THE ROYAL ECONOMIC SOCIETY
The 2013 Young Economist of the Year Competition
From the final shortlist of 17 essays drawn from a total entry of over 1150, the judging panel of Charles Bean (Bank
of England and RES President), Professor Tim Besley (London School of Economics), and Stephanie Flanders (BBC)
have selected four winners and wish to congratulate them all. Once again the overall standard was extremely high,
with a number of entries from international schools. A list of highly commended entries and also a list of the schools
and colleges from the UK and overseas that joined in for the 2013 competition is published at www.res.org.uk
This year the judges agreed that the best essay was by Ellie Heatherill, entitled: “Does the international mobility of
talent make it impossible to tax the rich?”
The judges found this to be “a very lively and well-written essay, with a clear narrative thrust and an effective use of
humour. The author not only unearthed a wide range of relevant evidence – on the international mobility of football
stars, for example – but showed independence of thought in considering the underlying economics of her examples.
She drew the important distinction between income mobility and physical mobility. She also understood that many
people work where they do because they benefit from being around other talented individuals – an ‘agglomeration
externality’ – so that taxation is just one factor among many in shaping the location decision. A thoroughly deserving
winner of the RES 2013 Young Economist Competition.”
Second Place went to Tom Rutter for his essay on the question: “Must quantitative easing end in inflation?”
The judges found this to be “a very clear and sophisticated explanation of the relationship between quantitative
easing and inflation, which distinguished itself from a number of other strong essays on this topic by the clear
structure of its argument and its use of a novel example, in the opening paragraph, drawn from the world of video
games. A willingness to go back to first principles suggested a mature understanding of the underlying economics.
The author also grasped that inflation was to some extent an intended goal of quantitative easing, rather than just a
potential associated risk.”
The judges selected two winners for Joint Third Place: Georgina Evans and Holly Metcalf both of whom addressed
the question: “Should the experience of China silence those who think democracy is good for growth?”
Georgina Evans “noted that GDP growth was but one measure of a society’s economic success. It was, for example,
important also to look at factors such as the distribution if income and the extent of corruption, with China looking
less successful on both dimensions. She made good use of evidence from a meta study to demonstrate the equivocal
nature of the empirical evidence on the relationship between democracy and growth.” The judges also liked “the
deployment of UK experience, for example on airport capacity, to bear on the debate, as well as more standard
academic evidence. The essay had a clear narrative structure.”
Holly Metcalf provided a “lucid explanation of the issues raised by China’s experience. She appreciated the need to
consider the incentives facing governments in creating a pro-growth environment and how the absence of political
accountability affected that. She also recognized that the stage of development affects whether or not democracy
supports growth. And she went the extra mile in marshalling evidence – for example on the effect of corruption on
countries with democratic and non-democratic forms of government.”
The 2013 Young Economist of the Year is therefore Ellie Heatherill of Runshaw College, Lancashire, who will receive
the glass trophy and a prize of £1,000. Second place goes to Tom Rutter of Bishop Wordsworth's School, Salisbury
(£500). And joint third place goes to Georgina Evans of the Perse School, Cambridge, and Holly Metcalf of St Paul's
Girls' School, London, who will receive £250 each. All winners are invited to an award ceremony to take place at the
RES Annual Public lecture at the Royal Institution in London on 28 November. Their winning essays will be published
on the RES website.
Charlie Bean, Tim Besley and Stephanie Flanders,
29 July 2013.
The essay titles set by the Royal Economic Society President and judges were:
1.
2.
3.
4.
5.
6.
Does the international mobility of talent make it impossible to tax the rich?
Should the experience of China silence those who think that democracy is good for growth?
Is the UK banking system too concentrated?
Should Universities embrace market forces in deciding what to teach and how?
Should those who object to Heathrow expansion be ``bought off’’ at taxpayer expense?
Must quantitative easing end in inflation?
The following Final shortlist of applicants were chosen by a teachers panel having considered all 1150 entries:
*
*
*
*
*
*
*
*
*
*
*
*
*
*
*
*
*
Alex Pound, RGS Guildford
Amarjot Sidhu, Rainham Mark Grammar School
Amy Fedeski, Heart of England School, Coventry
Andy Quach, Bishop Vesey's Grammar School
Charlie Mann, Notre Dame High School, Sheffield
Eliza Haydon, City of London School for Girls
Ellie Heatherill, Runshaw College, Lancashire
Georgina Evans, Perse School, Cambridge
Holly Metcalf, St Paul's Girls' School
James Skinner, King Edward VI School
Lucinda Chamberlain, Withington Girls School, Manchester
Lucy Holden, North London Collegiate School
Oliver Wood, Oundle School
Steven Thavendran, Wilson's School
Tom Rutter, Bishop Wordsworth's School, Salisbury
Vivek Midha, Merchant Taylors' School, Northwood
Yasmin Barber, Tunbridge Wells Girls' Grammar School
Winner of the Young Economist of the Year Essay Competition 2013 – Ellie Heatherill
(with RES President Charlie Bean)
ELLIE HEATHERILL
DOES THE INTERNATIONAL MOBILITY OF TALENT MAKE IT IMPOSSIBLE TO TAX THE RICH?
Ellie Heatherill
RES Young Economist of the Year 2013
ELLIE HEATHERILL
DOES THE INTERNATIONAL MOBILITY OF TALENT MAKE IT IMPOSSIBLE TO TAX THE RICH?
Higher taxes on the rich- a winning strike or an own goal?
For the average worker taxation is an inescapable chore that we grudgingly concede makes
economic sense. Is this universal… or are the rich different?
Welcome to the world of the wealthy elite! But who exactly are they? Unfortunately, there is no
clear-cut definition for ‘rich’- much to the disappointment of many an A-level Economics student
writing an essay on this topic. The rich cut-off point is an arbitrary choice; however, we will focus on
the top 1% of income earners. In Britain this is anyone earning more than £156,000; together they
contribute almost a third of all income tax revenue. However, it is necessary to look at both the ‘rich’
and the ‘super-rich’ who earn millions -if not billions- a year. The ultimate question is not should we
impose high taxes on the rich but can we?
With ever increasing austerity to reduce budget deficits along with attempts to reduce income
inequality through income redistribution, this ideologically driven debate has never been so
prominent, drawing upon principles from politics, economics and sociology. Although taxing the rich
at a higher rate may appear to be good politics, it may not necessarily be good economics as it can
be subject to the law of unintended consequences. With significant improvements in the mobility of
talent over recent decades, it has never been easier for the rich to emigrate in order to reduce their
tax liabilities. This connection was noted by Mirrlees (1982): “High tax rates encourage emigration”,
implying the affluent are likely to leave if their domestic utility is less than their utility abroad net of
migration costs, as a result of high taxation. This is supported by evidence from the 50p top income
tax rate that was introduced in the UK: in 2009/10 more than 16,000 people declared annual income
over £1 million but this fell to 6,000 after the top rate was raised, costing the government £7billion
in lost tax revenue. It is believed many rich Britons moved abroad or took steps to reduce their
taxable incomes. Can governments afford to adopt such risky tactics in this precarious economic
climate with one’s private jet so easily available?
