Wednesday, 11 May 2011

Free trade and democracy

The economic effects of free trade agreements (FTAs) are widely studied, but what about the political impact of FTAs? Using data from over 125 countries over the past 60 years, this column from argues that by removing protectionism, free trade can lower the government's power and hence the incentives of autocrats to hold office. All this can help strengthen democracy.

In recent research, Ornelas and Liu (2011), Xuepeng Liu and Emanuel Ornelas present evidence that participation in free trade agreements can destroy protectionist rents. They can also serve as commitment devices to destroy future protectionist rents. Of course rent seekers are never much in favour of FTAs and now we have on more reason why.
Since such [protectionist] rents are attractive for autocratic groups, FTAs can lower their incentives to seek power. While this has little value in established democracies, where the rule of law is strong and the risk of authoritarian disruption is negligible, it can be important for unstable democracies. These threatened states should therefore have an extra incentive to seek involvement in FTAs, over and above the incentive stemming from the agreements’ potential trade gains.
Ornelas and Liu
[...] provide the theoretical basis for [their] claims by extending the trade integration model of Ornelas (2005) to allow for endogenous changes in the political regime. At any trade regime domestic firms exchange contributions for protection with the government, which cares about national welfare and the contributions it receives. Key to understand the impact of an FTA is the recognition that the equilibrium external tariffs change with the constraint imposed by the agreement on the internal tariffs. Taking this into account, it can be shown that even though an FTA still permits lobbying for protection against excluded countries, the volume of protectionist rents falls after the formation of the agreement.

In a dynamic setting this implies that, all else equal, groups motivated mainly by office rents will have lower incentives to seek power if the country is deeply engaged in FTAs. Authoritarian groups tend to fit this description best. After all, due to their aptitude to resort to violence to keep power, authoritarian groups have less incentive to pursue policies that favour the population at large than democratic ones. If the gain of authoritarian groups from keeping power falls when the country is engaged in FTAs, but the costs and risks from attempting a coup d’├ętat are unaltered by the agreements, the likelihood of democratic failure will therefore be lower if the country participates more intensively in FTAs.

From this we learn that if the incumbent government in an unstable democracy realises this effect of "democratic consolidation", it will seek participation in FTAs more actively than it would otherwise. There are two reasons for this:
  1. An FTA will weaken the authoritarian threat, increasing the likelihood of democracy survival.
  2. Even if the dictatorial group takes control despite the FTA, the agreement will constrain its rent-extraction activities. Hence, unstable democracies tend to enter in FTAs more frequently than other countries, all else being equal.
What does this data stuff have to say about these results?

As a start Ornelas and Liu carry out a non-parametric survival comparison between democracies with and without FTA partners. They utilise a dataset that involving 126 countries over the period 1948-2007. Their statistical analysis confirms that, democracies without FTAs are unequivocally more likely to fail than those with FTAs.

Ornelas and Liu comment,
While striking, this result may be due to other differences between democracies with and without FTA partners. Thus, we also carry out a detailed econometric analysis. We rely on the strategy pursued by Persson and Tabellini (2009), who estimate the likelihood of democratic breakdown employing the concept of “democratic capital”. The domestic component of democratic capital takes into account the history of democracy in the country, while its foreign component considers current levels of democracy abroad. Along with other covariates, these two components of democratic capital allow us to estimate the likelihood of democratic failure in a country. Employing duration analysis techniques, we find that greater participation in FTAs significantly reduces the probability of democratic breakdown; i.e., FTAs contribute to the “consolidation” of democracies. This helps to explain why democratic experiences have been particularly successful since the late 1980s.

Having estimated the likelihood of democracy failure, we use its fitted values to estimate changes in FTA participation. In doing so, we consider only the portion of the likelihood that is not predicted by FTA participation. We find that a higher level of regime uncertainty indeed induces democratic governments to seek greater participation in FTAs. This helps to rationalise the outbreak of regionalism since the early 1990s, when many countries with limited democratic experience became involved in FTAs.

Our empirical results are robust to different econometric specifications and to different measures of democracy. The results are also economically meaningful. For example, Mongolia’s hazard rate in 2005 would drop from 3% to 1% if it had the same level of FTA participation as Chile, or to just 0.3%, had Mongolia the same FTA import share as Mexico.
Now what of free trade and political freedom?

Ornelas and Liu explain that
Our analysis also indicates that the rent destruction forces of FTAs are important drivers of the results. For example, our predictions hold consistently for agreements where most of the trade among the involved parties is liberalised. By contrast, the estimates are generally indistinguishable from zero for partial-scope agreements signed under the Enabling Clause of the GATT, which allow for many exceptions, and therefore impose few restrictions on the availability of rents from protection. It is also possible that FTAs help to maintain democracies not because of their rent destruction effects, but because of pressure from more democratic FTA partners. While this is a very plausible alternative mechanism, our empirical tests suggest that FTAs with more democratic partners are as valuable for the sustainability of a country’s democracy as FTAs with less democratic partners.
To end a word of caution is needed,
While all this is “good news” for democratic countries involved in FTAs, we must stress that participation in FTAs is, unsurprisingly, no panacea. They can help to consolidate democracies, but their reach is limited, as our estimates make clear. Similarly, there are as well many reasons other than democratic instability that also foster participation in FTAs.
That said the results still give us one more reason to support FTAs. Now we see that FTAs are good for both economic and political reasons.

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