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Growth Slowdowns, Inclusiveness, and Comparative Political Advantage

Richard L. Carson

Department of Economics, Carleton University, Ottawa, Canada

E-mail address:

richard.carson@carleton.ca

Abstract: This paper links political support to economic growth. Governments gain support from wealth

creation and wealth redistribution and only adopt policies they expect will raise their support. Growth

slowdowns can result from inefficiencies that that persist because their removal would lower political

support, and efficiency depends on comparative political advantage, as defined below. With the ‘wrong’

political advantage, policies that raise support also lower efficiency over the long run, leading to a high

consumption cost of growth plus inequality and potential stagnation. With the ‘right’ political advantage,

policies that raise support lead to high inclusiveness and sustainable growth, a kind of political invisible

hand.

JEL Classifications: D72, D79, H19, O40, P59.

Key Words: Growth Slowdowns, Inclusiveness, Comparative Political Advantage, Distributional Rent,

Rent Seeking, Efficiency.

1. Introduction: Political Support, Growth, and the Inclusiveness Parameter

Just as an economic boom can contain the seeds of the recession or depression that follows, so rapid

growth can contain the seeds of subsequent slow growth or stagnation. These lie in the nature and extent of the

interventions used to promote growth in an environment where governments gain political support from two

basic sources—wealth creation and wealth redistribution—and choose mixes of the two that maximize their

support. In redistributing wealth, governments take into account their abilities to gain political support from

special interests in return for rent, and special interests take into account their abilities to gain rents from

government in return for political support. This gives rise to rent seeking, in which special interests seek rent

by supplying political support in return. Here ‘rent’ refers to ‘distributional rent’ created by subsidies, as well

as by restrictions and controls that suppress market competition. Successful rent seekers are ‘insiders,’ who

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represent special interests and whose rent is extracted from ‘outsiders’—eg., via monopoly prices or

monopsony wages—in exchange for support. The more a government relies on insiders for support, the more

rent it will extract and the more rent seeking there will be. Political support takes the form of money,

resources, information, repression of political rivals or opposition groups, etc.

Increases in rent seeking lower efficiency and growth [Del Rosal 2011, pp. 316-17; Salinas-Jimenez and

Salinas-Jimenez 2011]. Since these increases can also raise political support, neither efficiency nor equality is

necessarily high at the support maximum. This depends on ‘inclusiveness’ and ultimately on comparative

political advantage, as defined below. A political system becomes ‘inclusive’ when the difference between its

‘insiders’ and its ‘outsiders’ disappears. Let be the share of outsiders in political support, which depends on

the nature of the political system. Changes in generate a spectrum of political systems where political

differentiation is based on changes in the mix of wealth creation and wealth redistribution through which a

government obtains its support. As rises, the support of insiders becomes less important and that of outsiders

more so until the distinction between the two vanishes. Thus, indexes inclusiveness.

Collectively, outsiders lose from rent-seeking redistribution and can gain only from creation of wealth.

Thus, as rises, a government relies less and less on rent seeking for support and more and more on wealth

creation. As a result, efficiency also rises. Because governments only make economic changes to raise their

support, the quest for support links efficiency to inclusiveness and, more generally, differences in economic

systems to differences in political systems. Thus, changes in also generate a spectrum of economic systems

and have multiple economic and socio-economic effects. In Why Nations Fail, Acemoglu and Robinson [2012]

also link efficiency to inclusiveness, but without defining inclusiveness in a precise or quantifiable way.

The supply element linking economic growth to political support is an aggregate production function,

which gives rise to a short-run production frontier, TR, in rent seeking, R, and useful output, Y. Here R indexes

political support provided or financed by rent seekers in exchange for rent, and wealth creation means production

of Y, which we take as numeraire. Only Y can yield utility from present or future consumption, the way in which

‘useful’ output is useful. We break Y into two components, rent-seeking profit, G, and all other useful output, (Y –

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G), writing Y = (Y – G) + G. A government's political support is given by U = U[(Y – G), G, R;]; a specific form

of U with as parameter will be derived. Economic growth is equilibrium growth if an economy stays on its

production frontier for given capital, labor, and technology as this frontier shifts outward. Disequilibrium growth

occurs when an economy is inside its frontier, owing to the appearance of new investment opportunities, which

leave it with a misallocation of capital that takes time to correct.

This paper makes two contributions. First, it derives a political support function, U, with as parameter

and shows how changes in affect rent seeking, efficiency, and growth, as well as secrecy in government,

political stability, and corruption. Second, it shows how the quest for support causes to change and how this

affects growth, with an eye to the causes of growth slowdowns. Depending on comparative political advantage,

this quest can lead to a highly inclusive polity, a kind of political invisible hand, or it can lead to a polity that is far

from inclusive. In the latter case, the response to new opportunities for growth may be swift, disequilibrium

growth of Y at first, but then a slower equilibrium growth or even stagnation, accompanied by inefficiency and

inequality resulting from protection of rents and rent seeking.

Questions relating to inclusiveness and growth recall the long-running sequence of empirical studies that

seek to answer the question, ‘Does democracy increase economic growth?’ The latest entry into this debate, as of

early 2019, is the paper by Acemoglu, Naidu, Restrepo, and Robinson [2019], which answers with a resounding

‘yes.’ These authors also reference earlier works on the subject, most of which give negative answers. Here I note

that inclusiveness is different from democracy and is neither necessary nor sufficient for democracy. Most highly

inclusive political systems are probably democratic, but autocracies can be inclusive under internal or external

pressure to be efficient. Moreover, most democracies are illiberal, rather than liberal [Zakariah 1997], and the

former are not necessarily inclusive. The argument for inclusiveness to increase growth is simply that when

governments need the support of outsiders to survive or to thrive, they need to grow the economy, since

redistribution favors insiders.

In what follows, we first set out the aggregate production function and use it to identify three types of

economic growth in terms of the sources of growth. We then introduce a model of government support

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maximization and examine the role of inclusiveness. In two of the three types of growth, government intervention

can give rise to privileges that become crucial to political support and therefore hard to remove. The same can be

true of regulatory failure that allows markets to malfunction, as in the Financial Crisis of 2007-9.