When it comes to the rich, the lack of homogeneity of workers means the labour market is not
perfectly competitive, resulting in the emergence of economic rent. In the case of some 'talented'
individuals, the supply of individuals able to do the job is limited in the short run and unresponsive
to wage increases, for example, an international footballer may be paid £150,000 a week but might
have been initially willing to do their job for much less. This 'excess' payment could be said to be
unearned income since it is beyond the weekly value the person put on their labour when they
decided to do that job so the government could tax away all their economic rent. If they attempt
this, leaving a worker with their transfer earnings alone, then talented individuals will move abroad,
to where taxes are lower. Tax revenue is lost along with associated skills/ jobs/ investment. As a
consequence of the international mobility of talent, combined with barriers to entry in the labour
market and the potential for relatively lower tax rates in other countries, it makes it almost
impossible for the government to tax the ‘excess’ earnings of the ultra-affluent.
Moreover, low barriers to international mobility of labour have also contributed to increased
difficulties when taxing the footloose wealthy. As a result of close economic integration in Europe,
the free mobility of labour within the EU removes barriers to labour mobility which helps facilitate
the migration of talent within the continent. The threat of migration is strongest within Europe
RES Young Economist of the Year 2013
1
ELLIE HEATHERILL
DOES THE INTERNATIONAL MOBILITY OF TALENT MAKE IT IMPOSSIBLE TO TAX THE RICH?
where wealthy, talented individuals can easily relocate to lower tax economies. The repressive 75%
tax rate on the rich in France has cost the country one million jobs with 60,000 of the country’s rich
now living abroad to avoid the tax. Concerns have also been raised that the mobility of talent is
creating harmful tax competition in some countries leading to a ‘race to the bottom’ and a loss of tax
progressivity within Europe. Low barriers to mobility aren’t just an added difficulty in Europe, but
also in the US where wealthy Americans are very mobile: if they don’t like the tax system in one
state they can easily move to another one.
How do these ideas fair in reality? A study by Kleven, Landais and Saez on taxation and the
international mobility of superstars in the European football market revealed that due to relatively
low mobility costs, professional European footballers have greater mobility since their talent
requires minimal place-specific investment of human capital. The study takes advantage of
variations in tax policies and labour regulation across Europe to identify the relationship between tax
rates and emigration of the rich. A strong negative correlation between top earnings tax rates in a
country and the fraction of players from the country playing at home in the domestic league was
found, suggesting significant behavioural responses to tax rates. The elasticity of probability of
playing in a given country depending on the net-tax rate on earnings is relatively large; younger
players are more sensitive to taxation with a parameter estimate of 0.72 compared to 0.48 for the
sample as a whole. When the sample is restricted to just top quality players, the coefficient is 1.15
meaning the most talented players are much more responsive to tax rate differentials making them
the most mobile with fewer geographical constraints on earning capacity. As a result, their
residential decisions may depend more on the ‘tax price’ of a given jurisdiction.
Preferential tax laws such as the ‘Beckham law’ saw a surge in the share of top international players
(figure 1) living in Spain with Cristiano Ronaldo moving to Real Madrid in 2009 to take advantage of
the 24% flat tax rate. Belgium and Denmark also adopted similar tax systems and saw the fraction of
foreign players rise sharply. However, with the Spanish tax system changing so that high earners
such as Ronaldo must now pay 52% on their earnings, is this the real reason he’s considering a
return to the Premier League? Large tax differentials across Europe, along with preferential tax
systems, encourage the mobility of talent. Some see tax rate harmonisation as the only possible
solution in this deeply economically integrated area but at present this seems unlikely.
However, in reality how many rich can follow in Beckham’s recently retired footsteps and simply
transfer to the country of their choice? Footballers and talent of this nature are a very select, elite
group and so the ability to tax them in relation to the international mobility of talent will differ
substantially from, for example, a highly skilled banker who may have higher geographical
constraints on earning capacity resulting in them being quite immobile. Positions in the most highlyskilled and highly-remunerated professions are often concentrated in particular places, for example
bankers in London’s financial district or Wall Street. In industries such as banking, agglomeration and
concentration effects of external economies of scale are important and consequently, this may
restrict the international mobility of talented bankers since they must reside in the same country as
they work in. However, the US and UK both have fairly high relative top marginal tax rates and so
these talented individuals must also face these high taxes. Moreover, talent is attracted by the
availability of other talented individuals and this may not be present in relatively lower tax
economies. The demand for their ‘talent’ is derived from the demand for workers needed for the
RES Young Economist of the Year 2013
2
ELLIE HEATHERILL
DOES THE INTERNATIONAL MOBILITY OF TALENT MAKE IT IMPOSSIBLE TO TAX THE RICH?
output they are required to produce. As a result, it may not be as easy for rich individuals to simply
locate to the country with a lower rate of income tax. If there is not sufficient demand for their skills,
there may be large wage differentials which could lead to a net loss of utility rather than a gain from
lower income taxes.
We must also consider –something we inadvertently forget- that not all wealthy, talented people are
motivated by money. Neoclassical economic theory suggests a simple cost-benefit analysis when
deciding whether to emigrate and non-pecuniary factors are just as important. The rich still have
strong ties to their country such as: home, family and community and they must also consider
linguistic compatibility, networks and socio-cultural affinity. Together with an individual’s ability and
willingness to give up their job to migrate, these factors influence an individual’s propensity to
migrate which determines how the incentive for tax flight translates into actual behaviour. Economic
literature suggests the general propensity to migrate in response to tax changes is fairly low for the
majority of rich people. This is corroborated by empirical evidence from the New Jersey millionaire
tax, which raised top income tax rates by 2.6 percentage points. The study found little
responsiveness to the tax increase with semi-elasticities generally below 0.1. The millionaire tax did
not lead to millionaire migration but in fact the overall population of millionaires increased (figure
2). It was a similar case in California in 2005, which raised the tax rate on income by 1 percentage
point (figure 3). These findings are suggestive of the socio-economic factors that constrain wealthy
individuals’ ability or willingness to migrate in response to higher tax rates. So although there is a
potential for the international mobility of talent, it may not always translate into emigration and lost
tax revenue.
If the rich still decide to emigrate, can the government ensure that they pay their fair due? Tax flight
concerns are lower when a country has worldwide tax jurisdiction meaning assets can be taxed
wherever they are located: similar to Mirrlees’ optimal nonlinear tax model in which both residents
and emigrants are taxed. Individuals can leave the tax system, if they renounce their citizenship after
emigrating. The US is the only advanced economy to enforce income and capital gains tax on
expatriates causing some high-profile Americans to take extreme measures to avoid tax, including
Eduardo Saverin, co-founder of Facebook, who renounced his US citizenship and took up residency
in Singapore to benefit from a top tax rate of only 20%, saving him an estimated $67 million.
Evidently there is a trade-off: allowing emigrants to avoid taxes by surrendering their citizenship
limits the ability of the home government to tax these individuals. In order to minimise this,
governments could tax rich emigrants on the same basis as non-resident citizens, who maintain a tax
home in a foreign country and benefit from the same tax laws as domestic citizens within home
territory. Although, this is a very stringent policy measure, it makes it almost impossible for the rich
not to pay tax despite the international mobility of talent which becomes superfluous.
So if the rich do emigrate, is high taxation to blame? You may be surprised to hear that the top
destinations of the footloose wealthy who emigrate from Britain include even higher tax economies.
