By Oyshee Gupta (CNLU Patna) & Suhaas Arora (RGNUL Patiala)
EDITOR’S NOTE:- The repercussions are most irreparably felt by the economy.Investors usually evaluate the prospects of investment based on the policies of the incumbent governments as well as the possibility of changes in government. For developing nations, the economy is the lifeline of the country and they cannot afford undesirable fluctuations in the stock market values of the shares of the public sector undertakings and firms in which the government itself has huge stakes. This article analyses the reactionary mechanism that investors follow in light of the US-Sino trade as well the Bangladesh economy in 2014. The author has also delved into the different approaches adopted by investors and the methods to mitigate economic losses therein.
To understand how economic stability and political uncertainty are related, we first need to understand the two concepts individually and then try to establish a logical relation between the same and analyse the situation with the help of certain data obtained from major economic policy makers and institutions.
Economic Stability is a term which is used to describe the financial system of a nation that displays only minor fluctuations in output growth and exhibits a consistently low inflation rate. Economic stability is usually seen as a desirable state for a developed country that is often encouraged by the policies and actions of its central bank.[i]
A stable financial system efficiently allocates resources, assesses and manages financial risks, maintains employment levels close to the economy’s natural rate, and eliminates relative price movements of real and financial assets to stabilize monetary and economic levels. When stable, the system absorbs shocks primarily via self-corrective mechanisms, preventing the adverse events from disrupting the real economy or spread over to other financial systems. Financial stability is paramount for economic growth, as most transactions in the real economy are made through the financial system.
Without financial stability, banks are more reluctant to finance profitable projects, asset prices may deviate significantly from their intrinsic values, and the payment settlement schedule diverges from the norm. Possible consequence of excessive instability includes: bank runs, hyperinflation, or stock market crashes. [ii]
Political instability is defined as the propensity of a change in the executive power, either by constitutional or unconstitutional means. A high propensity of an executive collapse leads to slower growth and, conversely, whether low growth increases the propensity of a government change.
Political instability affects growth because it increases policy uncertainty, which has negative effects on productive economic decisions such as investment and saving. A high probability of a change of government implies uncertain future policies, so that risk-averse economic agents may wait to take productive economic initiatives or might even “exit” the economy by investing abroad. Similarly, foreign investors are likely to prefer a stable political environment.[iii]
On the other hand, low growth increases government instability. Empirical literature has shown that in industrial democracies incumbent governments’ chances of re-elections depend on the rate of growth immediately before the elections. In non democracies, low growth increases popular dissatisfaction, creates incentives for antigovernment activities, and may make coups d’état more likely.[iv]
The interaction between growth and political instability can lead to a vicious circle: suppose that for some exogenous reason the probability of a government collapse increases. This might result, for example, from an increase in political conflict unrelated to the economy or from international political developments. Investment and growth fall as a result of the shock, further increasing the likelihood of a government collapse, leading to even more political uncertainty. On the other hand, suppose that the rate of growth falls for some exogenous reason – for instance, an adverse movement in a nation’s terms of trade.
The public will hold the government responsible, at least in part, for the poor economic outcome. This increases the probability of an executive collapse, reducing growth even more. The effect of uncertainty about government changes is larger the higher the degree of political polarization, where polarization is defined as the difference in economic preferences between different groups and political parties. The probability of a government change may not have much effect on the expectations of future economic policies if the next government is likely to follow policies similar to those of its predecessors; in highly polarized societies, instead, government changes may lead to radical changes in policy making.
Why is Global Economic Stability important?
Promoting economic stability is partly a matter of avoiding economic and financial crises, large swings in economic activity, high inflation, and excessive volatility in exchange rates and financial markets. Instability can increase uncertainty, discourage investment, impede economic growth, and hurt living standards. A dynamic market economy necessarily involves some degree of instability, as well as gradual structural change. The challenge for policymakers is to minimize instability in their own country and abroad without reducing the economy’s ability to improve living standards through rising productivity and employment.