2. Types of Economic Growth

2.1. Production Functions for GDP and Y; the Production Frontier and the Role of Efficiency

In Parente and Prescott [2004]—hereafter P & P—the aggregate production function takes the Cobb-

Douglas form, with constant returns to scale and Hicks-neutral technology, which they claim provides a good

empirical fit to the growth experiences of many nations. For any economy, we write this as:

GDP = Y + RR = (Y – G) + V = E*AKN1 – . (1).

Here GDP is gross domestic product or national income, Y is useful output valued in competitive prices, R is

rent-seeking output, or the output of political support provided in exchange for rent, R is the price of R in

units of Y, and V is distributional rent that arises from subsidies and government protections that restrict

competition. V can be broken down into rent-seeking cost, RR, and rent-seeking profit, G, giving V = G +

RR. An increase in V will give rise to an increase in R since a government will always take advantage of

opportunities to trade rent for political support. The two measures will correlate positively over time.

Since (Y – G) = (GDP – V), or GDP net of distributional rent, (GDP – V) is the income from

producing Y, while V is the income from producing R. Also K is the economy’s stock of physical and human

capital used in production, N is labor, A is the world’s stock of technological knowledge, E* is the efficiency

with which the economy uses technology and resources to produce GDP, and is capital’s share of value

added. E*A is total factor productivity (TFP) in producing GDP. Increases in E*A magnify output without

affecting the marginal rate of substitution of N for K at any given K/N. The elasticity of substitution, S,

between labor and capital is constant at one, and E* varies between zero and one. Since Y is denominated in

currency units, K and N are far larger than one.

We can re-write (1) as:

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Y = E*AKN1 – – RR = EAKN1 – , (1a).

which is also the equation of TR for given K, N, and A. Here E = (1 – SR)E* = SYE*, where SR = RR/GDP is the

share of R in GDP and SY = Y/GDP is the share of Y. When R > 0, E < E*. With R on the vertical axis, as in

Figures 1(a) and 1(b) below, the inverse slope of TR is YR = ERAKN1 – , where ER is the change in E when R rises

by a unit. Total factor productivity in producing Y is TFPY = EA. Dividing both sides of (1a) by N gives:

y = EAk, (2).

where y = Y/N is useful output per unit of labor and k = K/N is capital per unit of labor. We shall show specifically

what causes the growth of y to slow.

In (1), (1a), and (2), the values of and A are common across economies. Empirically, is .55 to .57 [P &

P, pp. 47, 47n], and P & P suggest (p. 38) that the annual trend growth of A is about .8%. By contrast, E is

economy specific. For given A, K, and N, the maximum value of Y worldwide is YF = W(A,K,N) = AKN1 – . This

is the frontier value of Y where E = 1 = SY = E*. Over time, A is rising, and in any economy, E rises when TFPY

grows faster than A and falls when TFPY grows more slowly. Thus Y moves closer to YF when E is rising and

further away when E is falling. If E and E* are positively correlated over time, moving away is not uncommon

[eg., Salinas- Jimenez & Salinas-Jimenez 2011, p.115; van Ark, O’Mahoney, and Timmer 2008, p. 34; Young

1994, p. 970], keeping in mind that YF is increasing as A rises.

P & P argue that differences in GDP per capita, both over time and as of a point in time, result largely from

differences in TFP. At any point in time, these differences reflect differences in E*, and growth ‘miracles’ occur

when E* rises rapidly following a change in and/or as a result of new investment opportunities that shift TR

outward. The levels of E* and E also affect growth by affecting the marginal product of capital and thus the return

on investment. The marginal product of capital in Y is YK = (Y)/K = (EYF)/K, which is increasing in E for given

, YF, and K. The lower is E the lower is YK and the greater is the increase in saving required to raise Y by a unit

(= 1/YK). In this sense, the consumption cost of growth is decreasing in E.

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2.2. Types of Economic Growth According to the Sources of Growth.

If we classify economic growth according to its sources, extensive growth is growth from increases in

inputs, notably capital, with total factor productivity held constant. Since we are mainly interested in the

growth of Y, this will be with EA held constant. Intensive growth is growth from increases in EA with inputs held

constant. The three types of growth are then: (a). extensive. (b). intensive and based on technology catch-up

—that is, on imported technology that is new to the importing country, but already in use elsewhere. (c).

intensive and based on innovation—that is, on technology that is new worldwide. Equation (2) implies:

yg = Eg + Ag + kg, (3).

where the g superscript denotes rate of growth. Thus yg is the sum of extensive and intensive growth rates of

y, although the two types of growth are complementary, in the sense that increases in TFPY raise the

marginal product of capital in Y for any given capital-to-labor ratio, thereby offsetting diminishing returns to

capital. In (3), Ag is a given to any individual economy, and systematic slowdowns in the growth of y result

from decreases in Eg and/or in kg.

To examine the complementarity between extensive and intensive growth, let yk)g be the rate of

change of yk over time. Note that YK = yk = y/k implies:

kg = yg – (yk)g, (4).

where yk)g is the rate of change of yk over time. Substituting (4) into (3) gives:

yg = [(Eg + Ag)yk)g] or yk)

g = ((1)[Eg + Ag yg] (5).

The growth of TFPY (or Eg + Ag) raises yk at each capital-to-labor ratio, thereby raising the value of k that

goes with any given yk. In this way, increases in EA create new opportunities for extensive growth. With

= .57, a .8% increase in A, with E constant, raises the value of k corresponding to any given yk by 1.86%.

Equation (8) becomes yg = kg = Ag/(1when E and yk stay constant. If Ag = .8%, both k and y will

grow by 1.86% per year when = .57. Over half of this growth is from capital deepening instead of

increases in TFPY, which is why all nations that have achieved modern economic growth have dramatically

raised their capital-to-labor ratios. Even though most of the growth of y is extensive, however, the intensive

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part is crucial in limiting the fall of yk. From (5), if y grows at a constant rate in an economy unable to

generate intensive growth, yk will be falling at (1 = .79 times that rate.

Of the three types of growth, only (c) is permanently sustainable. Type (a) eventually succumbs to

diminishing returns to capital, while type (b) must end with successful catch-up. However, government

interventions to promote growth of type (a) or (b) can raise Eg in the short run, but lower it over the long run,

on which more below. This can delay or prevent successful catch-up.

Let the U-subscript denote support-maximizing value. Then E = YU/YF = (YU/YM)(YM/YF), where YM

is the maximal value of Y (where R = 0) on the same TR as YU. Without rent seeking, YU = YM would hold,

and if this economy were on the worldwide technological frontier, YM = YF would hold. Thus, YU/YM is the

rent-seeking ratio, while YM/YF is the technology ratio, although the two are not completely independent.