According to research by Lloyds TSB, the top destination is France, followed by Spain, the US,
Australia and New Zealand, thus, going against the conventional wisdom. One in five wealthy Britons
has threatened to emigrate in the next two years with the biggest two reasons cited as crime and
weather and they would prefer infrastructure spending and ‘cutting red tape for business’ rather
than lower taxes. So, quality of life factors may be more influential for the rich than tax rates.
RES Young Economist of the Year 2013
3
ELLIE HEATHERILL
DOES THE INTERNATIONAL MOBILITY OF TALENT MAKE IT IMPOSSIBLE TO TAX THE RICH?
Moreover, an increasing number of the mega-rich around the world are surprisingly willing to pay
high rates of tax with affluent German and French even signing petitions for higher taxes! In the US
there is the “Buffett rule” named after the billionaire Warren Buffett, who strongly disagrees with
the US tax system allowing him to benefit from an effective tax rate which is lower than his
secretary’s. This suggests that they feel it is their duty to pay their fair share of the tax burden.
Ultimately, the mobility of talent may not be the greatest obstacle to taxing the rich; instead it may
be the mobility of taxable incomes. ‘The rich are different’ (Alm and Wallace) and their taxable
income elasticity may be more sensitive to marginal changes in the tax rate. Their greater tax
responsiveness may be facilitated by access to the best tax advice which finds them legal ways other
than emigrating, to readjust their income to avoid top rates, for example, through income splitting,
investing in tax shelters like flow-through shares or the use of off-shore accounts in so called ‘tax
havens’. The problem isn’t so much individuals physically moving somewhere else, instead it is them
legally moving their incomes somewhere else through tax avoidance or using illegal strategies to
evade tax. Financial liberalisation has generated rapid growth in off-shore banking with the rich
around the world holding $18 trillion in off-shore banks according to the IMF, which is greater than
the annual GDP of the US. Tax evasion is potentially an even bigger problem and recent cases have
highlighted this with Lionel Messi finding dodging taxes easier than dodging defenders and Dolce
and Gabbana being sentenced after evading $1.3 billion in taxes. This reinforces that whether
talented individuals emigrate or not, they can still reduce tax liabilities, making the international
mobility of talent less important.
Ironically, the British tax system is not driving the global elite from our shores. Why do so many
wealthy people choose to live in Britain when we have a relatively high rate of income tax? The
answer is: tax. In Britain there is a distinction between residence and domicile, with a favourable tax
regime for people who reside here. Britons are taxed on worldwide income whereas foreigners are
only taxed on the money they bring to Britain and spend here. This influx of talent makes a very
useful contribution to the UK economy.
So, does the international mobility of talent make it impossible to tax the rich? It makes it harder but
we must remember that not all rich individuals are perfectly mobile especially those who own
businesses or are in certain professions. It could be concluded that the mobility of talent to avoid
taxes may only be an option for those such as footballers- those who do not face constraints on
mobility. Perhaps reforms which close loopholes and broaden the tax base are a more efficient way
to generate revenue than high taxes on the rich which create the threat of the mobility of labour to
reduce tax liability. International tax cooperation reform is essential to end the abuse of tax havens
and off-shore finance and limit the extent to which rich individuals attempt to pursue less socially
productive activities to avoid taxes. According to Benjamin Franklin: “In this world nothing can be
certain except death and taxes” so it’s not impossible to tax the rich but it probably will be
impossible to convince the average tax payer that they’re ever paying enough!
Word Count: 2,499
RES Young Economist of the Year 2013
4
ELLIE HEATHERILL
DOES THE INTERNATIONAL MOBILITY OF TALENT MAKE IT IMPOSSIBLE TO TAX THE RICH?
Appendix:
Figure 1:
Impact of the ‘Beckham law’ in Spain
1995 Bosman Ruling
2004 ‘Beckham law’
Source: Taxation and International Migration of Superstars: Evidence from the European
Football Market (Kleven, H.J. & Landais, C. & Saez, E.)
Figures 2&3:
No. of tax filers (1000's)
New Jersey Millionaire Tax Filers
50
California Millionaire Tax Filers
2004 tax increase
40
30
20
10
0
2000 2001 2002 2003 2004 2005 2006
Year
Source: Adapted from The Wall Street Journal
Source: National Tax Journal
RES Young Economist of the Year 2013
5
ELLIE HEATHERILL
DOES THE INTERNATIONAL MOBILITY OF TALENT MAKE IT IMPOSSIBLE TO TAX THE RICH?
Bibliography and references:
Baldwin R. E. & Krugman, P. (October 7th 2002). European Economic Review 48 (2004) 1 – 23,
Agglomeration, integration and tax harmonisation, European Economic Review
Dinan, S. (September 19th 2012) House passes new Buffett Rule, The Washington Times
Diving into the rich pool, (September 24th 2011), The Economist,
http://www.economist.com/node/21530093
Dolce and Gabbana sentenced to jail for tax evasion, (June 19th 2013), BBC News,
http://www.bbc.co.uk/news/business-22977174
Frank, R. (April 20th 2011). Millionaire Tax Didn’t Chase the Rich From New Jersey, Study Says, The
Wall Street Journal, http://blogs.wsj.com/metropolis/2011/04/20/did-new-jerseys-millionaire-taxdrive-away-wealthy/
Frank, R. (April 16th 2012). Do Higher Taxes Drive Out the Rich?, The Wall Street Journal
Heath, A. (September 25th 2012) If you want the rich to pay more tax, let them grow even richer,
The Telegraph
Hills, S. (August 8th 2012) France plans savage 75% tax rate for top earners as the rich vow to desert
country if it goes ahead, The Daily Mail
Kleven, H.J. & Landais, C. & Saez, E. Taxation and International Migration of Superstars: Evidence
from the European Football Market http://sticerd.lse.ac.uk/dps/pep/pep14.pdf
Mcrae, H. (April 26th 2006) The Big Question: Why do the world's super-rich live in Britain - and do
we want them here?, The Independent
Mirrlees, J.A. (April 1982). Journal of Public Economics 18 (1982) 319-341, Migration and Optimal
Income Taxes, Journal of Public Economics
The Global Elite Are Hiding 18 Trillion Dollars In Offshore Banks, http://www.globalresearch.ca/theglobal-elite-are-hiding-18-trillion-dollars-in-offshore-banks/5317691
Winnett, R. (December 12th 2012). Two-thirds of millionaires disappeared from official statistics to
avoid 50p tax rate, The Telegraph
Young, C. & Varner, C. (June 2011). National Tax Journal 64 (2, Part 1), 255–284 Millionaire Migration
and State Taxation of Top Incomes: Evidence from a natural experiment, National Tax Journal,
http://www.stanford.edu/group/scspi/_media/working_papers/VarnerYoung_Millionaire_Migration_in_CA.pdf
RES Young Economist of the Year 2013
6
Must ‘quantitative easing’ end in inflation?