Economic and financial stability is both a national and a multilateral concern. As recent financial crises have shown, countries have become more interconnected. Problems in one sector can result in problems in other sectors and spillovers across borders. No country is an “island” when it comes to economic and financial stability.[v]
During the election campaigns in India in 2013-14, even a casual follower of Indian news cannot have failed to notice the wild reactions of the stock markets, those dubious oracles of an economy’s prospects, to the results of several prominent state elections and the general consensus (purportedly represented by opinion polls) condemning the ruling Congress party to an ignominious defeat in this year’s general election. In the RBI’s Financial Stability Report last December, the governor too highlighted political instability as a detrimental force. This is in addition to the rather bold assertions by certain ratings agencies that suggested that a victory for Narendra Modi would be better for India’s economic future.
Their conclusions seem to have found much support among the investing community if the stock market’s reaction to a resounding BJP victory in some major states is any indication. It is no secret that many prominent members of the business community have been agitating for more pro-growth policies despite the scourge of inflation rearing its head once again. As the government entered its last six months in office with populist measures seeming to be all it could think about, and the recent state debacles leaving it hamstrung to build consensus on politically tough but economically necessary reforms, it was felt by many that a change in government was the way forward.
Investment and uncertainty
One channel through which political uncertainty could affect the economy is via the investment decisions of firms.[vi] Investment is a key driver of the economy, helping to augment the productivity that is so vital for sustained growth. Most investment decisions, especially those by firms in the manufacturing sector, involve significant outlays and considerable time before they become active. As a consequence, evaluating the costs and benefits of investing, as usually done in Net Present Value (NPV) calculations, is fraught with uncertainty, having to account for several risks that could delay the project or affect expected returns. These returns would depend (among other things) on the state of the economy at the time the project would start generating returns, which could depend considerably on government policies expected then.
Further, these expectations of future policy and economic environment would depend on current policy and the macroeconomic scenario. Expectations of a dim future would deter expansion today, which would further worsen the current economic situation.
The fact that interest rates affect investment decisions is hardly surprising, as most investments involve lengthy loans and the “cost of capital” is the rate of interest. However, political instability essentially affects expectations of the future, and it is this concomitant uncertainty that is relevant here. Traditionally, the approach has been to account for some of the risks associated with the future through a risk premium, which basically raises the interest rate or discounts the future more heavily to account for uncertainty and the possibility of non-repayment. The greater the perceived risk, to which political instability is likely to contribute, the more the future would be discounted, which would then raise the cost of financing projects.
This traditional approach overlooks many realities about the investment process. Most investments are lumpy, i.e. are staggered over time and are often irreversible, i.e. sunk. Consequently, the timing of the investment process is vital. The real options theoretical literature emphasises these two aspects of the investment process, and suggests an analogy between the investment timing decision and financial options literature. In particular, the value of delaying an investment can be derived using methods similar to those employed in the financial options literature.
Holding such a “call option” [vii] would give the firm the right to invest at the time of its choosing without facing the obligation to do so, thereby allowing it to hedge. By delaying, the firm can attempt to gather more information in order to arrive at an investment decision. Typically, option rights arise from ownership of land or resources, patents or through a firm’s position and influence in industry. The option value of delay is high if uncertainty is high, so that firms might want to wait before deciding to commit, although in certain cases (like competition in a new market) getting a head start might prove critical.
The main conclusion here is that NPV valuations alone are incorrect if they do not account for the value of delaying investment, which in turn would be affected by political instability and policy uncertainty. Uncertainty also leads to firm inertia and stasis, which might confound an intended policy effect. This has also been the suggested reason behind pro-cyclical productivity, i.e. productivity growth during booms, as the process of weeding out inefficient firms and projects that should be aided by a downturn gets impeded.[viii]
Related to political instability is policy uncertainty, the idea that policy might be reversed at some point in the future, for example if a new government with a different economic agenda or approach comes to power. The prominent case of environmental clearances for projects is another example. The idea here is that investors, while deciding whether to invest in a project, would account for the possibility that the conditions might change in the future. So, if they are attracted by a favourable economic policy decision, they must also consider the possibility that that policy might be reversed later.