Rent seeking depresses YU in part by protecting rents on obsolete technologies and associated work skills. In

an economy where rent seeking has been present for some time, YM < YF will hold, and current rent seeking

will depress YU below YM. Paradoxically, efforts to speed up type (b) growth by raising the technology ratio

can lower the rent seeking ratio and, in time, the technology ratio as well, causing Eg to fall.

2.3. Equilibrium vs. Disequilibrium Growth.

Downward sloping TR implies YR = ERYF < 0 in equilibrium growth so that ER < 0. The loss of efficiency

when R rises has two components. First is the direct loss because resources used to produce R could also produce

Y. The direct loss is always positive. Since E = (1 – SR)E* = SYE*, an increase in R causes SY to fall. Second is an

indirect loss resulting from the supply restrictions and other interventions used to generate the rent that insiders

receive for R. This is the cost of protectionism, really a cost of V, but as argued above, R and V correlate

positively. An increase in protectionism is equivalent to a fall in Y valued in competitive prices.

The indirect cost usually lowers E*, so that E, E*, and SY correlate positively over time, although

percentage changes in E are greater than in E* or SY, since only E embodies both direct and indirect effects.

Positive correlation is important because economists measure E* rather than E. Rising R will lead to a less

competitive economy with a lower reward for entrepreneurship, but ER can still be positive during disequilibrium

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growth, since Y and R can then increase together. When ER is positive, the indirect loss of Y, denoted by –YiR, will

be negative and greater than the direct loss.

In this context, E is increasing in two types of capital, which differ from the capital, K, used in

production. These are the capital, J, used to import technologies and implant them in the domestic economy

and the capital, H, used in new product research and development, which gives E = E(R, J, H). An economy

is inside TR when total capital, K + H + J, is misallocated between K, H, and J. In disequilibrium, the

government maximizes U for any given A, K, J, H, and N. Let EJ and EH be the changes in E when J and H

increase by a unit. A support-maximizing allocation of K, J, and H requires each to have the same value of

marginal product in Y. For J this is YJ = EJAKN1 – = EJY/E = YK = Y/K and likewise for H, giving:

EJ = EH = E/K < 1/K, (6).

along an equilibrium growth path when J and H are positive. EJ and EH are then nearly zero. Let eEJ and eEH

be the partial elasticities of E with respect to J and H. We then have:

Eg = eEJJg + eEHHg + eERRg. (7).

Equation (4) implies that eEMJg = (/K)dJ and eEHHg = (/K)dH, where dJ and dH are the annual changes in J

and H. Unless dJ is very large, eEMJg will be tiny, and likewise with dH and eEHHg.

2.4. Growth Slowdowns.

From (3), growth slowdowns in the form of decreases in yg can come from decreases in Eg and in kg.

They can also come from decreases in Ag, but the latter is viewed as outside the influence of any single

economy. Suppose that an economy finds new opportunities to grow by importing technology that is new to

this economy, although in use elsewhere. As a result, EJ shifts upward, so that (4) no longer holds, and

disequilibrium growth of type (b) prevails. In addition, it will take time to embody the new technology into

K, and this is another reason for disequilibrium. Let KT be capital with the new technology, and suppose that

either KT or labor working with KT has a higher marginal product than other capital/labor. This can also be a

cause of disequilibrium growth. Subsidies, restrictions, controls, and rationing of credit and resources—the

instruments of ‘industrial policy’—can often raise E by speeding up the importing and dissemination of new

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technologies, as well as the moving of resources into sectors with relatively high marginal products, and the

lowering of costs by gaining experience using the new technologies in production.

However, subsidies, restrictions, controls, and rationing also create protections and rents for favored

suppliers, in return for which the government will expect political support. When an economy reaches its TR

frontier, E must stop rising and start to fall if support maximization requires R to continue to rise, since TR

slopes downward. By then, the government may have become heavily dependent on rent seeking and

insiders for support. If so, the transition from disequilibrium to equilibrium growth will cause growth to

slow—yg will fall—unless kg increases by enough to offset the fall in Eg. But with yk already falling because

E is falling, further decreases in yk owing to the growth of k may be inconsistent with support maximization,

given that decreases in yk are also increases in the consumption cost of growth.

With the above in mind, we can identify three basic types of growth slowdowns that occur because

political support depends on rent seeking. (A). kg falls because of diminishing returns to capital (falling yk)

and an increasing consumption cost of growth. An implication is that the economy has a rate of

technological progress that is too low to offset the downward pressure on YK. A low rate of technological

progress can arise in turn because of protection of distributional rents associated with existing technologies.

(B). A transition from disequilibrium to equilibrium growth occurs in which E is growing in disequilibrium,

but falling in equilibrium because support maximization requires R to continue to rise. (C). During

equilibrium growth, R begins to rise or to rise more rapidly, and the resulting negative effect on E is not

offset by technological progress or increases in k, so that yg falls. Note that (A), (B), and (C) all result from

reliance on R and V for political support and the resulting inefficiencies.

3. The Production Trade-Off between Useful Output and Rent Seeking.

Subject to TR and to Y = G + (Y – G), a government maximizes U, assumed to be second-order

continuous, strictly quasi-concave, and non-decreasing in R, G, and (Y – G) for any given . If we first

maximize U subject to Y = G + (Y – G) for any given , R, and Y, the support-maximizing division of Y into

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G and (Y – G) occurs where UG = U(Y – G) when G > 0. Here UG and U(Y – G) are the changes in U when,

respectively, G and (Y – G) increase by one unit. For simplicity, we ignore the error that arises because a

unit increase in G implies a unit increase in V, which has an indirect effect on Y. When UG = U(Y – G) at each

value of Y, U can be re-written as U(Y,R;), with UY = UG = U(Y – G).

Let MCR be the marginal cost of R, defined as the fall in Y along TR when R increases by one unit,

including both direct and indirect effects. Then TR is strictly concave from below if MCR is rising as R

increases along TR. The rationale for rising MCR is that a government will try to minimize the loss of Y

resulting from any given increase in R, but that these efforts are subject to diminishing returns as R/Y

increases. Given our concavity assumptions, there will be one local maximum of U, which is also a global

maximum. If MRT and MRS are the marginal rates of transformation and substitution of Y for R, and R is

plotted on the vertical axis, the first-order conditions for maximizing U along any given TR are:

MRT = (MCR) –1 = MRS = UY/UR = UG/UR = U(Y – G)/UR = (R) –1 = –(YR) –1 = – (ERYF)1. (8).

