulted in failure,
- In post-Communist Europe, democracy plus free markets resulted in success,
- In the post-WWII US, democracy plus free markets resulted in success,
- In the post-WWII UK, democracy plus state-guided economics resulted in failure.

Quick conclusions that can be drawn from this evidence are that:
- neither democracy nor free markets can guarantee success,
- democracy and free markets together work better,
- the performance of authoritarian regimes are highly dependent on the vision of the ruling elite, and most importantly:
- the combination of democracy and state-guided economics is a recipe for failure.

Why may this be? Democracies have often provided good results coupled with free markets, and several authoritarian regimes achieved success under state-guided economics; so putting the blame on democracy or state-guided economics alone is not justified by the data. Then, it must be the interaction between democracy and state-guided economics that creates the problem.

In free-market economies, people accept that the engine of economic growth is private enterprise. The government is responsible to provide the legal infrastructure and macroeconomic stability for free enterprise, but generating growth itself is the responsibility of the private sector. In state-guided economies on the other hand, the government takes on the responsibility of achieving growth, so people measure the success of a government by the country's growth performance. Liberalisation is not only a legal and commercial issue but also an issue of mentality and expectations.

In free-market democracies, as the role of the state in the economy is limited to providing a sound legal infrastructure and stable macroeonomics, governments can focus exclusively on these issue without worrying about micromanaging growth. In state-guided economies, on the other hand, governments have to trade off their actions on legal infrastructure and macroeconomics with sectoral policies. While they still attempt to provide macroeconomic stability, electorates tend to prefer political parties which promise growth over political parties which do not. Political parties which accept this trade-off are bound to lose against political parties which try to allocate resources on both fronts. The extra funds required for these twin goals are raised through either inflation or debt.

After long periods of government activism supported by inflation or debt, countries which try to combine democracy and state guided economics face either hyperinflation or unsustainable debt dynamics. Both under hyperinflation and under very high debt, the economy becomes fragile against shocks. Any internal or external influence which worsens the inflation dynamics or debt dynamics - including domestic political uncertainty, worsening terms of trade or adverse global market conditions - worsens expectations and hence risk premia, creating a vicious cycle that feeds back into worsening dynamics. The result is either the collapse of state guided economics (good outcome) or the collapse of democracy (bad outcome).

Why do democracy and free markets work? It has been established through comprehensive research since the 1950s that the primary factor behind economic growth is technological development. Technological development means producing more output from a fixed quantity of resources. This naturally involves “doing things differently”.

But for the society to do something differently, someone must first try the different, see that it works, and persuade the rest of the people. In societies where dissent is not tolerated, new things are tried only by the very few people at the top. However, for a society to develop, new things have to be tried and tested by large numbers of people. Democracy ensures this on the political front and free market ensure this on the economic front.

To liberalise means not only reducing the state’s control of the economy, but also to persuade people not to expect growth from the government. Otherwise, a government with less tools and but the same responsibility to drive growth is doomed for failure.

There is a common theme between democracy and free markets: both involve giving people more freedom coupled with more responsibility. Under a democracy, people cannot blame the failure of government on anyone but themselves – they elect their rulers. Under a free market, people cannot blame their economic ills on others – they made their own resource allocation decisions.

When democracy exists in absence of free markets, it allows people to escape from responsibility. This, more than anything else, may be the reason why state guided economic policies only work under authoritarian regimes. More importantly, democracy and free markets can be used to reinforce each other. This is a reality no developing nation should ignore.