Again, the idea of adjustment costs, costs of exit and entry (commencing another project), is vital. An investor would no longer be satisfied by just a competitive rate of return, but would demand compensation for the adjustment costs borne and, most important, for the reversal risk borne. Aggregate investment would then be negatively related to the likelihood of reversal.
The very presence of uncertainty, therefore, might stymie investment inducements. Of course, not all reforms come accompanied by a reversal risk. Considering the babble about early elections and the potential impossibility of a single-party dominated government forming, the recent successes of the BJP may have actually reduced the level of uncertainty by, at the very least, solidifying the perception of a dominant anti-Congress sentiment, besides also capturing the positive economic expectations from Modi.[ix]
There are some interesting political economy theories describing the impact on the economy. One approach is drawn from the political economy world, and has re-election concerns playing a vital role. Governments that face uncertainty regarding their election prospects engage in suboptimal policies (“strategic inefficiencies”) in order to worsen the state of the world inherited by their successors, or even to signal their own competence as crisis managers.
Another approach deals with policymaking in particular, and suggests that weaker governments are more prone to being “captured” by vested interests, e.g. lobbies, resulting in not necessarily efficient outcomes. Possibly related are the multifarious populist schemes (which would tend to increase as the outcome for an incumbent looks bleaker), and the possible transfer of resources away from their most productive uses, impacting growth.
Uncertainty about the identity of a reform-affected group could delay its implementation, which would eventually occur when conditions deteriorated enough to override objections. Such uncertainty could also explain gridlock between different arms of the government or different allies concerning reform implementation.
Other studies consider the dynamic implications of expected policy decisions. For example, a government that is pursuing unsustainable fiscal policies would raise expectations of future restraint. However, the actual effects would depend considerably on uncertainty regarding when and how such an adjustment would be made, which in turn would be intimately linked to political factors.
It is now firmly established that secure property rights are foundational for economic growth. Secure property rights are vital for investment, and the flux that accompanies instability would make investors demand a premium against confiscation or even lockdowns following disputes. While this does not deal directly with politics, inconsistent policies and even forced confiscation would inevitably dampen investment incentives.
The channels we have laid out above deal with short to medium term investment. Longer-term investment, like R&D, might even be encouraged by uncertainty. The idea here is that a bad state of the world might lead only to a loss of development costs, but getting the rub of the green could mean even greater expected profits. The relevance of this link would depend on the nature of the industry and therefore the possible policy effect.[x]
We have hitherto focused mainly on investment under uncertainty. Consumption too might be adversely affected, as uncertainty would result in more precautionary saving. Higher saving should tend to lower interest rates and boost investment, but our earlier discussion suggests that this tendency does not often get realised, possibly due to the interest rates not being too responsive.
One might also consider the impact of political instability on voting behaviour. Turnout issues notwithstanding, voters choose between alternatives (candidates representing parties or independents) based on the utility they derive from their platforms. In an environment where one’s own preferred candidate is unlikely to win, citizens might vote strategically based on an expectation of how the future will pan out. In a situation where there is considerable uncertainty, like a tight race where the favoured candidate is a contender, the likelihood of being decisive goes up and strategic behaviour might not be too relevant. However, in a situation where one’s favoured candidate is highly likely to be booted out, strategic concerns might dominate. Of course, there could be uncertainty about which of the other alternatives stand the best chance of winning.
One could interpret a preference for stability using the same framework as above. Voters have preferences over issues, like economic policy, and would like to vote for the party that is closest to their position. There might be considerable ex post uncertainty, however, regarding the likely winner of the election. This is particularly true in an environment where coalition governments are the norm. Consequently, there might not be much clarity regarding the actual policy to be implemented. In effect, the voter is choosing over degrees of uncertainty.
Stock market responses
As has been discussed above, the BSE has responded to virtually every major development in the electoral scene over the past few months, unafraid to highlight the lack of confidence in the incumbent’s ability to shepherd the economy in the future. Such significant responsiveness to political developments is hardly peculiar to India. During the uncertain period of the European debt crisis, with the possibility of no bailout agreement materialising, stock markets around the world latched on to every titbit of information. A similar effect was noticed during the Debt Ceiling episode in the United States. The interconnectedness of economies in a globalised world implies that even slightly significant developments that might affect an economy resonate in markets around the globe, depending of course on the degree of connectedness.