For anyone playing the wildly popular online role-playing game Diablo 3 back in May, the
effects of an expansion of the monetary base on the price level were evident. For the
uninitiated, some background detail would be helpful. Each player controls one character
in a world also populated by the characters of other players. The game proves interesting
study for economists due to the way in which scarce in-game items are allocated; through
an auction house, where players bid for items being sold by other players. By doing this
the auction house essentially creates a market for each item in the game, with price being
determined by the interaction of supply and demand. In May, a bug in the game allowed
players to quickly add massive amounts of gold, the in-game currency, to their account in
a very short period of time. The result: prices for most goods in the auction house shot
up. For example the radiant star ruby, which had been hovering just above 20 million
gold for the previous 6 months, shot up to 85 million in one day. However the most
interesting price change to note was in the price of gold itself. Players can buy in-game
gold using real money; this is one of the ways the producers profit from the game. The
price of 10 million gold had been dead stable at $2.50 for the previous 3 months, before
falling to 39 cents in one day, reflecting the reduced purchasing power of gold in-game.
While the events of Diablo 3 are perhaps the most recent, history abounds with such
examples. Liberal printing of money led to hyperinflation in Zimbabwe in 2008 and in
the 1920s Weimar Republic. Even further back than that, when the value of coins was
linked to the precious metal contained within them, prices in Europe quadrupled during
the 16th Century when gold and silver began flowing into Europe from the newlydiscovered Americas, driving down the value of the precious metals contained in each
coin.
When looking to explain these effects of a changing monetary base, we could first look at
the work of Irving Fisher, an American economist prominent in the early 20th Century.
He noticed that the amount of money in the economy, multiplied by the number of times
money changes hands in a given time period (the velocity of money), must be equal to
total expenditure in the economy over that time period. Similarly, the total expenditure
in the economy in a given time period must be equal to the general price level multiplied
by the goods sold during that time. Combining these two statements gives the identity:
MV=PQ (Fisher’s equation of exchange)
This identity underpins the quantity theory of money. When it is assumed that the
velocity of money and the quantity of goods produced is constant, it becomes clear that
there is a constant ratio between the monetary base and the price level; a change in the
monetary base will lead to a proportional change in the price level. This theory directly
implies another, the neutrality of money. First proposed by Friedrich Hayek in 1931; the
idea behind the theory is that money can only influence nominal variables in the
economy, such as price, with no effect on real variables, such as inflation-adjusted GDP, as
1
Must ‘quantitative easing’ end in inflation?
any increase in the monetary base will be completely offset by the proportional rise in
prices.
So with this knowledge of the link between the monetary base and the price level, we
should be able to answer the question as to whether quantitative easing (QE) must always
end in inflation. QE was first implemented by the Bank of Japan in 2001 as an attempt to
use monetary policy to stimulate a stagnant economy while interest rates were down
against the zero lower bound, a situation nowadays referred to as a liquidity trap. QE
entails the government electronically creating funds and using these funds to buy various
securities from banks. When people deposit savings into a bank, the banks loans out some
of the money in order to make a profit, but it has to keep some of the deposit within the
bank, so it isn’t overextended and can pay out money to people who want to withdraw
their savings. This is known as fractional reserve banking. The requirement for reserves
has increased as a result of the international Basel III agreement. If banks are liquidity
constrained, they will be unable to lend money, which is where QE comes in. Buying
assets from banks floods them with liquidity, which will hopefully enable and encourage
private lending, by giving banks reserves well above the levels they need, leaving them
with little risk of a liquidity shortage. In the case of Japan, the assets the central bank
bought up were mainly long term government bonds. More recently the US Federal
Reserve has conducted QE via buying up mortgage backed securities and carrying out
liquidity swaps with other central banks. Since then, the Fed has also begun to buy up
government securities.
The reason we may expect QE to lead to inflation is that in electronically creating funds to
buy securities the government expands the monetary base. So by the quantity theory of
money we would expect an increase in the price level proportionate to the increase in the
monetary base. Looking at recent economic data from Japan and the USA …
Index (Jan 2008 =100)
The Monetary Base and the CPI in the
USA since 2008
400
350
300
250
200
150
100
50
0
2008
CPI
Monetary Base
2010
2012
2014
Year
2
Must ‘quantitative easing’ end in inflation?
The Monetary Base and the CPI in
Japan since 2001
Index (Jan 2001 = 100)
250
200
150
CPI
100
Monetary Base
50
0
2001
2006
2011
2016
Year
… we don’t see that relationship at all. We would expect proportionality to be clearly
visible when using indices as the lines would more or less follow the same path, yet here
this is evidently not the case. In the example of Japan, we actually have deflation
accompanying a quantitative easing program that is massively increasing the monetary
base. There are other factors at work here though, which have influenced the price level.
In Japan, an ageing and contracting population is reducing demand for goods. At the same
time, fear of bank insolvency has encouraged many Japanese to buy treasury bonds as
opposed to saving their money in a bank account, meaning there has been no money
available for lending, again reducing demand for goods. Deflation itself is selfexacerbating, as the Yen strengthens reducing the cost of imports and people hold out on
buying goods in case of further price drops. Nonetheless we would expect such a huge
change in the monetary base to override these factors, meaning that we can still conclude
that there is no significant relationship between the monetary base and the price level in
these situations.
So, do these results invalidate Fisher’s equation of exchange? Not quite! This equation is
an identity – it holds in all situations. We should look instead at the assumptions that the
velocity of money and the quantity of goods remain constant. The cases of Japan and the
USA suggest that at least one of these is incorrect.
First we’ll examine the assumption that the velocity of money stays constant. This
assumption was challenged by John Maynard Keynes, a British economist who lived
through the years of the Great Depression and is arguably the father of modern economic
thought. He argued that money is used not just as a medium of exchange while buying
and selling goods, but also as a store of value, in that it can be saved today to be spent later.
3
Must ‘quantitative easing’ end in inflation?
Keynes argued that money’s use as a store of value is determined by the interest rate.
Using money as a store of value has an opportunity cost, which is the assets that could be
bought with that amount of money. You might hold assets instead of cash, as assets have
the advantage of earning interest over time. This idea is referred to as liquidity preference
theory. The advantage of holding money is that it can be used at will, whereas with assets,
converting into hard cash can be more difficult. When interest rates are high, assets yield
higher returns, so people are inclined to hold assets. In our current situation, where
interest rates are near-zero as a result of measures taken to stimulate the stagnating
economy, there is next to no opportunity cost to holding money; individuals and
corporations will forgo what little profit they may receive on assets in order to have cash
on hand. The effect is compounded, as individuals are particularly wary of bonds in zero
interest rate situations, as interest rates cannot fall any further. Once the economy has
recovered and interest rates rise again, the price of bonds will fall. The significance of
liquidity preference theory for QE is that when money is being held as a store of value at
the margin, the money banks receive from QE is primarily padding out their cash reserves,
without it ever really entering the economy. Think back to the Fisher equation of
exchange and separate the new money created by QE and the money that already existed.
MV + M1V1 = PQ
If the new money created simply sits in a bank’s reserves, its velocity will be zero, and
hence there will be no change in the value PQ.
Now we’ll look at the assumption that the quantity of goods produced by the economy
remains constant following a change in the monetary base. Consider when Milton
Friedman remarked that the USA could fight price deflation by printing money and
dropping it from a helicopter. Although it was mentioned by Ben Bernanke, now the
Chairman of the Federal Reserve, back in 2002, it seems like an absurd policy. However,
you could consider a £1,000 fixed tax break financed by the central bank purchasing
government bonds equivalent to a helicopter drop. Clearly this is simply expansionary
fiscal policy financed by QE, which sounds like a more plausible policy option, although
lacking the drama of money falling from the skies. Aggregate demand would inevitably
increase, as families now have more disposable income they can spend on goods.
