Economic Growth and Freedom: A Causality Study

By Vega-Gordillo, Manuel; Alvarez-Arce, Jose L. | The Cato Journal, Fall 2003 | Go to article overview
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Economic Growth and Freedom: A Causality Study

Vega-Gordillo, Manuel, Alvarez-Arce, Jose L., The Cato Journal

Each year the Fraser Institute and the Heritage Foundation (in conjunction with the Wall Street Journal) publish indexes of economic freedom, while the Freedom House publishes an index of political freedom around the world (Gwartney and Lawson 2002; O'Driscoll, Holmes, and Kirkpatrick 2002; Freedom House 2001). The explanations and graphs in those reports illustrate the relationships between each of the indexes and relevant socioeconomic variables such as GDP growth, life expectancy, and measures of human development. What the annual reports suggest is that there is a positive relationship between economic freedom and the standard of living, as well as between economic growth and political freedom.

Although such assertions would appear to be intuitively correct, the reports do not undertake any rigorous empirical tests to provide scientific support to such relationships. The empirical analyses existing in the literature afford more or less clear, but inconclusive, results. They highlight the positive impact of economic freedom on growth, (1) or the ambiguous relationship between growth and political freedom. Fewer studies have been published on the association between the two types of freedom, but much attention is paid to the hypothesis of both being mutually enhancing.

Such conclusions are open to criticism. Generally speaking, they depend on the choice of methodology and sample size. Moreover, a series of control variables must be included in the model for the analysis to be robust. In other words, there is a need for data on a broad range of variables, for a considerable number of countries, over a long period of time--a task whose complexity should not be under-estimated. Indeed, in many cases we are obliged to work with a small sample of countries and a small set of time observations. This problem conditions the methodology to be used (Judson and Owen 1999). Under such circumstances, any new contribution on the subject is welcome, as bar as it can offer additional evidence on the behavior of these variables and contribute to suitable institutional reform. It is along these lines that our study is intended.

Our study adopts the general approach previously taken by Farr, Lord, and Wolfenbarger (1998), hereafter FLW, although with a different econometric technique. We do not try to analyze the variables relevant to economic growth, (2) but rather to discern the causal relationships existing among economic freedom, democracy, and growth. With this aim in mind, we have structured the article as follows. First, we provide a review of what we regard to be some key ideas in the existing research on the relationships among the three variables. Second, we define economic and political freedom and briefly explain the most relevant ingredients used to build the indexes to measure them. Third, we develop the model we use to study and analyze the different associations and statistical relationships between the variables, and we succinctly explain the methodology. Finally, we examine the results and set out our conclusions.

Democracy, Economic Freedom, and Growth: The Question of Causality

As North (1990) has pointed out, a society's institutional framework seems to play an instrumental role in the long-term performance of its economy. As appropriate data have become available, empirical researchers have added economic freedom, democracy, and other institutional variables to the set of potential determinants of economic welfare. More specifically, many studies attempt to identify the variables that determine economic growth and how they do so. But some interesting questions remain, as the following review of the relevant literature will show.

A significant body of research indicates that economic freedom enhances economic growth. Baumol (2002) stresses that the free-market economic system acts as a powerful innovation machine--a fundamental driving force behind growth processes--in societies where the rule of law prevails.

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