In Figures 1(a) and 1(b), four maxima are shown, at A and B in Figure 1(a) and at B and C in Figure 1(b).

It is straightforward to show that a point on any TR corresponds to unique values of R, Y, MRT, MCR,

G, (Y – G), V, and GDP. Let PM be the point on any TR where R = G = 0 and Y = YM. This is the most

efficient point on TR, as well as the point at which (GDP – V) = (Y – G) is maximized. Let Ym be the output

at which V reaches its maximum feasible value of Vm, and let Rm and Gm be the corresponding values of R

and G. As shown below, RU, GU, and VU all change in the same direction along any TR in response to a

change in U. This makes Rm and Gm the maximum values of RU and GU and Ym the minimum value of YU on

any TR. Let Pm be the point (Ym, Rm). At any point (Y,R) where Y is less than Ym, R ≤ Rm must hold as well,

and U is lower than at Pm. Thus all possible support maxima lie between Pm and PM.

The flatter are the isoquants of U for any given TR—and thus the higher is (MRS)–1, the demand price

of R, at each (Y,R)—the higher RU and the lower YU will be. This is shown in Figure 1(b), where UB leads to

higher RU and lower YU than UC. Likewise, for any given support function, U, let TR become steeper, in the

sense that MRT rises and MCR, the supply price of R, falls at each given Y. Then RU/YU will again rise. In

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Figure 1(a), TR1 shows a higher past demand for rent-seeking support (R) than does TR2, which shows a

higher past demand for useful output (Y). Thus, a steeper TR, such as TR1, reflects a greater build-up of

physical and human capital specialized to rent-seeking support than does a flatter TR, such as TR2.

Suppose a political change lowers MRS at each (Y,R), causing the isoquants of U to become flatter, as

in the shift from UC to UB in Figure 1(b). The short-run result is a move from C to B, which raises RU and

lowers YU. The higher demand for R also stimulates the demand for rent-seeking specialized capital, thereby

causing MRT to rise and MCR to fall over the long run at any given R/Y. TR becomes steeper, shifting from

TR2 to TR1 in Figure 1(a), and RU/YU again rises, as in the move from B to A. Over time, the demand and

supply effects of the political change are reinforcing.

4. The Effect of Inclusiveness on Political Support.

4.1. Assumptions and the Nature of the Political Support Function.

A government’s support, U, is assumed to depend on and to be a non-decreasing function of insider

support, UI, and outsider support, UO. Assumptions (i) and (ii) then determine the nature of U: (i). Let

index a government’s ability to rely on UO for support, interpreted as the share of UO in U. Let (1 – )

index its ability to rely on UI. Then depends only on the political system. (ii). UI = sR, where s = s(G,R)

indexes a government’s success in gaining support from any given R. Let sG and sR be the changes in s when

G and R increase by one unit. Then 0 ≤ s ≤ 1, sG ≥ 0, and sR ≤ 0. An increase in G gives a stronger incentive

to support the government, while an increase in R weakens this incentive by spreading a given G over more

R. UI is increasing in R and G, with marginal products, UIR = s + sRR and UI

G = sGR. UO is an increasing

function of (GDP – V) = (Y – G), the income from producing Y, with marginal support value UO(Y – G). A

government is able to compare the sizes of UI and UO, implying that UO can be measured in units of R.

For any given , (i) and (ii) imply that U is Cobb-Douglas in UI and UO. Thus:

U = [UO(Y – G)][UI(R,G)](1

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where U, UO, and UI are all measured in units of R. When = 1, U = UO and RU = GU = VU = 0. The

support maximum on any TR is then at PM where R = 0 and (YU – GU) = YU = YM. This is the most efficient

point on TR. If = 0 were possible, U = UI and GDPU = VU would hold. In practice, VU cannot rise above

Vm, and the minimum value of is therefore the one, say = m > 0, that gives a support maximum at Pm,

the point of maximum rent extraction. Since the ability to extract rent is limited, varies between m and

one. Moreover, outsiders must receive some income, implying GDPU > VU and YU > GU. Thus U always

depends on outsider welfares and over-all economic performance and never on rent alone, although the

weight of Y – G is increasing in .

A final assumption is (iii). UO(Y – G) is non-increasing in (Y – G). Also G and R show diminishing

returns and complementarity in UI in the sense that UIG is decreasing in G and increasing in R, while UI

R is

increasing in G and decreasing in R. A government uses increases in G to give rent seekers stronger

incentives to support it, thereby raising UIR as well as UI at each R.

Assumption (iii) implies that UI is strictly quasi-concave.

4.2. Basic Results: How Wealth Creation, Rent Seeking, Rent-Seeking Profit, Distributional Rent, Market

Competition, Secrecy in Government, and the Level of Corruption Change When Inclusiveness Changes.

We next ask how the underlying variables change when changes along a given TR and how this

affects efficiency, E. When < 1, (9) implies that:

U(Y – G)/UG = [(1 – )](UI/UO)(UO(Y – G)/U

IG). (10).

Since U(Y – G)/UG = 1 is necessary for dividing Y into (Y – G) and G in a support-maximizing way, suppose

that UG = U(Y – G) holds initially at each (Y,R), which implies that MRS = UIG/UI

R. From (10), if then

increases, U(Y – G)/UG must rise at each point ((Y – G), G, R). By assumption (iii) this requires G to fall and

(Y – G) to rise at each (Y,R) in order to restore UG = U(Y – G). The fall in G raises UIG/UI

R, while the increase

in (Y – G) has no effect on UIG/UI

R. Thus, an increase in raises UIG/UI

R, and therefore MRS, at each (Y,R).

The isoquants of U become steeper in (Y,R) space, as in the shift from UB to UC in Figure 1(b).