When thinking about the effects of QE on aggregate demand, we should also think about
the impact QE has on long term interest rates. When the central bank decides to buy
bonds and other securities, the price of the bonds increases due to the increase in demand.
The yield on these securities, which is usually a fixed nominal value for the term of the
bond, decreases as a percentage of its value, and this decrease in percentage yield should
trickle through the economy to rates on loans, credit cards and mortgages. With interest
rates lowered, aggregate demand will increase as it is cheaper to borrow money.
Investment in particular should pick up as most investment is financed through
4
Must ‘quantitative easing’ end in inflation?
borrowing. Usually this would lead to an increase in the price level; in fact this would be a
typical case of demand-pull inflation. However this may not occur under some
circumstances.
The recession has caused a lack of demand in the economy – that much is clear. When UK
house prices fell in 2007, people and corporations began slashing their spending in an
attempt to reduce debt. This fall in aggregate demand creates an output gap, where a
country produces fewer goods than its capabilities allow it to. In 2009, the UK was
estimated to have had an output gap of roughly 4% of GDP, which shows just how
significant the effects of the recession have been. Clearly the output gap means that there is
unemployed capital in the economy. Keynes told us that prices are sticky. Hence with a
large amount of unemployed capital, when demand increases firms are willing to increase
output without increasing prices. This leads to the conclusion that the aggregate supply
curve is fully elastic when there are large amounts of unemployed resources. The
importance of the above is that an increase in aggregate demand, caused by both reduced
long term interest rates and the potential for some new money to leak into the economy,
would not have to be inflationary if it put unemployed resources to use.
And yet, the above cases only concern the short run. Friedman, Keynes and Hayek,
arguably the three titans of 20th century economics, all told us that in the long run money
is neutral, so surely inflation must occur eventually? When the economy recovers, banks
will start to lend their reserves and the velocity of money will increase back towards
‘normal’ levels. Aggregate demand will recover to the point where it intersects on the
upwards sloping section of the aggregate supply curve, and the price level will be higher
than it would otherwise have been without the increase in the monetary base. This is the
case, which is why the central bank will start contracting the monetary base once the
economy starts to recover, thus never allowing inflation to be realised.
There are
numerous ways a central bank can do this, known as ‘exit strategies’.
5
Must ‘quantitative easing’ end in inflation?
Essentially, if the central bank has bought up lots of assets, it can start selling them,
destroying the money it receives from sales. The central bank can also raise interest rates,
which will encourage people to switch away from holding money, reducing inflationary
pressure. Sadly however, the solution is unlikely to be as simple as dumping assets and
hiking interest rates. If this happens too abruptly, before the economy is ready, then the
green-shoots of recovery could be trodden underfoot, as was the case following the rise in
interest rates in Japan in 2006. Furthermore, instantly calling a halt to QE could lead to a
spike in bond yields, which would be potentially problematic. In order to give itself more
flexibility with regard to the timing of monetary tightening, the central bank could pay
interest on cash reserves stored there, as the Federal Reserve has just been given permission
to do. This would delay bank reserves flooding into the economy, as banks would not
lend them out at rates less than the rate earned for storing reserves risk-free at the central
bank. Another tool the central bank could use is reverse repurchase agreements, where
the central bank sells assets and promises to buy them back later for a higher price. In
fact, these stall strategies could allow the central bank to let its assets mature, as opposed to
selling them and risking hefty losses.
In summary, a look at the effects of QE and the possible exit strategies seems to provide
the answer to the question posed. Quantitative easing, in the short run, need not be
inflationary – and even in the long run it doesn’t have to end in inflation, as it is a
temporary and fully reversible measure. Getting the exit right, however, may be more
complex than patching a video game.
2433 words excluding bibliography
6
Must ‘quantitative easing’ end in inflation?
Bibliography
Diablo 3 Price Tracker - http://www.diablohub.com/auction-house/
US Department of Labour Statistics – CPI - ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
Federal Reserve - Aggregate Reserves of Depository Institutions and the Monetary Base http://www.federalreserve.gov/releases/h3/default.htm
Official Statistics of Japan – 2010 base Consumer Price Index http://www.e-stat.go.jp/SG1/estat/ListE.do?bid=000001033702&cycode=0
Bank of Japan Statistics – Monetary Base – www.boj.or.jp/en/statistics/boj/other/mb/mblong.zip
DK – The Economics Book – Pages 30-33 – Money Causes Inflation
Alan S. Blinder – Quantitative Easing: Entrance and Exit Strategies http://www.princeton.edu/ceps/workingpapers/204blinder.pdf
Simon Wren-Lewis - Mainly Macro – Money and Inflation – 21st December 2011
http://mainlymacro.blogspot.co.uk/2011/12/money-and-inflation.html
Simon Wren-Lewis – Mainly Macro – What do people mean by helicopter money? – 12th October
2012 http://mainlymacro.blogspot.co.uk/2012/10/what-do-people-mean-by-helicoptermoney.html
Paul Krugman – Conscience of a Liberal – Monetary Policy in a Liquidity Trap – April 11th 2013
http://krugman.blogs.nytimes.com/2013/04/11/monetary-policy-in-a-liquidity-trap/?_r=0
The Economist – The President Speaks – June 4th 2009 http://www.economist.com/node/13768746
Ben Bernanke – The Fed’s Exit Strategy – The Wall Street Journal – July 21st 2009
http://online.wsj.com/article/SB10001424052970203946904574300050657897992.html
Nouriel Roubini and David Backus – Lectures in Macroeconomics – The IS/LM Model
http://people.stern.nyu.edu/nroubini/NOTES/CHAP9.HTM#topic6
Stephanie Flanders – Should Bank start the helicopter? – BBC – 12th October 2012
http://www.bbc.co.uk/news/business-19925013
Kenji Nishizaki, Toshitaka Sekine, Yoichi Ueno – Chronic Deflation in Japan
http://www.boj.or.jp/en/research/wps_rev/wps_2012/data/wp12e06.pdf
Tom Pybus – Office for Budget Responsibility – Estimating the UK’s historical output gap
http://cdn.budgetresponsibility.independent.gov.uk/WorkingPaperNo1-Estimating-the-UKshistorical-output-gap.pdf
7
June 2013
Should the experience of China silence those who think democracy is
good for growth?
The Gastil Concept states that ‘political rights are the rights to participate meaningfully in the
political process. In a democracy this means the right of all adults to vote and compete for public office
and for elected representatives to have a decisive vote on public policy’ – Gastil (1986-87 ed p.7)
Winston Churchill once said that ‘democracy is the worst form of government except all the
others that have been tried’ and, for a long time, this was an essentially unchallenged
consensus. However, the end of a prolonged age of Western growth in 2008, with only faint
signs of a palpable recovery since, has led some to question the very foundations on which
our countries are governed. Indeed, the cogency of this view has only been enhanced by the
persistently strong growth over recent decades of the indisputably undemocratic nation,
China. Can it really be the case that we should succumb to the assertion that democracy is
not in fact economically optimal and instead move in the direction of an authoritarian state?
Certainly it is easy to argue that if GDP growth rate is the exclusive metric by which we
measure economic success, then China should be a model for other developing countries.
