The role of ethnic diversity in influencing economic growth BACHELOR THESIS WITHIN: Economics NUMBER OF CREDITS: 15 ECTS PROGRAMME OF STUDY: International Economics Tutor: Pia Nilsson and Helena Nilsson AUTHORS: Ruslan Gatykaev and Bogdan Voronetskyy JÖNKÖPING August 2018 Bachelor Thesis in Economics Title: The role of ethnic diversity in influencing economic growth Authors: Ruslan Gatykaev and Bogdan Voronetskyy Tutor: Pia Nilsson and Helena Nilsson Date: 2018-08-29 Key terms: fractionalization, diversity, index, economic growth Abstract While previous research largely finds a negative relationship between ethnic diversity and economic growth for the period of 1960-1980, less is known about how this link holds for the recent decades. The aim of this paper is to explore whether the connection between ethnic diversity and economic growth changes when the sample includes the data from 2000s and the measure of ethnic diversity is updated accordingly. We also check the robustness of the new relationship with an index of ethnic diversity employed by previous research. In a large cross- country panel, we find that ethnic diversity no longer contributes negatively and significantly to economic growth. i Table of Contents 1. Introduction ......................................................................... 1 2. Theory .................................................................................. 3 2.1 Previous research .................................................................................. 3 2.2 Channels that link economic growth and ethnic diversity ....................... 4 2.3 Negative outcome links .......................................................................... 5 2.3.1 Conflict ................................................................................................... 5 2.4 Positive outcome links ........................................................................... 6 2.4.1 Trust ....................................................................................................... 6 2.4.2 Misallocation of labor ............................................................................. 6 2.5 Ethnic fractionalization within economic growth framework ................... 7 3 Background ......................................................................... 9 3.1 Outline of definitions .............................................................................. 9 3.2 Measuring diversity ................................................................................ 9 3.3 Brief history on development of diversity indices ................................. 10 3.3.1 Ethno-Linguistic Fractionalization Index (ELF) ..................................... 10 3.3.2 Ethnic, Linguistic and Religious Fractionalization (Alesina et al. 2003) 11 3.4 Updated Ethnic Fractionalization Index ................................................ 12 4 Empirical framework ......................................................... 14 4.1 Data ..................................................................................................... 14 4.2 Variables .............................................................................................. 14 4.2.1 Dependent variable .............................................................................. 14 4.2.2 Independent variables .......................................................................... 15 4.3 Data summary ...................................................................................... 16 4.4 Descriptive statistics ............................................................................ 17 4.5 Correlation matrix ................................................................................. 18 4.6 Assumptions ........................................................................................ 18 4.7 Model selection .................................................................................... 18 4.8 Estimated model .................................................................................. 19 5 Results ............................................................................... 24 5.1 Updated Ethnic Fractionalization ......................................................... 24 5.2 Ethnic fractionalization (Alesina et al. 2003) ........................................ 25 5.3 Interpretation ........................................................................................ 27 6 Analysis ............................................................................. 28 7 Limitations ......................................................................... 31 8 Conclusion ........................................................................ 32 9 Reference list .................................................................... 33 10 Appendix I ......................................................................... 38 11 Appendix II ........................................................................ 49 12 Appendix III ....................................................................... 50 13 Appendix IV ....................................................................... 51 ii 1. Introduction An established way of measuring economic development of a country is GDP per capita (McDowell, 2012). When measuring economic development, the majority of studies rely on purely economic variables such as investment or the existing stock of capital that have a proven impact on GDP per capita (Harrod, 1939; Solow, 1956). However, it is perhaps not entirely correct to believe that they are the only underlying reasons behind the economic growth of a country (Alesina et al. 2003). Hence, additional, not strictly economic variables are sometimes added to studies to accompany existing economic models with the aim of providing additional insights into a topic. These variables can vary greatly in nature, they can be of political origin like quality of government, or historical, like colonial ties (see Olson, 1993; Stoler, 2001). This thesis considers closely one of such non-economic variables, namely ethnic diversity. Ethnic diversity is an important social factor that indirectly affects growth through other intermediate variables, with examples such as government policy decisions, quality of institutions and levels of internal conflict (Collier, 2000; Alesina et al. 2003; Montalvo & Reynal-Querol, 2005). The influence of ethnic diversity on economic growth is of interest for several reasons. The question of whether this diversity positively or negatively affects economic growth is a highly disputed question among researchers (Bove & Elia, 2016). This topic is a growing field of study that has only relatively recently received serious attention from researchers and seen a growing body of research emerge (Posner, 2004; Bossert et al. 2011; Gören, 2014). However, most widely accepted previous research investigated three decades of 1960s, 1970s and 1980s (see Alesina et al. 2003). This time period captured much of the decolonization, Cold War and breakup of the USSR, all three events associated with conflict, civil wars and general instability (Suny, 1993; Gleditsch et al. 2002). Countries remained largely ethnically unchanged during the time period investigated by previous research. Migration at that time occurred on a much smaller scale, given that there were several barriers that are not as prevalent today. Countries were separated by democratic versus communist ideology, and political allegiance of a particular citizen was a big concern for immigration authorities, this made emigration 1 from communist to democratic countries, and vice-versa, very difficult. Another barrier, the iron curtain was also in place, outright prohibiting emigration from the Soviet bloc. In addition, emigration was simply more expensive due to more expensive international travel. We have reasons to believe that the ethnic composition of societies has changed substantially since the time period under consideration by previous research. For one, the means of transportation have improved. Border policies and international environment have become more open since the decades included in previous studies. This has led to mass migration which brought about change in the ethnic composition of modern societies, societies have become more diverse (Castles, 2013; Collier, 2013; Bove & Elia, 2016). This is the reason why we calculate an updated index of ethnic diversity using more modern data on ethnic composition, to capture the changes in diversity that occurred and we expect the world to be more diverse than it was. The aim of this thesis is to investigate a more modern time period to examine the relationship between ethnic diversity and economic growth in terms of GDP per capita. This can be useful for policy-makers and politicians, especially in Europe with the recent influx of refugees. The chosen measure of diversity is the index of fractionalization. We update the index using data from Encyclopaedia Britannica, CIA World Factbook, and Census bureaus. Neoclassical growth model is used as a theoretical base to test the role of diversity indices in influencing economic growth. We are investigating a large sample of 217 countries for the period of 2003-2015, hence a panel approach is used. The results indicate that ethnic diversity does not play a significant role in determining economic growth in terms of GDP per capita. The result has been checked for robustness by the use of an index previously employed by Alesina et al. (2003). 2 2.