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Following the rise in , MRS is therefore greater than MRT at the old support maximum, and the new

maximum is where MRT is higher and TR is steeper than at the old. As a result, RU must fall and YU

must rise—the most basic effect of an increase in . YU is increasing and RU is decreasing in . Despite the

rise in YU, GU must be lower after the rise in than before, for otherwise the support-maximizing value of

UIG/UI

R would be lower afterward, by assumption (iii), because of the fall in RU. Thus, GU is decreasing

in , and both GU and RU are positive when and only when < 1, the rationale for positive GU being that

increases in G have political support value. Viewed as the supply price of R, R correlates positively with R

along any given TR so that VU is also decreasing in in the short run; markets become more competitive as

rises. Less inclusive governments rely more on insiders for support and therefore need to extract more

distributional rent to pay for this support, which requires greater protectionism and concentration of

economic power and lower market competition. Reliance on insiders for support also makes also makes

them harder to regulate in their economic roles—regulators are more likely to be captured.

Since utility comes only from consuming Y, a government will be secretive when is low in order to

hide the loss of Y from rent seeking and extraction of rent. Secrecy also provides a favorable environment

for the politics of identity and victimization—key elements of populism—and for corruption, defined as the

use of political office for personal gain. A polity with low inclusiveness will have a relatively high level of

corruption, and governments will award positions with opportunities for corruption in return for political

support. The support of a corrupt official, who is an insider, is more valuable to a government when is low

than when is high, while the support of outsiders who bear the cost of corruption is less valuable.

4.3. Institutional Requirements for Inclusiveness to be High.

The backbone of an inclusive polity is a set of institutions of restraint—such as an independent and

impartial police and judiciary and a free press—that uphold basic rights and freedoms and limit corruption

and government abuse of its power [Rodrik 2014]. Institutions of representation, which translate popular

preferences into government policy, are also part of liberal democracy, but without effective institutions of

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restraint, institutions of representation can be undermined. By upholding impartiality and raising the cost of

maintaining secrecy, institutions of restraint make it harder for rent seeking to raise political support and for

secrecy and deception to cloud the link between government policy and economic performance. This raises

the importance of wealth creation as a source of support. When political support is measured in votes,

publicity is a key to limiting the ability of politicians to extract rent [Chang, Golden, and Hill 2010].

Institutions of restraint—notably a free press—have the task of providing useful information that will enable

voters to evaluate the alternatives facing them at relatively low cost.

Institutions of restraint restrain an incumbent government in the ways it can gain and exercise power.

Thus, they lower the value of political power. However, when is high, a different government with

different political skills is likely to be in power than when is low. Thus, when is high, one or more

major political parties or coalitions will benefit from effective institutions of restraint that enable them to

hold power. Such parties/coalitions will defend such institutions against efforts to lower their effectiveness,

which potentially enables them to survive and remain effective over time.

4.4. Low Inclusiveness and Loyalty.

A dictator relies on an elite base of supporters [Wintrobe 2004] to sustain him in power. These are

the insiders, and political stability imposes a loyalty requirement on them. UIR ≥ 0 implies sR = –(sRR/s) ≤ 1

at the support maximum. Thus –(sR/s) < 1/R and since sR is negative, (sG/s) < MRT/R; the latter holds

because MRS = UIG/UI

R = sGR/(sRR + s) = MRT at the support maximum when < 1. If R increases by x

percent with G fixed—which dilutes the incentive to support the government—s must fall by no more than x

percent. Thus either RU and GU are low along TR—and U is low if is low—or RU and GU are high, and

both (sR/s) and (sG/s) are numerically small since MRT is then low.

For an autocratic or other non-inclusive government to be strong and stable, s must be high and

insensitive to changes in R and G, in the sense that sR/s and sG/s are numerically small. This makes UI

sensitive to changes in R. Likewise, for an inclusive government to be strong and stable, UO must be

sensitive to changes in (Y – G), implying a threat of losing power if (Y – G) falls too far below YM. This can

16

result from electoral competition or forceful removal from power—eg., as a result of external pressure or

internal uprising. Thus, it does not necessarily imply democracy.

Autocrats not facing such constraints can gain support by making s insensitive to changes in R and G

and if in power can gain support from rules that give a strong advantage to incumbency when political

competition does arise. They will also select and promote insiders whose inherent loyalty to the ruler is

high, where ‘inherent’ loyalty, indexed by , is loyalty that stems from shared attributes, values, goals, and

experiences—or from the presence of a charismatic leader and more generally from factors other than G.

Emphasis on loyalty as a success criterion also implies a substitution of loyalty for competence, and the

protections and restrictions that often accompany type (a) or type (b) growth accommodate this by lowering

the demands on managerial and administrative ability.

4.4. Comparative Political Advantage.

An actual or potential government has a comparative political advantage in UI at any point on TR, if

UI > UO there, and a comparative political advantage in UO if UO > UI. Comparative political advantage

depends on past and present values of , as well as on the skill set a government brings to producing

political support. Past values of help to determine the accumulation of human and physical capital

specialized to rent-seeking support vs. that specialized to useful output. Suppose the support maximum for a

government over all is expected to stay where = m. Then there will be an incentive to accumulate

capital specialized to rent seeking. This makes TR steeper, reinforcing the stability of , although low

efficiency and a high consumption cost of growth can still undermine this system. An initial support

maximum at = 1 that is expected to last creates an incentive to accumulate capital specialized to Y, which

makes TR flatter, again reinforcing political stability.

Suppose is between m and 1. Then a comparative political advantage in UI implies that a fall in

will raise U, while a comparative political advantage in UO implies that an increase in will raise U. Thus,

the only possible support maxima over all are the endpoints of the political spectrum where = m and

= 1. If successful, the quest for support becomes the road to either low or to high inclusiveness. In the latter

17

case, a government following its own self-interest may increase efficiency and welfare by more than if it set

out to do this from benevolence alone—an ‘invisible hand’ is at work. Efforts of governments to raise their

support move away from mid-range, and political and economic systems that are initially similar can

become quite different in time. However, non-co-operative behavior, fragmentation of political support, or

changes in the ranking of contenders in terms of total support as changes can prevent from moving all

the way to a extreme.

Comparative political advantage therefore plays a major role in determining a government’s approach

to growing Y. It helps a government with a comparative advantage in UO to emerge if competition for

insider loyalties keeps low for any potential government, thereby keeping UI low. Vulnerability to low is

a potential Achilles heel of a non-inclusive polity, as is its relatively low average living standard.