Staggering statistics in a recently published OECD report state that two decades ago China
accounted for slightly less than 4% of World GDP, by 2013 this figure has risen dramatically
to 13%. Since 1978, the Chinese economy has grown at an average rate exceeding 8% a year:
several times the amount of all democratic economies. The result is that China has gone
from being one of the poorest countries in the world, with GDP per capita at just one fortieth
of the US level in 1978, to one fifth today. Indeed the magnitude of these figures provides
compelling evidence for the advantages of China’s quintessentially neo-Leninist regime. The
argument follows that non democratic regimes can coercively implement policies designed
with the primary intent to stimulate growth. China is able to target 7.5% annual growth,
something that would be impossible in the UK, in large part because the government can act
above the rule of law to suppress conflicts and plan for the long term interests of the
country. This is in contrast to democracies which characteristically submit themselves to the
demands of the masses, who are often blinded by their own short term interest. In ‘Does
democracy stifle economic growth?’ Huang introduces the point that The Shanghai Growth
Model emphasises infrastructure, airports and bridges. To do this, a strong government
which has little respect for property rights is essential. The problem for democratic
governments is that they are constrained by public opinion. Take the example of the London
airport debate. London’s airports are going to require more capacity in the very near future,
if not already, to keep up with rising demand (ironically, from China’s growing middle
class). Yet the Conservative-led coalition, that has a number of MPs in the south-west
London constituencies which a larger Heathrow would disrupt, has ruled out, at least in the
short term, plans for a third runway. Recommendations from a commission of inquiry have
been postponed until after the election in 2015. In short, although expansion of airport
capacity in London would be beneficial to the UK’s long term growth, it is not politically
popular; hence no agreement will be reached soon, a hindrance to growth, the result of
democracy.
There has also been an array of research into the quantitative relationship between
democracy and growth. In an article published by Hristos Doucouglios and Mehmet Ali
Ulubasoglu of Deakin University, the authors find that the majority of regressions ‘have not
been able to find the ‘desired’ positive and significant sign for the impact of democracy on
growth’ and conclude that ‘there is indeed zero direct effect of democracy on growth’. This
is a conclusion echoed in other research such as that of Robert J. Barro who finds the overall
effect of democracy on growth to be ‘weakly negative’. Barro identifies that the growth
retarding features of democracy include the tendency to enact redistributions of income in
systems of majority voting.
Furthermore, democratic governments often succumb to
popular demand at the expense of more profitable investments.
However this is not to say that the evidence is entirely irrefutable. After all, not all
authoritarian regimes have been successful: China under Mao Zedong did not experience
high levels of growth. Again, If we look at two other countries, democratic India and the
less democratic Pakistan, India’s GDP per capita rose from $300 in 1990 to $700 by 2008
whilst Pakistan’s rose from $460 to just $650. This anecdotal evidence suggests democracy’s
impact on growth could be very positive. Indeed, Doucouglios and Ulubasoglu did find that
democracy does have a positive indirect impact through higher human capital, as they
respond to the public’s demands for investment in areas such as education and health, and
higher levels of economic freedom. The idea here is that in a liberal economic environment
with free dispersal of information and secured tenure of property, there is more personal
incentive for citizens to work, invest, and maximise profits. (Note that meta regression
analysis indicates economic freedom and political freedom are positively correlated.) We can
actually look to China to provide evidence for this. From the start of the 1990s, markets for
agricultural inputs and outputs were gradually liberalised and government interventions
were substantially reduced. This provided farmers with the necessary incentives to adopt
modern technologies leading to an average annual growth rate of total factor productivity
reaching 5.10% between 1988 and 1998. There have even been suggestions that these
agricultural reforms were the most crucial source of China’s growth during the first two
decades of economic reform. This could also suggest that the nature of the regime,
democratic or authoritarian, is not a significant determinant of growth. It could be that there
are numerous other defining factors of growth and that the corresponding policies can be
implemented under numerous forms of government.
Be that as it may, there is evidence implies that democracies tend to enable a higher quality,
rather than quantity of growth, creating more favourable distributional outcomes. Indeed in
authoritarian China, since the late 1970s, when growth took off, income inequality has
increased by over 50%. As a result, China is now one of the most unequal societies in Asia.
As an example of this, the World Health Organisation rated the fairness of the Chinese
healthcare system below all countries, with the exceptions of Brazil and Burma. In their
book ‘Red Capitalism’, Carl E. Walter and Fraser J.T.Howie delve into this idea in greater
depth; they attribute the income inequality to be the direct result of the choice of China’s
leaders to implement economic reform without political reform or the establishment of the
rule of law.
It seems the lack of democracy gives rise to rampant corruption within
government; on average 140,000 party officials and members were caught in corruption
scandals each year of the 1990s, yet only 5.6% of these were prosecuted. The reality is, with
unchecked power, officials have found ways to turn their power into wealth. China has a
government in which power is a valuable personal asset and arguably the resulting fixation
on growth is purely a means to bolster their legitimacy so as to reduce pressure on the ruling
elites to liberalise, allowing the corruption to go on. Walter and Howie summarise this thus:
‘greed is the driving force behind the protectionist walls of state-owned economy inside the
system and money is the language’. This fixation on growth also means that officials are
rewarded for delivering growth, laying rise to a flawed incentive structure which fuels a
misallocation of resources to so called “image projects” that burnish their records. The
World Bank gives a striking estimate that between 1991 and 2000, a third of investment
decisions in China were misguided.
There are also underlying frailties at the heart of the financial system -although it is not in
officials interests to acknowledge this. The truth is that China is the first country in history to
have achieved record economic growth whilst simultaneously having a record number of
non-performing bank loans, as scarce resources are channelled to local elites who do not
invest efficiently. Ultimately, China’s state controlled banks, which make up a high majority
of the market, are technically insolvent.
Therefore, it could be argued that China’s
impressive growth is an elaborate façade which masks the overwhelming weaknesses at the
heart of the Chinese economy. Estimates that China will overtake the USA to become the
largest economy in the world in 2020 should not be viewed with certainty, predictions can
be wrong: in 1967 Herman Kahn predicted Japanese per capita GDP would overtake the
USA’s by 2000; today US GDP per capita is $10,000 higher than Japan’s.
Yasheng Huang gives a different perspective, arguing that the ‘rise’ is itself misleading
when we consider that China has historically always been one of the World’s largest
economies: in 1820 China accounted for one third of the World’s GDP, much more than it is
today. It is fair to say that China has had far more scope for growth since 1978 than the USA
and Britain. Even today, China’s GDP per capita is still just $5,444 which is comparable to
Britain in 1926. This leads to an interesting point: in 1926, Britain was not a fully democratic
country; all women were not granted the vote until 1928. In fact the Lipset hypothesis, an
idea that prosperity stimulates democracy, has recently been examined and shows a strong
empirical regularity that increases in standard of living, including GDP, generate a gradual
rise in democracy. This would suggest that rather than being good for growth, democracy is
the result of growth. Democracy can be seen as a luxury good which rich countries consume
more of because it is desirable. Indeed, recent events in Brazil, with 1 million protesting
across the country last week, are an example of rising expectations and hopes for more
political freedoms after years of rapid growth. China itself has also incurred increasing strike
protests; annual protests of ‘mass group incidents’ rose from 8,700 in 1993 to 87,000 by 2005.