There have been recent theoretical developments motivated by these fluctuations, which aim to understand the implications of political instability for stock markets. Given the importance of the stock market as a source of raising funds for expansion/investment and the spill-over effects of crashes on other indicators and sectors of the economy, this is clearly of considerable importance.
These concerns are discussed in a recent paper by Lubos Pástor and Pietro Veronesi. Uncertainty could affect stock markets in two ways. If uncertainty forced the government to undertake corrective action, i.e. not just window dressing but dealing with the root of the problem, it would help resolve immediate problems and perhaps deter future ones. This is like the famous “Greenspan Put”, effectively a put option that eased liquidity during busts. On the other hand, political uncertainty is a common risk, so it isn’t fully diversifiable. This could depress asset prices by raising discount rates, a channel we described above.
Political uncertainty might affect the profitability of individual firms differently and, crucially, in unknown ways. Over time, however, firms learn about the impact of the implemented policy and revise their beliefs accordingly. There are thus two types of uncertainty, concerning which policy will be implemented, and how the chosen policy will affect individual firms.
The first source depends on government choice, which in turn depends on a cost-benefit analysis of the options available. With rational, forward-looking agents, this becomes interesting if there is uncertainty about the nature and magnitude of costs and/or benefits. In an environment where the current policy is not having its desired impact, the government is more likely to (and agents promptly anticipate) change, going by the rationale that the costs of persisting are higher. Although elections are not considered in their analysis, an uncertain outcome would only add to the uncertainty regarding policy choice.
These shocks have consequences for asset prices, over and above the normal impact on investment incentives. Uncertainty about the impact of policies affects investment decisions and asset prices, as do expectations of likely policies or policy changes in the future (political shocks). It is this factor that explains the unusual responsiveness of markets to information: information alters beliefs and hence expectations of a policy change. As discussed, in a weaker environment, change becomes more likely and thus information becomes more impactful. This potential change then counters the impact shock effect by making current policies temporary. However, investors demand a premium for the political shock effect. Further, as is expected given the common nature of the shock, political uncertainty causes asset prices to move together, while the learning process raises volatility.
Besides supportive anecdotal evidence and its general plausibility, this particular description also has some empirical backing. Stock markets, more than anything else, are taken as indicators of that elusive idea, sentiment. As we have seen, the common story of uncertainty impacting investment decisions is an important factor affecting their response. Political uncertainty then is not simply media fodder but has wide-ranging and uncertain real world consequences. The implications of political uncertainty are not confined to temporary (although perhaps extreme) swings, but have the potential to alter the economic trajectory of a nation
The impact of policy uncertainty on economic activity is potentially important, but controversial because it is hard to identify and quantify. Recent research provides a framework to identify the impacts of policy uncertainty on firm decisions, and finds it has strong effects in the context of international trade. China’s WTO accession secured its most-favoured nation status in the US, and the evidence shows this reduction in uncertainty can explain a significant fraction of its export boom to the US.[xi]
The theoretical impact of uncertainty on some firm investments is understood. There is also some empirical evidence linking the two. Unfortunately, there is scarce empirical evidence on the impacts of policy uncertainty, because it is both hard to measure and difficult to identify its impact on specific economic outcomes. One approach is to construct news-based indices of economic policy uncertainty. While such indices contain useful variation over time, they are insufficient to clearly identify causal effects of policy uncertainty on firms.
At the beginning of the 19th century Argentina was one of the wealthiest countries in the world. In 1960, Argentina’s income per capita was in the top twenty in the world and was higher than that of Japan. In the last forty years, however, Argentina has often come close to economic collapse. In 1960, Japan had a per capita income below Iraq, Ireland, and Argentina and was not even in the top twenty-five in the world. Since then Japan has experienced one of the fastest growth rates in the world. Argentina has had a history of political instability, with several coups d’etat and much political violence. In contrast, until very recently Japan has been a model of political stability, with the same political party in office continuously from 1960 until 1993.