Fragmentation can also undermine an inclusive polity, but such a system thrives on competition for

support—as long as there are only a few competitors—whereas a non-inclusive polity needs strong restraints

on this competition to keep sR/s and sG/s close to zero. As falls, both market competition and competition

for political support will decrease if the political system remains stable. Since efforts to restrict competition

often wind up displacing it instead, however, competition for power when is low is more like competition

to become a monopolist than competition for votes based on tax cost and quality of government services and

policy-making. Under autocracy, two-thirds of all leadership changes result from non-co-operation—coup,

regime change, assassination, popular uprising, or foreign intervention [Svolik 2012, p. 5]. Such competition

can lead to periods of calm and stability interspersed with periods of conflict and instability.

5. How Types (a) and (b) Growth Affect Efficiency

5.1. Comparative Political Advantage and Growth Slowdowns.

Earlier, we identified three types of growth slowdowns—(A), (B), and (C) above—that occur because

political support depends on distributional rent and rent seeking. Now we can also tie these slowdowns to a

comparative political advantage in UI. An advantage in UI is likely to lead to a lower rate of technological

18

progress than an advantage in UO because of greater protection of distributional rents associated with

existing technologies. Likewise, an advantage in UI is the reason for E to stop rising and start falling when

disequilibrium growth gives way to equilibrium growth. And the emergence of a comparative advantage in

UI would cause R to turn around and start rising during equilibrium growth.

With an advantage in UI, policies designed to promote growth will include more privileges and rents,

in return for which governments will expect more political support, on which they will become more reliant.

There will be more protection and subsidies, more mobilization of resources, and more credit rationing in

order to increase savings and channel investment funds into sectors with high growth priority. Low-priority

borrowers will have to build up their savings in advance of large purchases or retirement or to be ready for a

rainy day, etc., while high-priority borrowers benefit from low rates and good access. Such interventions can

temporarily raise growth and are often part of a growth strategy that involves import substitution and export

promotion of high value-added products.

A low growth of y can also result in a low or middle income trap, in which type (b) growth leads to a low

or middle-income level of y, but no higher because investments that could break the economy out of this trap

would compete away rents crucial to political support. Of course, this can be true of Y and GDP as well. One

sign that government has a comparative political advantage in UI is an emphasis on export-led growth, since

turning entrepreneurial efforts outward allows for protectionism at home.

Suppose that new opportunities to grow by importing technology appear with a comparative political

advantage in UO. Then a government will exploit these opportunities by relying more on market competition

and less on state intervention that replaces market outcomes. If is initially below one, it will rise—provided

support-increasing political reforms occur—and the same is true of E. In these conditions, the transition from

disequilibrium to equilibrium growth can as easily cause yg to rise as to fall. Such an economy will have a lower

growth of y in disequilibrium since it uses fewer interventions that can temporarily speed growth. It will have a

higher growth in equilibrium, and there may be no slowdown in the transition. Growth could even speed up.

19

Moreover, the higher is and the lower is the political support value of rent seeking, the more leeway a

support-maximizing government will have to implement efficient changes—notably, to allow sectors within Y to

decline when demand falls, and to shift the released resources into more efficient uses or to adopt new

technologies that destroy existing rents. When is high, special interests are relatively weak. When is low,

these interests are strong, and they will resist the decline of sectors they represent because this lowers their

ability to supply political support [Acemoglu and Robinson 2001].

5.2. Empirical Support.

There is empirical support for the negative link between rent seeking and efficiency, provided rent

seeking and corruption correlate positively—both over time and cross-sectionally—and provided E and E*

correlate positively. Then efficiency will vary inversely across nations with the level of corruption, a finding

of Salinas-Jimenez and Salinas-Jimenez [2011]; see also Keita [2017]. Corruption is a form of rent seeking

and the factors that favor corruption—secrecy and lack of openness or transparency in government—also

favor other forms of rent seeking, including lobbying to protect rents on existing technologies and skills.

While corruption may seem worse than lobbying, each involves a transfer of wealth from rent seeking

victims to successful rent seekers, and each is likely to raise political support by more when its victims are

unaware of the transfer.

5.3. The Transition to type (c) Growth.

Once there are no more gains from type (b) growth, it is time to switch to growth of type (c), the only

kind that is permanently sustainable. For a government with a comparative political advantage in UO, this is a

natural next step since such a system is favorable to innovation during growth of type (b). But for a government

with a comparative advantage in UI, this conflicts with the support need to keep V high, which requires

protections that crowd out innovation and new product R&D. In type (b) growth, the technologies to be

imported are understood and have known requirements for effective utilization. But in type (c) growth, this is no

longer true, which makes dirigiste policies of doubtful value. Successful dirigisme requires a government to

know which industries, technologies, and production methods to promote and in which specific types of human

20

and physical capital to invest. Without observable past experience as guide, this knowledge either does not yet

exist or is scattered among various agents—producers, consumers, researchers, etc.—and much of it remains

tacit. An advantage of markets noted by Hayek [1945] is that they can work well without having to centralize

this information.

Type (c) growth requires competition, well-developed financial markets, and freedom from market and

trade distortions. Supply restrictions such as those associated with credit rationing, which are endemic to type

(b) growth, are a major barrier to the entry and expansion of small firms and thus to innovation and the

development of technically sophisticated products [Aghion, Harmgart, and Weisshaar 2008, esp. pp. 50-54].

6. A Brief Look at the Growth Experiences of the Soviet Union and Japan.

6.1. Growth Slowdown and Inefficiency in the Soviet economy.

Mainly extensive growth outside the space and defense sectors was a feature of the state-managed

Soviet-type economy (STE), a planned and controlled system with many quotas, restrictions, and subsidies.

These interventions probably raised the growth of Y initially by creating forced savings, rapid capital

accumulation from a low base, and strong incentives for labor to migrate from agriculture to industry. In the

Soviet Union, GDP per capita grew over 1928-1990 by an annual average of 2.6% to 5 times its original

level [Ofer 2008], although nearly all the sustainable growth occurred before 1970. A key problem in

sustaining growth was diminishing returns to capital. A falling marginal product of capital was documented

by Weitzman [1970] as early as the 1960s.

Relative to the U.S., Soviet GDP/capita peaked at 37.5 % in 1970 [Ofer 2008]. After 1970, the

Soviet capital-to-labor ratio soared, while the marginal product of capital in GNP fell rapidly [Easterly and

Fischer 1995, p. 358]. By the Gorbachev years, the economy was stagnating; GNP/capita rose by just .4%

per year over 1986-1990 and then fell in 1991 [Ofer 2004]. Using a Cobb-Douglas production function, the

growth of TFP averaged a half percent per year over 1950-87. This growth was slowing during that period,

and became negative during the 1970s until the end of Soviet Union [Ofer 2004, Table 1].