Similarly, since 1978, the system has moved in a more liberal and more democratic direction
as they have introduced village elections and increased the security of proprietors.
In conclusion: yes, China is an example of incredibly strong growth in an authoritarian
regime. However, when all published democracy-growth effects are plotted in a funnel plot
(see Figure 1), not only is there a wide distribution of results, but also the centre, which
represents the estimate of the true underlying effect, shows a zero correlation. Perhaps the
logical inference is that it is not the type of the regime, democratic or authoritarian, but
instead other factors that define the growth of a country’s economy. Similarly, a strong
argument could be made that democracy, whilst having a detrimental impact on growth at
certain stages of development, is eventually a necessity to sustain a stable economy once a
high level of wealth has been achieved. The reason why growth may slow in democracies
may be that a democratic government tends to occur at a point when higher growth is nearto impossible. Hence, whilst the experience of China might go some way towards silencing
those who think democracy is good for growth, it certainly should not silence those who
believe democracy is good for the economy in the longer term. There have, after all, been
very few historic examples of long term authoritarian regimes which have experienced
growth. In the past, as soon as countries can afford to do so, they have moved towards
democracy because, in reality, development and welfare are not purely dictated by GDP.
Eventually problems of inequality and corruption, characteristic of authoritarian regimes
such as China’s, outweigh the benefits those governments have on growth, making them
unsustainable. China’s leaders may do well to appreciate this to avoid calamity.
Word count: 2,000
Figure 1: Published Democracy-Growth Effects, All-Set (n=483)
Bibliography:
http://www.oecd.org/china/47408845.pdf
http://www.bbc.co.uk/news/business-20679148
http://news.bbc.co.uk/1/hi/magazine/7674841.stm
http://www.usnews.com/opinion/blogs/economic-intelligence/2012/05/21/chinas-scaryfinancial-system
Does democracy stifle economic growth? – Yasheng Huang (TED talks)
Red Capitalism - Carl E. Walter and Fraser J.T.Howie (Book)
Academic journals:
Understanding China’s growth: Past, present and future - Xiaodong Zhu
Democracy and growth – Robert J. Barro
Democracy and growth: A meta-analysis - Hristos Doucouliagos and Mehmet Ali
Ulubaşoğlu
The Dark Side of China's Rise – Minxin Pei
Should Mumbai learn from Shanghai? – Yasheng Huang
Holly Metcalf
Should the experience of China silence those who think that democracy is good for
growth?
Picture the political activist, the product of a liberal Western education, trying to market her
idea of democracy to the rest of the world. Having considered all the political benefits of
democracy, she still feels that her argument lacks a certain gravitas. Recalling her economics
training, she considers the concept of aligning incentives: how to convince people that
democracy is the best system of government for their pockets as well as their civil liberties?
The obvious argument: prove that democracy is good for growth. It seems at first to be
backed up by data: seventeen of the world’s twenty richest countries, she notes, are
democratic. But, she cautions herself, correlation may not be cause. It could be that higher
incomes lead to calls for democracy, rather than the other way round. Secondly, she must
remember that growth measures not the level of income in a country, but the rate of change.
Comparing growth rates, she discovers, things are not so straightforward. One country in
particular stubbornly refuses to fit her model: growth rates frequently reaching 10% over the
last thirty years, but rated by the Centre for Systemic Peace’s Polity IV project at -7 (highly
undemocratic). Does the experience of China put an end to her quest to convince the world
that democracy is good for growth?
She wonders what it is that has caused these unprecedented growth rates. Are these factors
unique to China’s political system? China’s economic strength is usually traced back to Deng
Xiaoping’s market-orientated reforms of 1978, which allowed the growth of village
enterprises and small private businesses. The resulting productivity increases, combined with
capital accumulation and an export boom, saw a quadrupling of per capita income between
1983 and 1997. So economic liberalisation could be viewed as the key to China’s impressive
growth, and in implementing these reforms China has shown that a country can to some
extent embrace market principles whilst maintaining an undemocratic constitution. China’s
lack of democracy does not seem to have impeded its growth; bad news for our activist.
Furthermore, even a committed campaigner for democracy must acknowledge that there are
some ways in which China’s lack of democracy has aided growth. Yasheng Huang illustrates
the success of the ‘Shanghai theory of economic growth’ by comparing Shanghai with
Mumbai. In the case of urban development China’s one-party state gives it an advantage over
the democratic India; the Chinese government is not hindered by planning regulations and the
need to respect private property rights, and can therefore implement construction projects
with more ease than the Indian government, which is, as Huang puts it, ‘constrained by public
opinion’. The Chinese government is also far more likely to plan for the long term, and
therefore invest in infrastructure projects to aid growth, than a government in India, which
must also focus on the best strategy for re-election at the end of their five year term. So
India’s democracy could explain why the country’s growth rates are significantly lower than
China’s: averaging 5.9% for the 1990s compared to China’s 9.7%. The Chinese government
is also unhindered by scrutiny from other political parties, pressure groups or trade unions,
which could, through lobbying for shorter working hours or environmental protection, reduce
productivity and stifle growth.
A lack of political accountability may also have contributed to China’s success at currency
manipulation: by using renminbi to buy up other governments’ debt (particularly US
Treasury securities) the country keeps the value of its currency low, contributing to the
competitive export prices which have made China the modern ‘workshop of the world’ and
fuelled much of its growth. In doing so China has not complied with Article IV of the IMF’s
Articles of Agreement which, since an alteration in 1978, has stated that members should
‘avoid manipulating exchange rates or the international monetary system in order […] to gain
an unfair competitive advantage.’
So far it’s not looking good for our activist; China’s lack of democracy does not seem to have
hindered its economic growth – in fact, it may even have aided it. But what do the experts
say? Numerous studies have examined the relationship between democracy and economic
growth, but there is no conclusive evidence that democracy is good for growth. A 2002 paper
by Almeida and Ferreira summarises the problem: ‘A large empirical literature examines this
question by looking at the relationship between democracy indices and cross-country average
economic growth rates [but] this literature, taken as a whole, is fairly inconclusive.’
There are, however, some theories that democracy can indirectly lead to growth by providing
institutions conducive to growth, such as a secure legal framework which protects private
property rights, encourages competition and entrepreneurship and protects personal and
economic freedoms. A democratically accountable government with an independent judiciary
is more likely to respect the rule of law and property rights, which could encourage
investment as well as enterprise and innovation, all of which could act to increase
productivity, thus contributing to growth. Democracies are more likely to restrict
monopolistic tendencies which still exist in China in the form of State Owned Enterprises
(SOEs). Despite a significant decline due to China’s market-orientated reforms, they still
constituted an estimated 30% share of China’s GDP in 2006. In a country with less rigorous
competition laws there is a tendency for vested interests to be protected, making it harder for
new or foreign firms to break into some markets. These quasi-monopoly powers could
actually reduce productivity and hinder growth, as they create high barriers to entry into
certain markets, and discourage innovation and investment from new firms.