We have two pertinent questions to attend to:
- Does this tale about Argentina and Japan capture a more general correlation between economic growth and political stability?
- Does political stability foster economic growth, or does low economic growth lead to political instability?
On the one hand, the uncertainty associated with an unstable political environment may reduce private investment and, therefore, growth. On the other hand, poor economic performance may lead to government collapse and political unrest.
Social and economic changes extend political consciousness, multiply political demands, and broaden political participation. These changes undermine traditional sources of political authority and traditional political institutions. The result is political instability and disorder. The primary problem of politics is a lag in the development of political institutions behind social and economic change. On this view therefore, economic development can be identified as a (if not the) source of political instability. An alternative view attributes primacy to the political. Political instability on this view is attributable to frustrated political aspiration. The core mechanism underlying political instability on this view is a failure of a political order to gain acceptance due to a rupture in the consistency and coherence of the principles on which it is based. This impairs the political system to represent adequately the values and identity of those whom it serves, finally leading to change in more or less violent form.
In recent research, we see that firms’ international trading decisions are useful in overcoming those measurement and identification issues for three reasons:[xii]
- First, we observe the applied policies that firms face in different markets (e.g. tariffs) and the counterfactual worst-case values, which helps us measure policy uncertainty.
- Second, we can tie those policies to certain observable firm outcomes by product and destination to establish a causal relationship (e.g. market entry, sales, and quantities).
- Third, there are many trade reforms that allow us to answer whether and how governments and international institutions can affect policy uncertainty.
Understanding policy uncertainty in trade is also important in its own right. Globalisation implies that trade policy uncertainty has a direct effect on an increasing number of firms that export, use imported intermediates, and offshore parts of their production process. Uncertainty can directly affect firms’ investments to enter markets, adopt new technologies, or offshore. Via the trade channel, uncertainty can also indirectly affect purely domestic firms (and consumers) by changing domestic prices, productivity, and employment. While the WTO and its predecessor, the GATT, have long emphasised its role in maintaining “predictability through bindings and transparency [to] promote investment”, until recently there was no evidence for this channel.[xiii]
China accounted for only 2% of the world’s imports in 1990, but its rapid growth, export-led policies, and possibly its WTO accession propelled that share to 11% in 2010. The share of US imports from China in that period rose even faster – from 3% to 19% – and recent evidence has linked this recent export boom to declines in US prices, wages, and manufacturing employment.
China’s import share grew twice as fast in 2001–2010 as in 1990–2000. This acceleration coincided with China’s WTO accession, which appears initially puzzling since there were no significant changes in applied trade barriers in the US. What did change was the uncertainty Chinese firms faced about future US policies. More specifically, since 1980, China enjoyed most-favoured nation status in the US. This meant China faced tariffs similar to WTO members exporting to the US, with a key difference – China’s status was subject to uncertain renewal.
While China never lost most-favoured nation status, it came close. After the Tiananmen Square protests, the US Congress voted on such a bill every year until 2001, and the House passed it three times. Had the status been revoked, the average US tariff would have increased from 4% to 35%. Many products would have faced tariffs as high as 50%, and this would likely have sparked a trade war. Policymakers and firms in both countries understood the potential effects of this uncertainty. Several industries lobbied the US congress prior to 2001 to make most-favoured nation status permanent, and argued that “the imposition of conditions upon the renewal of most-favoured nation is virtually synonymous with outright revocation. Conditionality means uncertainty.”[xiv] But it was only in January 2002 – after WTO accession – that the US president granted permanent most-favoured nation status, which according to the Chinese foreign Ministry “eliminated the major long-standing obstacle to the improvement of Sino-US trade.”
The timing of China’s WTO accession and the actions of policymakers and businesses regarding most-favoured nation status are necessary conditions for trade policy uncertainty to help explain the observed export boom, but they are clearly not sufficient – China could have started growing faster or investing more in export industries for other reasons.
