Saturday, September 19, 2009

A Risk Argument: Democracies versus Dictatorships

A few days ago, Tom Friedman, the columnist for the New York Times, and best-selling author of books on globalization, evoked controversy when he opined that "one party autocracy" is not too bad if it is led by a "reasonably enlightened group of people, as China today". To be honest, I have never found Friedman's work to be particularly thought provoking, nor do I much care for his characterizations of globalization: flat earth, fat earth, round earth, whatever.... . However, his article did start me thinking about whether businesses face less risk or more risk in a democracy than in a dictatorship.

As a generalization, there is more day-to-day uncertainty when dealing with a democracy than with a dicatorship. A democratically elected government can offer policies that are favorable to business, but may either not be able to deliver them legislatively or have to modify them to meet public consent. A dictatorship operates under no such constraints and can deliver on its promises, albeit at substantial cost to some segments of its population. Furthemore, the nature of democracy is that governments change and policies change with them. The flip side is that dictatorships do not last forever, and a benign dictator today can become malignant one in the future. Policies can then be turned on their head and today's favored businesses may fall out of favor tomorrow.

The choice between democracies and dictatorships, in my view, boils down to whether you prefer to deal with the continuous, ongoing risk of operating in a democracy or the discontinuous risk of operating in a dictatorship. The former will manifest itself in a chaotic environment of changing rules, fiscal and monetary policies and exchange rate regimes. The latter may show up in periodic upheavals in policy, nationalizations (real or quasi) and a requirement that you pay due respects (or more) to policy makers.

I have argued in my book on strategic risk taking that it is far easier to deal with continuous risk than discontinuous risk for two reasons.

1. The first is that market traded instruments work better at dealing with continuous risk, whereas insurance, often imperfect, is the tool you need for discontinuous risk. To illustrate, compare floating exchange rates to fixed exchange rates. The former create more day-to-day uncertainty for businesses but is eminently hedgeable using options or futures contracts. The latter allows for long periods of stability, interspersed with sudden revaluations and devaluations of currencies, much more difficult to hedge.

2. Managers of firms in the (artificially) stable environments created by dictatorships are lulled into a false sense of complacency and are completely unprepared for the risks that inevitably follow. Managers of firms in chaotic environments learn to cope with change, one reason why I think these companies may have a competitive edge in the more uncertain global economies of the future.

Friedman's arguments are not new. Mussolini's supporters initially thought of him as benign and argued that he made the trains run on time, an incredible accomplishment in Italy. In later years, they discovered his dark side. I do not trust any group of people, no matter how well trained and intentioned, to make decisions for me for the rest of eternity. So, I come down on the side of democracy, chaotic and frustrating though it may be, because I can manage its risks better (both as an individual and a business) than I can in a dictatorship. We will have a ring side view of this tussle, and the strengths and weaknesses of both systems, as we watch the Indian and Chinese economies struggle for dominance over the next few decades.


Steve Nunez said...

Interestingly, I also had a few comments on Friedman's article, for once (mostly) agreeing with him.

Where he gets it wrong I think is in using China as an example. I would suggest that Singapore is a much better example of a one-party autocracy that works.

Granted, whether or not the future Singapore will remain benevolent is uncertain, but in many ways this self-perputating system is more stable than many multi-party systems.

Take Costa Rica for example, who's democratically elected government signed oil exploration leases, only to have the opposition renege as a political expediency.

I'd argue that, in many of the Western democracies, you have greater discontinous risk due to the opposition reversing previous policies, no matter how good those policies were, simply to gain a few points with their constituency.

- Steve

Aswath Damodaran said...

Fair enough, but rather than use anecdotal evidence - Singapore, after all, is your best case scenario - I think that we need to examine the empirical record of businesses in both systems across long periods and across many countries. The data may be scanty but the question is a very important one.

Steve Nunez said...

Of course we'd all like to have evidence of the effectiveness of various forms of government, however I'm unaware of any empirical measures. Certainly willing to look at all thesis in that regard. Being on the commercial side of this equation, I'd welcome the evidence that the academics can bring to the table.

I'd love to see some hard data on this question, as I think it's quite important in this day and age.

Aswath Damodaran said...

It is actually not a difficult empirical question to answer but it has not been dealt with seriously because it falls in an area between two disciplines - political science and economics. The former has generally paid only lip service to the economic impact of political systems and generally focused on freedom and general welfare. The latter has been so focused on market data that any economy without market data - pretty much all of the dictatorial regimes until recently - has been ignored. That is changing.

Hari said...

Very interesting post, Prof. However, I wonder how much of this is to do with stability rather than the type of governance. An unstable dictatorship does not provide the environment for business to grow. Neither does an unstable democracy.

We have seen that unstable governance structures of different types (Oman - Monarchy, Pakistan - dictatorship, India in 1997-99 - democracy) have not nurtured their respective economies in spite of good intentions by the then rulers.

However, for comparable stable periods, I agree with your view that Democracy is better than dictatorship, economically.

Unknown said...

Unknown said...

Professor Aswath,

First of all, my respects and admiration from Caracas, Venezuela. I've a fan of finance, and of course, I'm also a fan of you and your books. Certainly, the best books about valuation I've ever read.

This post is particularly useful and applicable for Venezuela. The fixed exchange part is a mirror situation of we live right now here...

Thanks for sharing