So according to China’s critics there are some aspects of its political system which are not
good for growth, and where a democracy might serve the economy better. But China’s
impressive growth rates seem to defy this, and there is no robust data to support the argument
that democracy is good for growth. There is, however, one aspect of the Chinese political
system which does hinder growth, and which is openly acknowledged by even the Chinese
leadership: the prevalence of corruption. Transparency International’s 2012 Corruption
Perceptions Index (CPI) gave China a dismal rating of 39 out of 100. The problems China
faces were expressed by Zhao Ziyang (General Secretary of the Chinese Communist Party
from 1987-89) when he described in 2004 how ‘those with power will certainly use their
control of the resources to turn society’s wealth into their private wealth. These people
become a huge entrenched interest… what China has is the worst form of capitalism.’ At last,
thinks our activist, here is a strong rebuff to advocates of the Chinese model. But Zhao was
dismissed for allegedly handling the Tiananmen protests of 1989 too liberally – surely his
views cannot be entirely representative of the Party leadership?
Apparently they are. The outgoing Premier Wen Jiabao highlighted the importance of
tackling corruption in his final address to the National People’s Congress in March, and the
new President Xi has already launched a campaign against corruption at senior and lower
levels, or, as he called the corrupt officials, ‘tigers’ and ‘flies’. Corruption is likely to be bad
for growth as it can lead to rent seeking and resources being diverted away from more
productive uses. And it is clear that corruption is a serious problem in China, which the
Chinese leadership itself want to address. But is corruption any more likely to occur in a nondemocratic country like China than in a democracy? The UK’s Corruption Perception Index
rating greatly exceeds China’s at 74, but is this superior rating a result of our democracy?
Other European democracies score far lower than the UK, which suggests that democracy
may not reduce corruption: Italy, for example, scores little better than China at 42, and
Greece is actually ranked below China with a CPI rating of 36.
Now at last there is a paper that can help. When exploring the relationship between
corruption, democracy and economic growth, Drury, Krieckhaus and Lusztig conclude that
‘corruption has no significant effect on economic growth in democracies, while nondemocracies suffer significant economic harm from corruption.’ They explain that ‘although
corruption certainly occurs in democracies, the electoral mechanism inhibits politicians from
engaging in corrupt acts that damage overall economic performance and thereby jeopardize
their political survival.’ Think of the Cash for Questions scandal in the UK; the democratic
system could not prevent it occurring, but the scrutiny of the British press, which is far freer
than in China, exposed the perpetrators, and this, combined with the prospect of being judged
by the public at the next election, acts to prevent more widespread corruption.
China’s successful growth rates show that, although its undemocratic system may have
caused corruption and other effects which hinder growth, its economic model is a successful
one, and its political system is, at the very least, not unsuccessful. It has weathered the global
financial crisis relatively well and, despite slowing growth rates, still managed to report a
figure of 7.7% growth for the first quarter of 2013. But is the Chinese model sustainable? In
Wars, Guns and Votes Paul Collier reports that ‘in the absence of democracy, as a society
starts to get rich it becomes more prone to political violence.’ He notes that China has already
passed the income threshold ($2,700 per capita) at which democracy has no net effect on
violence. If China follows his model, then its lack of political freedoms is likely to cause
increased civil unrest in the future, and this could seriously impede growth. The Arab Spring
of 2011 sparked off pro-democracy protests in many Chinese cities, which could be a
precursor to more unrest to come. As well as corruption and lack of democracy, another
problem which could spark more protests is inequality, which, according to the Financial
Times, ‘lies at the heart of social unrest in China’. China’s Gini coefficient, released in 2012
for the first time in over a decade, is a poor 0.474. Admittedly the problem of inequality is
not unique to China, or to non-democratic countries - the USA, for example, has a Gini
coefficient of 0.450, little better than China - but it is likely that democratic accountability
would reduce the powers of vested interests which often contribute to income and wealth
inequalities.
Those who think that democracy is good for growth may yet find that China conforms to their
expectations. Chinese growth rates are slowing: the 7.7% reported in the first quarter of 2013
was less than the 7.9% for 2012 Q4, and below the 8% forecast. It is widely acknowledged
that the nine or ten per cent growth rates of previous decades are over: as the then Premier
Wen said in his final address, development is ‘unbalanced, uncoordinated and unsustainable’.
If the Chinese leadership successfully manages the slowing of growth rates through the shift
of focus from targeting the quantity of growth to a quality based approach, then the country
may continue to fly in the face of those who believe that democracy is good for growth. But
in order to do so China must face many problems which may hinder its economic progress,
particularly dealing with corruption and with increased calls for democracy.
The fact that, so far, the Chinese model has proven a successful one does not prove that the
Chinese model is the best for growth. It may be that the effect of democracy on growth varies
depending on the stage of economic development. Many people argue that for developing
countries democracy can actually hinder, rather than aid growth. This could help to explain
why China surpasses India in growth terms, as its undemocratic government has been able to
prioritise economic growth over political factors such as human rights and freedoms, and the
‘Shanghai model of economic growth’ has aided urban development and the creation of
infrastructure as China industrialises. But as it enters a new stage of economic development
the Chinese model may not remain so successful.
So China’s experience should not silence those who think that democracy is good for growth;
our democracy campaigner may find that as incomes rise and growth rates slow China’s
authoritarian polity may pose problems for its people’s incomes as well as their civil liberties.
But the experience of China should make the advocates of democracy rethink their strategy.
There is as yet no conclusive evidence that democracy is good for growth, and the experience
of China shows that, for a developing economy, nor is it necessary. Perhaps our activist
should stick to political arguments for democracy, and leave the economics to the policy
makers.
References and Bibliography
A.C. Drury: Corruption, Democracy, and Economic Growth. International Political Science
Review 27.2 (2006) Accessed via www.jstor.org 05.06.13
Almeida, Heitor, and Daniel Ferreira: Democracy and the Variability of Economic
Performance (2002) www.business.illinois.edu Accessed 24.6.13
British Embassy in Beijing: China Economic Focus, May 2013 www.britishchamber.cn
Accessed 05.06.13
Center for Systemic Peace: Polity IV Project, 2010 Series www.systemicpeace.org Accessed
04.06.13
Central Intelligence Agency: The World Factbook www.cia.gov Accessed 24.06.13
Congressional Research Service: Currency Manipulation: The IMF and WTO (2011)
www.fas.org/ Accessed 29.6.13
The Economist: Inequality: Gini out of the bottle (2013) www.economist.com Accessed
12.6.13
Financial Times: China’s Inequality (2013) www.ft.com Accessed 24.06.13
House of Commons Library: China: New Political Directions under a New Leadership?
(2013) www.parliament.uk Accessed 07.06.13
International Monetary Fund: Article IV of the Fund’s Articles of Agreement www.imf.org
Accessed 24 .06.13
OECD: State Owned Enterprises in China: Reviewing the Evidence (2009) www.oecd.org
Accessed 24.06.13
Paul Collier: Wars, Guns and Votes: Democracy in Dangerous Places (2009)
Prem Shankar Jha: Crouching Dragon, Hidden Tiger: Can China and India Dominate the
West? (2010)
Transparency International: Corruption Perceptions Index (2012) www.transparency.org/
Accessed 29.06.13
UK Trade and Investment: China: Wen’s Last Work Report (2013) www.ukti.gov.uk
Accessed 06.06.13
Yasheng Huang: Does democracy stifle economic growth? (2011) www.ted.com/talks
Zuliu Hu and Mohsin S. Khan: Why is China growing so fast? (1997) Economic Issues 8
www.imf.org/external/pubs Accessed 06.06.13