21

If the elasticity of substitution (S) is less than one, as Weitzman and Easterly/Fischer [1995] believed

to be true of the Soviet economy, growth will slow more rapidly as k rises, since the greater difficulty of

substituting capital for labor makes the marginal product of capital fall faster. Under constant returns to

scale, (ykk/yk) = (1 – )/Sk. The lower is S, the faster yk will fall. One argument for low S is that the high

rate of Soviet investment made it hard for planners to substitute capital for labor in old production units at

the same time that they were building new ones. Thus, some capacity lay idle for want of labor [Ofer 2008].

This co-existed with widespread overstaffing of firms, one way in which resource allocation was poor.

Easterly/Fischer originally estimated S to be .37 for the Soviet economy (pp. 355-357), later

corrected to .49 [Easterly and Fisher 2008], following criticism by Beare [2008]. Using S = .49, they

estimate TFP growth to have been falling over 1950-1987, reaching near zero in 1987. Given that A

increases at about .8% per year, E* is likely to have been falling well before the end of the Soviet Union

regardless of whether S was below or equal to one,. Rent seeking was also rife, in part because tax revenues

depended on the profitability of state firms, which in turn depended on the productivity of capital. Their

falling profitability caused growing budget deficits. These were largely monetized, leading to higher

nominal incomes and rising differences between official and demand prices, which generated rent seeking in

the form of efforts to take advantage of these differences. In Russia, the freeing of consumer prices in

January 1992 caused them to more than double from official levels at the end of 1991.

The STEs left a legacy of resistance to market-oriented reforms in successor transition economies by

those whose rents were threatened [Aslund 2002, ch. 9]. This weakened the impact of economic reform

except where a new government with a comparative political advantage in UO could gain enough support to

come to power. Because the institutions of a Soviet-type economy and those of an efficient market economy

are quite different, the costs of switching were high, and this helped the STE to survive for many years

despite poor performance. Over 1970-91, there was hardly any net growth of GDP per capita in the Soviet

Union, and in Russia, GDP plunged by nearly 40% in 1992, the first year of transition [Ofer 2008].

6.2. Growth Slowdown and Efficiency in Japan.

22

For many years, Japan had high rates of GDP growth and provided the model for much of East Asia.

Japanese experience and the subsequent experiences of smaller East Asian ‘tigers’ suggested that

government intervention in the form of industrial policy could permanently raise the growth of GDP, and

several economists forecast that Japan would overtake the U.S. in terms of per-capita GDP. This was largely

growth of types (a) and (b), in which government played a leading role—in facilitating technology imports,

in disseminating technologies to domestic producers, in assisting their learning to use these technologies, and

in channeling resources into targeted growth sectors.

Japan and other East Asian nations promoted export-led growth, building efficient export industries

and achieving an economic ‘miracle’ in the process, using an approach that included large public

investments in infrastructure and technical education, as well as targeting of growth sectors. Targeted

industries were subsidized and protected, and large investments were made in them. This required controls

on financial markets that channeled loans to favored borrowers—who were initially not competitive on

world markets—as well as barriers to imports, which were often tightly controlled, thereby protecting the

domestic market. Many inefficient firms benefitted from this protection. Other East Asian economies also

built up their human capital and shifted comparative economic advantage within Y toward higher value-

added products that were physical or human capital intensive. Their cost advantage often rested on

inexpensive human capital.

For Japan, however, the high-growth era is now just a memory. Many resources are tied up in inefficient

firms, including ‘zombies’ that only continue to operate because of protection and subsidies. The peak of the

Japanese economic miracle occurred between the mid-1950s and the early 1970s. By 1970, Japan had the

highest per-capita GDP in Asia, using purchasing power parities [APO 2017, p. 29]. But then growth slowed,

and in the early 1990s, stagnation set in, from which Japan has yet to recover. Annual growth of real GDP per

capita in Japan averaged 8.2% over 1960-73 during the economic miracle, but then fell to 1.2% over 1990-2007

[U.S. Department of Labor 2008].

23

Using purchasing power parities, Japan had fallen to second place in Asia in terms of per-capita GDP by

1990, behind Singapore, and by 2015, to fourth, with less than half the GDP per capita of Singapore, 71% of that

of Hong Kong, and 86% of that of Taiwan [APO 2017, p. 29]. South Korea, which had only 17% of Japan’s per

capita GDP in 1970, had about 85% in 2010 and 90% in 2015. Relative to the U.S., Japanese per capita GDP

peaked in 1991, at 87%, according to the IMF, from which it fell to 71% in 2015. In Japan, E* grew over 1970-

90, since annual TFP growth averaged 1.37% [Sanchez and Yurdagul 2014]. However, annual TFP growth was

just .44% over 1990-2007 and .33% over 2007-2011, so that E* fell over 1990-2007. E* has fallen in most years

since 1990 and was well below its 1990 level in 2015. All the Asian countries that moved ahead of Japan in per-

capita GDP over 1970-2015 had faster TFP growth, if we take into account the corrections suggested by Hsieh

[2002] for Singapore and Taiwan.

Of course, other East Asian nations are potentially vulnerable to the forces that divert resources from

growth to rent seeking and cause political support to be based on wealth redistribution rather than wealth

creation. But both Taiwan and South Korea became democracies during this period and therefore plausibly

acquired more inclusive political systems. Singapore faces strong external pressures to be efficient and to

maintain racial and religious harmony. Japan is a democracy, but one in which distributional rents of powerful

special interests appear to dominate growth as a source of political support.

7. Conclusion: Rent Seeking and the Role of Government

7.1. Rent Seeking in the Financial Crisis and ‘Great Recession’ of 2007-2009.

Government efforts to grow the economy more rapidly by replacing or ‘governing’ the market [Wade

2004] in Soviet-type economies, Japan, and elsewhere often worked for a time, but then gave way to slow

growth or stagnation. Arguably, the main culprit was reliance on rent seeking for political support. In

disequilibrium growth, it was possible to promote the growth of Y through interventions that also helped V

and R to grow. With the return to equilibrium growth, however, rent seeking maintained systems of

privileges that depressed efficiency and lowered growth. The high demand for rent seeking also built up the

24

economy’s endowment of rent-seeking specialized capital—helping to entrench rent seeking as a source of

political support—and prevented reforms that could have sustained or revived growth. The antidote was a

government with a comparative political advantage in UO and thus an incentive to make the political system

more inclusive and less reliant on insiders for support.

