Regional Instability and Economic Growth: Thy Neighbor's Curse

We show that regional instability defined as political instability in neighboring countries has strong negative effects on a countrys income per capita growth rate. The magnitude of this negative externality is found to be equivalent to the effect from an identical increase in domestic political instability. We find that there are three main channels in which regional instability hurt growth. First regional instability disrupts trade flows. The shares of merchandise and manufactured trade are substantially lower in countries with high regional instability. Second regional instability require increases in military outlays at the expense of other productive activities. Third the composition of investment is found to be skewed against the share of equipment investment in countries with high regional instability. To the extent that equipment investment has a higher social rate of return than transport or structure investment this shift can reduce aggregate returns to capital and hamper growth. (authors)