Economic Development as a Matter of Political Geography

We start out from the hypothesis that limited government leads to low uncertainty and low transaction costs. If political institutions affect the degree of uncertainty and transaction costs, we formally show they should affect the steady state level of income per capita. The impact of uncertainty and transaction costs on income per capita is formalized in a simple capital market model with credit constraints. Empirically, we find increases in political constraints precede economic growth, which is in line with the idea that economic development is driven by political development. Furthermore, only when there are high political constraints is polity persistence positively related to income per capita. We interpret these findings in the sense that limited government is the path towards economic development, being a pre-condition for poor countries to converge towards rich countries.