The data show that in 2000 to 2005, Chinese export growth to the US was 18% higher in industries where the potential profit loss was initially high than those in which it was low. Because changes in tariffs and transport costs are very small, they cannot explain this differential growth – but other factors could. So, to clearly identify the effect of policy uncertainty, we employ regression analysis. Our main empirical findings are the following:
- Prior to WTO accession, Chinese exporters placed a positive probability on losing most-favoured nation status in the US. The accession substantially reduced this probability and generated stronger export growth in industries that initially faced higher potential losses.
- The reduction in policy uncertainty increased China’s aggregate exports to the US between 22% and 30%. This is equivalent to an average reduction in applied tariffs of up to nine percentage points.
- There were higher product entry rates in industries with initially higher potential profit losses.
- The uncertainty reduction lowered aggregate prices in the US, which translates into a substantial real income increase for its consumers. We therefore quantify an effect of trade agreements thus far ignored – they can increase welfare by reducing uncertainty.
Bangladesh in 2014
The outgoing year has been one of the most disturbing years for Bangladesh in the recent past in terms of domestic political instability caused by hartals, oborodhs and deadly violence for months. As a result, the economy had to bear the brunt in many ways. The World Bank International Monetary Fund, Bangladesh Bank (BB) and many experts have projected the gross domestic product (GDP) to be lower than 6%, which is much below the target of 7.2% for FY2014. Some even apprehend it may be lower than 5%.
It will be a blow to the growth momentum which is considered to be promising by the international community because of its ‘development surprise,’ despite being caught in a plethora of constraints. During the last three decades the country has increased its growth by 1% per decade. Therefore, it will face difficulty in increasing the growth rate by 1% and graduate to the 7% mark, a natural expectation based on previous decade’s experience. Reduced growth will have ramifications that will boil down to lower efforts for poverty reduction.
It is evident that political instability has contributed to this situation. Investment has been insufficient for the projected growth as it is struggling to cross even 30% of GDP. Though public investment has increased, private, domestic and foreign investments continue to be disappointingly low.
Infrastructural bottlenecks, slow decision making, corruption and low skills of human resources are some factors that discourage higher investment in the country. Prolonged political crisis could only make it worse. Credit to the private sector is lower than the target and banks are sitting with excess liquidity as investment demand has been slowing. This is also reflected through industrial loan, which was negative during July-September 2013. Low investment implies less employment generation and low income, which in turn has poverty implications.
It is also frustrating that while there is dampened demand for credit the amount of non-performing loans (NPL) is soaring at an alarming rate that tells upon the health of the banking sector. As of September 2013, NPL reached 12.79% compared to 10.03% in FY2012 and 6.12% in FY 2011. Though this is partly due to a number of large financial scams that misappropriated thousands of crores of Takas from banks, it is also due to the inability of many genuine borrowers to service their loans given the dull business due to political turmoil.
Reduction of NPL and bringing discipline in the banking sector will thus be most challenging tasks for the concerned quarters in the coming months. Government expenditure during political unrest also gets affected, which is evident from low implementation of the Annual Development Plan (ADP) during the first few months of the current fiscal year. This is mainly because of low disbursement of foreign aid due to political instability. During July-September 2013 only Tk. 6 crores had been disbursed as foreign aid as opposed to Tk. 36 crores during the same period of FY 2012. [xv]
Foreign aid fell to $41.8 million in July 2013 from $156.8 million in July 2012.
As for revenue generation, there is still shortfall in meeting the target. During July-October 2013 revenue generation by the National Board of Revenue (NBR) was only 16.4%, while the target is 25.3% for FY2014. This has been due to losses suffered by most businesses. Additionally, NPL and excess liquidity have been increasing and profitability of banks is on the decline. Thus lower corporate tax has been a major reason for the revenue target of NBR to go off-track.
Though there is low demand for credit by the private sector, high government borrowing will only add to the interest burden of the government. A consequence of depressed business is unemployment. Many employees who lost their jobs have returned to their villages in search of work while others are haunted by the fear of uncertain future in cities. A large section of the low income group, such as workers in hotels, restaurants, shops, transport sector and the like, rickshaw pullers and day labourers have suffered huge loss of income.
