Explaining the non-Linear Relationship Between Money Creation and the Rule of Law with a Threshold Approach (PSTR)

One tool to achieve macroeconomic goals is to control the volume of liquidity. There are two views on the control of liquidity volume. The first view argues that good governance and commitment to the laws for money creation hinder increasing  and uncontrollable volume of money. This view emphasizes the important role of institutions in controlling or growing liquidity. So, one of the reasons for the growth of liquidity is rooted in the laws and the extent of the rule of law of the countries. The second view suggests how the creation of money affects the rule of law and its influence channels. Long-term mismanagement of money has sudden and unpredictable effects and leads to institutional and sometimes fundamental change. The purpose of this article is to explain the non-linear relationship between money creation and the rule of law. For this purpose, the panel model with a threshold approach (PSTR) has been used, based on the data of the countries having oil reserves during 2002-2020. Based on the results, the variables of money creation and rule of law have negative relationships with each other, and the results confirm the acceptance of both views. In other words, the creation of money and its consequences changes and weaken the rule of law through various channels. Also, the weakness of laws in oil countries leads to the growth of money creation. Therefore, one of the causes of the weakness of the rule of law in these areas should be sought in the creation of money and its consequences. Moreover, the growth of liquidity is affected by the weakness of the rule of law in the growth or control of the amount of liquidity.

In the early models of economic growth, the role of saving and investment was emphasized. In the next models, factors such as the growth of knowledge and technology, human skill and business growth were taken into consideration. In the last few decades, the role of non-economic factors such as democracy (Sen, 1999) and institutions (North, 1990; Acemoglu, 2004) on economic growth has been emphasized. Acemoglu et al. (2005) argue that the distribution of resources and the distribution of power have dominant effects on the growth path of countries precisely through their effect on economic institutions such as property rights (Hartwell, 2018). From this point of view, it is political institutions that affect economic variables.
On the other hand, extreme behavior by economic institutions, whether during or in the acceleration of a crisis, may in turn disrupt or determine political institutions and their subsequent paths and quickly change the status quo in a destabilizing manner. Periods of crisis and periods of severe inflation have the ability to impose changes in the distribution of power throughout society, and as a result, change political institutions. Even more "normal" economic disturbances may change bargaining strategies and political coalitions, and transform a country's political institutions (Hartwell, 2018). From this point of view, the economic institution of money will have an effect on political institutions (Money affects political institutions)
Based on this, the present study, while examining the relationship between money creation and the rule of law, and how these two affects each other, seeks to examine two perspectives. The first perspective believes that the rule of law prevents the expansion of the money supply. Therefore, the reason for the growth of liquidity should be investigated in the laws and the extent of rule of law. In other words, the weakness of the rule of law causes the growth of liquidity. Another perspective emphasizes the issue of money creation and its benefits and examines how money creation affects the rule of law and its influence channels. If we look at money as a receipt for production, it means that the people of a nation determine GDP by producing and creating wealth and receive a receipt in the form of money in return for their share in it. Next to this group, there is another group (governments and bankers) who have the power to create money (or those who are given money created by the choice of the government and banks) and when dividing GDP, next to the first group own part of the production. This is the effect of money creation on property rights and consequently on the rule of law.

In this research, the bilateral and non-linear relationship between money creation and the rule of law is investigated among selected oil-abundant countries during 2002-2020 by using the Panel Smooth Transition Regression Models (PSTR).
To investigate the mutual effects of rule of law and money creation, two models were considered. In the first model, the rule of law index was considered as a dependent variable, and in the second model, broad money growth (annual %) was considered as a dependent variable. Control variables according to previous studies include oil rents (% of GDP), economic growth (GDP growth), trade openness, urban population growth, quality of regulations and abundance of natural resources.

The linear part confirms the negative and one-way causality relationship from money creation to the rule of law. The estimation results of the non-linear part of the model confirm the existence of a negative relationship between money creation and the rule of law, and confirm the bilateral causality relationship between the two. In other words, the results show that the creation of money is a factor to weaken the rule of law and the weakness of the rule of law has also caused the growth of liquidity.

The results confirm the existence of a negative relationship between money creation and the rule of law, as well as the bilateral causality between these two variables. In other words, the results show that the creation of money and its benefits change and affect the rule of law through various channels. Also, the weakness of rule of law in oil countries leads to the growth of money creation. Based on the results, it is suggested that the oil governments provide space for investment and free trade by shrinking their bodies, and with commercial freedom and the development of financial markets, and by directing foreign exchange income and stray liquidity to the real sector of the economy in a targeted manner. It is also suggested that the oil countries manage their liquidity by reforming the monetary system and the banking sector, and defend private property and the rule of law by preventing the transfer of ownership that occurs through money creation and inflation. This can provide more opportunities for the private sector. The prosperity of the private sector and the increase of competition in different economic sectors and the use of economic freedom policies lead to more dynamism of the economy.