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Why and When Does the Economy Need a Committed Government?

Armando Razo
Department of Political Science
Stanford University
December 2001

My research addresses the question of what political institutions are needed to make economies grow. This is a fundamental question of political economy, which is the study of the interaction between politics and the economy. I use tools of political economy that are widely employed, but are rarely employed together. In particular, I use mathematical models to make theoretical predictions about the impact of politics on private economic decisions and I use history to see actual examples of the effect of politics on advanced and developing economies. With this combined approach, I set the foundations for a more general theory of economic growth and regulation than is currently available.

One may ask why the economy needs to be concerned about government commitment. The answer is provided by an insight from political economy often referred to as the "sovereign dilemma" or "credible commitment" problem. This dilemma arises because sovereign governments are like two-edged swords. Societies need to give governments enough authority to do a good job such as protecting property rights, but that authority empowers the government to turn against society. Economic actors thus worry about the possibility that the government will confiscate their wealth and profits. If economic actors do not believe that the government is committed to protecting property rights, then they will not invest in the economy.

In theory, the solution to the credible commitment problem is simple: put in place political institutions that give the government enough authority to do good things for the economy, while restraining it from doing bad things. In practice, finding the exact set of institutions that solves this commitment problem in a given country is not an easy matter, especially given the wide diversity of political settings throughout the world. What may work in one country may not work as well in another.

Social scientists have relied on history as an important tool to identify sets of institutions that have helped solve the commitment problem in some countries. For example, historical studies of today's advanced economies show that governments have a major role in protecting property rights and enforcing contracts, two tasks that are essential for the development of any industry and national economy. In these countries, the political institutions needed for these tasks involved division of powers among different branches of government. For example, policymaking in the United States is not concentrated in one person or agency, but takes place with the participation of many political actors. The rationale is that such division of powers limits the ability of the government to confiscate property and assets from the economy. For this reason, historians and social scientists are in general agreement that the solution to the commitment problem is some form of "limited government" prescribed by a constitution or other laws.

One potential problem with the limited government (LG) solution is that we see many countries that are able to grow despite having authoritarian or un-limited governments. The evidence poses a puzzle for theories of limited government and growth because these countries appear not to have solved their commitment problems, yet their economy is able to grow. The puzzle suggests that either (1) not all societies face a sovereign dilemma or (2) the economy does not require a committed or limited government.

My research addresses this puzzle in two ways. First, I develop models that study the interaction of government and business in abstract settings that do not depend on the particular history of any country. My findings are that all societies face some type of commitment problem, but sometimes it is groups in society, rather than government, that need to be restrained. This explains why some countries are able to grow without having a limited government. Second, I draw on history to evaluate how countries were able to grow without limited government. My findings are that limited government is not a general solution to the commitment problem, but countries that rely on limited government have the advantage of relatively more competitive economies that grow for longer periods of time.

My research is primarily theoretical, but it has many practical applications. The theoretical aspect is that it extends current theories with abstract models that admit a wider variety of political settings than previously studied. The practical advantages include a better understanding of the interaction of politics and economics that can serve governments to implement better policies, citizens to pass better laws, and investors to understand how politics affect their domestic or foreign investments.