What drives economic growth? This has been a dominant concern for senior global leaders for ages. Adam Smith in Wealth of Nations provided an answer much earlier, “Commerce and manufactures can seldom flourish long in any state which does not enjoy a regular administration of justice, in which the people do not feel themselves secure in the possession of their property, in which the faith of contracts is not supported by law…”
Economic growth has three primary determinants: physical capital growth, human capital growth, and technological innovation. If individuals are less confident their private property rights will be enforced, they are less likely to invest in physical capital (business facilities, manufacturing plants and equipment) since physical capital can be expropriated. This expropriation can be led by the state if the country does not have rule of law, or if the rule of law does not enforce respect for private property rights. If a country has rule of law but does not enforce respect for private property rights, then expropriation can occur in the form of looting by non-state individuals using physical force and threat of armed violence on the owners of the physical capital.
Human capital is more difficult to expropriate than physical capital. The primary reason most individuals invest in human capital (education, trade apprenticeship, professional training) is it enhances their ability to generate income and create wealth. Income and wealth can be expropriated almost as easily as physical capital. Hence, if individuals are less confident their private property rights over their income and wealth will be enforced, they are less likely to invest in human capital. The usual way most individuals use their human capital to generate income and create wealth is by starting businesses, selling to customers, employing workers, growing their busines, selling to more customers, hiring more employees; with this self-reinforcing positive impact on job and wealth creation. Hence, as individuals stop or decrease investing in their human capital, this has a negative multiplier effect on job creation and economic growth.
Technological innovation is a key driver of economic growth. The latter is primarily driven by the intellectual and creative efforts of those with significant human capital. Hence, as individuals stop or decrease investing in their human capital, this dampens technological innovation which has a negative multiplier effect on job creation and economic growth.
***
We obtain GDP per capita from the International Monetary Fund, World Economic Outlook Database, October 2019. Data on Rule of Law are from The Worldwide Governance Indicators, 2019 Update. Rule of Law reflects perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. We obtained an alternate set of data on country governance variables from The PRS Group’s International Country Risk Guide (ICRG). Their Law and Order index is focused on their assessment of the strength and impartiality of the legal system, and the popular observance of the law. The Law and Order index ranges from 0 (poor governance) to 6(good governance). We use the GINI index constructed by The World Bank to measure income inequality.
Some salient examples of how Law and Order and GDP per capita are related:
In 1990, India’s GDP per capita ranked it at the 15.0 percentile compared to the GDP per capita of the other countries in the world; its Law and Order index was at 1. In the early nineties, India liberalized its international trade and deregulated its industries; by 2015 its Law and Order index was at 4.5, and its GDP per capita rank was at 26.1 percentile. A more relevant way of looking at the data is that from 1990 to 2015, several hundred million Indians went from abject poverty to a quasi-middle class standard of living.
China’s case is even more dramatic: In 1984 its Law and Order index was at 3, and GDP per capita rank was at 3.3 percentile. After extensive adoption of free market policies, its Law and Order index was at 4.5 in 2006 and its GDP per capita rank was 31.3 percentile. Again, a more relevant way of looking at the data is that from 1984 to 2006, almost a billion Chinese went from subsistence living to quasi-middle class standard of living.
Argentina enjoyed a GDP per capita rank of 64.9 percentile and Law and Order index of 5 in 1999. Subsequently, with changes in their political regime, greater regulation and less free markets, their Law and Order index in 2017 stood at 2, and the GDP per capita rank at 57.1 percentile.
Venezuela enjoyed a GDP per capita rank of 62.6 percentile and Law and Order index of 4 in 1999. Subsequently, first under Chavez and then under his successor Maduro they nationalized major industries, and significantly increased government spending. As oil prices fell, they resorted to printing money. This led to hyperinflation. Venezuela imposed price controls which led to severe shortages and social unrest. In 2017, Venezuela’s Law and Order index was 1 and its GDP per capita rank was 37.6 percentile. While Venezuela’s decline in GDP per capita is significant, it should be viewed in light of the shattered lives of the tens of millions of Venezuelans during the past two decades.
Figure 1 plots the GDP per capita and Law and Order index for 2019 for 50 countries with the largest populations; countries are labeled with the three alphabet World Bank code. Similar positive relation is observed for our full sample of 134 countries, and for every year in our sample period of 1984-2019.
Figure 1.
The above examples and graphs are illustrative of the relation between economic growth and the rule of law. We undertake a more rigorous and comprehensive analysis of the empirical relation between economic growth and the rule of law using panel regressions for 134 countries for the period 1984-2019. We document a significant positive relation between ICRG’s law and order index, and GDP per capita. This relation is robust to alternative measures of law and order, for different sub-periods during 1984-2019, and for the sample of just the 50 most populous countries. Also, countries that are less corrupt and where the military is less involved in politics enjoy a significantly higher GDP per capita.
Besides the size of the national pie, which is measured by GDP, senior policy makers and the media across the globe are increasingly concerned about how this pie is sliced, that is, about income inequality. We find that countries with greater adherence to rule of law are characterized by less income inequality. We find this to be a very robust relation – robust to alternative measures of income inequality, alternative measures of rule of law, and over different time periods. Conceptually, as law and order improves in a country, its citizens have greater confidence that they can enjoy the benefits of their investment in physical capital and human capital; increased incentive to invest in physical and human capital leads to more income for the broader citizenry resulting in less income inequality. Also, we find that countries with greater GDP per capita are characterized by less income inequality; however, once we control for rule of law in the country, we do not observe this negative correlation between GDP per capita and income inequality. This further highlights the importance of rule of law in attenuating income inequality.
***
The above empirical analysis leads to the following policy recommendations. For political leaders in various countries around the globe: Focus on ensuring respect for private property rights, an effective police force, and fair courts; this will enhance economic prosperity of your citizens and diminish income inequality in your country. For the leadership of international organizations like the United Nations and World Bank: Encourage the political leaders of the countries around the world, especially the developing countries, to give top priority to ensuring respect for private property rights of their citizens, an effective police force, and fair courts; this will enhance economic prosperity for their citizens and diminish income inequality in their respective country.