However, supporters of a minimal economic role for government drew a quite different lesson from

the Soviet, East European, and Japanese experiences, which reinforced their belief in the efficiency of self-

regulating markets—the ‘magic’ of the market. Overlooked was the fact that this ‘magic’ required a

government to implement and enforce the property rights and rules that enable efficient exchange to occur.

The idea that self-regulating financial markets would be efficient replaced older views, including that of

Adam Smith, who had argued in favor of government regulation to avoid ‘endanger[ing] the security of the

whole society [Smith, p. 324].’1

In the United States, financial de-regulation and lax regulation increased the potential rents of

lenders, which led to a lending frenzy, the counterpart of which was a rise in the ratio of debt to borrowers’

incomes. Borrowers were willing to take on debt because high asset prices raised their perceived wealth.

Big lenders who were insiders had some control over government’s ability to regulate—regulators were

captured to a degree—which is a weakness of a political system that relies on insiders for much of its

support. These factors created the conditions for subsequent borrower defaults, which started the financial

crisis and ‘Great Recession’ of 2008-9. A sudden tightening of monetary policy also played a role.

According to Mian, Sufi, and Verner [2017], increases in the ratio of household debt to GDP over 2002-2007

by region are a good predictor of unemployment increases between 2007 and 2010.

Opportunities for rent seeking arose from a rapid increase of property values caused by easy money

and deregulation in combination with government promotion of home ownership. The increase in value of

property raised demand and household borrowing via the wealth effect. Together with regulatory gaps,

deregulation allowed lenders to issue and then to sell low-quality mortgages at little risk to themselves. A

ready market for these ‘sub-prime’ and ‘non-prime’ mortgages relieved lenders of the cost of borrower

25

default, which they passed on to buyers of mortgages and mortgage-backed securities. As a result, low-

quality mortgage lending grew rapidly, and low-quality mortgages came to comprise over half of all

mortgages. After issuing these mortgages, the issuing bank or shadow bank would either sell them outright

or cut them into pieces and pool them with pieces of other mortgages to produce securities that were sold.

A ready market for these mortgages arose because the quasi-public mortgage giants, Fannie Mae and

Freddie Mac, stood ready to buy mortgages at high prices, which they then securitized and sold. Ultimately,

the lending frenzy depended on the generosity of Fannie and Freddie and on buyer over-valuation of

mortgage-backed securities. Their quality was not transparent, and bond-rating agencies were captured by

securities issuers, resulting in ratings that were too high. The bull market spawned by easy money and home

ownership promotion also contributed to the over-valuation. Rising property values led to rising prices of

mortgage-backed securities, which provided good returns to securities buyers as long as property values kept

rising. Rising asset prices increased the supply of collateral for loans, which made lending appear less risky.

7.2. Recession and the Changing Wealth Effect on Demand.

At first, monetary policy accommodated the above process, but in 2004, the Fed abruptly changed

course and began tightening money and credit. It raised interest rates 17 times over 2004-2006—the

discount rate rose from 1% to 5.25%—and then began lowering rates again, the discount rate reaching near

zero in December 2008. House prices peaked in mid-2006 after rising for 15 years and then began to fall.

When this fall speeded up over 2007-2008, borrowers often found that they owed more on their mortgages

than their properties were worth, in addition to which sub-prime borrowers faced low initial payments, which

then escalated. Many mortgage holders defaulted, revealing the riskiness of securities based on these

mortgages. The demand for them imploded, causing the sub-prime mortgage market itself to collapse in

2007. The home ownership rate went up and back down [Callis and Kresin 2014, 2015].

At first, rising property values boosted demand via the wealth effect. Easy money and credit

intensified this boost. Prices of real estate and securities soared, but these were on a bubble, which burst

when mortgage borrowers began to default in numbers. The subsequent fall in values of real estate and

26

mortgage-backed securities, aided by the Fed’s temporary tightening of money and credit, put the wealth

effect into reverse and reduced the supply of collateral for loans. Demand fell, and the riskiness of lending

rose, especially to small borrowers whose net worth had fallen and many of whom were by now carrying

large amounts of debt. The fall in demand for durable goods by households and small firms—which was

intensified by higher borrowing costs and tighter credit—was the main cause of general economic decline

and subsequent slow recovery.1 The crisis lowered employment in financial services, where rent seeking had

been intense, and in sectors, especially construction, where demand had been buoyed by rent seeking.

The shadow banking system grew during the housing bubble to become larger than the banking

system. Shadow banks avoid regulation by selling securities to access savings instead of accepting savings

deposits, and fail to benefit from the insurance systems that support banks. When the bubble burst, the

shadow banks suffered the equivalent of bank runs and became the part of the financial system that shrank

the most. Fannie and Freddie received government bailouts, as did private ‘too big to fail’ financial

institutions. Interest rates have remained low, at high cost to savers. (Most of the bail-out funds were later

paid back, however; indeed the government has taken far more in profits earned by Fannie and Freddy than

the latter received during the financial crisis.)

The combination of boom and bust provided a net benefit to Americans in the top 1% of the income

distribution, with most of the cost of the Great Recession falling on small lenders and mortgage holders.

According to Saez and Piketty, the top 1% received nearly all the income gains from the 2009-10 recovery

[Lowery 2012]. Even though the U.S. has a different political system, it appears to have relied heavily on

rent and rent seeking for political support, much as the Soviet and Japanese systems did.

The ability to trade political support for distributional rent is a problem facing many societies and not

just because of efficiency issues. High levels of rent-seeking support signal secrecy in government,

corruption, and inequality in the form of unequal treatment of insiders and outsiders via barriers that

constrain social mobility and equality before the law and perpetuate greater economic opportunity for some

27

than for others, as well as concentration of economic power. The way a government obtains its support has

much to say about the nature of the society it governs.

Notes:

*I am indebted to Sarah Aboul-Magd for drawing the diagrams.

1. For an extended discussion and partly different point of view, see Krugman [2009, chs. 7-10]. As well,

see Mian, Sufi, and Verner [2017].

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