The industrial sector has been affected as the products could not be distributed across the country. The exporters could transport their products with much difficulty, not only at higher transport costs but also at high risk of getting them burnt during political violence. Though exports are still showing high performance, buyers of readymade garments (RMG) have alerted Bangladeshi manufacturers about shifting their orders from Bangladesh to other sources such as Cambodia, Vietnam and even India if political violence continues. Any such move will mean unemployment of a large number of workers, who will create pressure on the already pressured economy in terms of employment generation capacity. This will also create social problems as a majority of RMG workers are women who have been empowered through economic independence by way of working in the RMG sector.
The agriculture sector is vulnerable during times of political turmoil as the whole supply chain is disrupted. The media reported that producers of agricultural commodities had to give away their commodities at a minimal price as those were perishable and could not be transported to cities regularly. Milk producers literally threw milk on the streets out of frustration as they could not fetch the right price. Disruption of the supply chain pushed prices up in cities. Food inflation went up to 9% in December 2013 as opposed to 5.28% in December 2012. Notably, the target for inflation during FY2014 has been set at between 6% and 6.5% by BB, which seems to be difficult to achieve in view of the emerging situation.
On the whole, political unrest has affected the production process both directly and indirectly. The direct impact is through lower economic activity and indirect effect is through disruption of various channels and means of production. With the political unrest cooling down gradually, many economic activities have started to get back on track.
Political instability reduces growth. This result is particularly strong for the case of un-con- stitutional executive changes such as coups, as well for changes that significantly affect the ideological composition of the executive. The effect of instability on growth is less strong for the regular and frequent executive turnovers typical of industrial democracies. To some extent, and with some caveats, we also find that low growth increases the likelihood of government turnover, particularly in the case of coups d’etat. However, we cannot find any difference in the growth performance of democracies compared to nondemocracies. Finally the occurrence of a government change increases the likelihood of subsequent changes, suggesting that political instability tends to be persistent. First, it seems worthwhile to continue in our effort to distinguish cases of major government changes from routine turnovers of leadership that entail no significant changes in the ideological orientation of the government.
Political instability is regarded by economists as a serious malaise harmful to economic performance. Political instability is likely to shorten policymakers’ horizons leading to sub-optimal short term macroeconomic policies. It may also lead to a more frequent switch of policies, creating volatility and thus, negatively affecting macroeconomic performance. Considering its damaging repercussions on economic performance the extent at which political instability is pervasive across countries and time is quite surprising.
The widespread phenomenon of political (and policy) instability in several countries across time and its negative effects on their economic performance has arisen the interest of several economists. As such, the profession produced an ample literature documenting the negative effects of political instability on a wide range of macroeconomic variables including, among others, GDP growth, private investment, and inflation.
As regards to private investment, socio-political instability generates an uncertain politico-economic environment, raising risks and reducing investment. Political instability also leads to higher inflation. Quite interestingly, the mechanisms at work to explain inflation in their paper resemble those affecting economic growth; namely that political instability shortens the horizons of governments, disrupting long term economic policies conducive to a better economic performance.
- Political Instability and Economic Growth,Alberto Alesina, Sule Özler, Nouriel Roubini and Phillip Swagel ,Journal of Economic Growth, Vol. 1, No. 2 (Jun., 1996), pp. 189-211
- Pierce, J R and P K Schott (2012), “The Surprisingly Swift Decline of US Manufacturing Employment”, NBER Working Paper 18655.
- Bloom, N (2009), “The Impact of Uncertainty Shocks”, Econometrica 77(3): 623–685.
- Autor, D, D Dorn, and G Hanson (Forthcoming), “The China Syndrome: Local Labor Market Effects of Import Competition in the US”, The American Economic Review.
- Auer, R A and A M Fischer (2010), “The effect of low-wage import competition on US inflationary pressure”, Journal of Monetary Economics 57(4): 491–503
Edited by Raghavi Viswanath
[vii] Dani Rodrik in “Policy Uncertainty and Private Investment in Developing Countries”, Journal of Development Economics, November 1991
[xiv] China Most-Favored-Nation Status, “Hearing before the Committee on Finance”, US Senate, 6 June 1996, p. 97.