6-2005 Institutions and Growth Volatility

Apart from the human suffering it causes, growth volatility is a major factor that retards growth. Recently several studies provided empirical evidence that democratic political institutions generate less volatile growth. In the economics literature fluctuations in major macroeconomic processes, like aggregate investment, are considered fundamental factors influencing growth volatility. However, the studies on democracy and growth volatility do not provide any link between democracy and investment volatility. Here, instead of democracy, we consider another institutional variable in explaining growth volatility: we focus on the specific channel that links individualistic societies and low growth volatility. In our theoretical model, it turns out that in a collectivistic society agents choose to invest together or choose not to invest together. In an individualistic society, on the other hand, there are also some parameter values at which the agents with more wealth choose to invest while the agents with less wealth do not find it worth investing. Hence, investment volatility and consequently growth volatility are lower in an individualistic society than in a collectivistic society. This is because in an individualistic society, agents are able to reap the entire benefits of their individual investments themselves and make their investment decisions regardless of the other agent’s investment decision. Whereas in a collectivistic society, individuals are not able to reap the entire benefits of their individual investments themselves and cannot make their investment decisions regardless of the other agent’s investment decision. We test the theoretical model’s prediction by constructing a two-equation system of investment and income growth volatility, allowing various measures of individualism to influence growth volatility both directly and indirectly. Using standard controls, we importantly control for the development of democratic institutions. Based on a battery of sensitivity tests, we find individualism significantly directly and indirectly influences growth volatility negatively. We also find that, unlike individualism, democracy’s influence on investment depends on the measure of democracy and econometric specification used. ______________________________________________________________________ * We would like to thank Geert Hofstede, Cem Karayalcin, Dani Rodrik and Mehmet Ali Ulubasoglu for their many helpful comments and suggestions at various stages of this project. ** Nejat Anbarci, Department of Economics, Florida International University, University Park, Miami, FL 33186, phone: 305.348.2735; fax: 305.348.1524; e-mail: anbarcin@fiu.edu (corresponding author). Jonathan Hill, Department of Economics, Florida International University, University Park, Miami, FL 33186, phone: 305.348.2682; fax: 305.348.1524; e-mail: hilljona@fiu.edu. Hasan Kirmanoglu, Department of Economics, Bilgi University, Inonu cad., No. 28, Sisli, Istanbul 80130, Turkey; phone: +90.212.311.6329; fax:+90.212.216.8478; e-mail: hkirman@bilgi.edu.tr.