National Council of Applied Economic Research
Opinion: K P Krishnan
There is a strong connection between bolstering democracy and achieving a better functioning financial system
A great debate has surged in recent weeks in India about democracy and “tough” economic reforms. In the field of finance the main path of reforms is intertwined with deepening of democracy. This is what has been observed elsewhere in the world in the early experience of India with reforms and in the way ahead for financial economic policy. The essence of democracy — dispersion of power and the rule of law — generates the precise conditions for the flowering of the market economy of which finance is the core.
The NITI Aayog CEO Amitabh Kant reportedly said that “tough” reforms are “very difficult in the Indian context” as “we are too much of a democracy” but the government has shown “courage” and “determination” in pushing such reforms across sectors including in areas like mining coal labour and agriculture. This led to a storm with many critics fervently defending Indian democracy and the CEO clarifying in a column in The Indian Express that he had been misunderstood.
While the concept of peaceful handover of power through elections looms large in our minds there is much more to democracy than elections that determine who is the elected ruler. The essence of democracy lies in dispersion of power in containing arbitrary state power in channelling state power into the path of the rule of law. Under the rule of law private persons and economic agents feel safe that the coercive power of the state will be deployed in a predictable and rules-based way impartially. This encourages investments in building firms and building personal wealth. There is thus a deep connection between the emergence of democracy and the willingness of the private sector to commit to spend decades building organisations and to keep their wealth in the country.
These concepts apply with full force in the essence of the market economy i.e. finance. Every financial system involves financial regulation. When state and regulatory power is unchecked regulators have discretion on who is targeted. Under these conditions private persons invest in the power game in influencing the use of state power. The focus of private persons is then more on managing the political regulatory and bureaucratic environment and less on understanding consumers technology and efficient methods of running organisations.
For these reasons there is a strong connection between bolstering democracy and achieving a better functioning financial system. A common law framework is one where legislators or regulators operate in a more principles- based way where the state does not prescribe details of products or processes where the state does not pick winners where micro-management of private persons is absent which give a bigger role to judges to think about a novel situation and to effectively make law. Many researchers starting from Brown University Professor Rafael La Porta and co-authors in the Journal of Political Economy in 1998 have developed the idea that common law frameworks work better for financial sector development. A recent literature has looked at events where a country graduated to a higher level of democracy and the evidence is positive in favour of the idea that increased democracy is good for increased financial development. This includes two important papers by Peking University Professor Yiping Huang in World Development in 2010 and by W Ghardallou in the Journal of Financial Economic Policy in 2016. In this sense in finance we know that more democracy is good for financial development.