Academic journal article The Cato Journal

Economic Freedom, Institutional Quality, and Cross-Country Differences in Income and Growth

Academic journal article The Cato Journal

Economic Freedom, Institutional Quality, and Cross-Country Differences in Income and Growth

Article excerpt

In the past few decades, the issues in the literature on economic growth have broadened from the development of general theories of growth, largely based on Solow (1956), toward an examination of why there are differences in growth rates across countries, and why some countries continue to grow while others stagnate at low levels of income. This study takes an institutional approach and uses a recently developed measure of institutional quality, the Economic Freedom of the World (EFW) index (Gwartney and Lawson 2003) to examine the issue of cross-country differences in income levels and growth rates. The emphasis on the importance of institutions to economic prosperity goes back at least to Adam Smith (1776), and has been found in the more recent work of Olson (1982), Scully (1988), North (1990), Barro (1996), Barro and Sala-i-Martin (1995), Landes (1998), Hall and Jones (1999), and Acemoglu, Johnson, and Robinson (2001). Despite this interest in institutions, much work on economic growth treats institutions peripherally if at all.

One challenge to the institutional approach is to find a way to quantify the quality of institutions. The EFW index used here is a measure of institutional quality and, to the extent that higher EFW ratings lead to more rapid growth and higher income levels, it provides insight into the characteristics of an environment conducive to prosperity. The results show that better institutions lead to higher income, and that institutional improvements result in higher rates of economic growth.

Three Explanations of Cross-Country Differences in Economic Performance

Over the past decade, the economics literature has offered three different types of explanations for the differences in income levels and growth rates across countries. The most well-established explanation in the literature takes a production function approach based on the work of Solow (1956). The second approach explains differences in income and growth across countries as a function of institutions, and is represented by the work of North (1990) and Landes (1998). A third type of explanation, promoted by Sachs (2003), points to the effects of geography and location as determinants of growth and income.

The production function approach views output (Q) as a function of capital (K) and labor (L), such that Q = f(K,L). Within this framework, output is increased by increasing the amount of inputs (K and L), and by technological improvements that alter the production function so that more output can be produced with the same amount of inputs. This approach focuses on increasing human and physical capital, and on technological progress through, for example, research and development. This explanation suggests that higher growth rates can be generated by increasing inputs into the production function, and by discovering ways to employ those inputs more productively.

The institutional approach to growth is based on the idea that both the availability and productivity of resources will be influenced by the institutional and policy environment. While there is some debate about the exact characteristics of the institutions that are most appropriate for economic growth and prosperity, there is considerable agreement that secure property rights are crucial, and that the impediments to exchange must be minimal. Institutions and policies are reflective of government actions. To promote economic growth, governments must not only follow actions that are supportive of secure property rights and freedom of exchange, they must "also make a convincing and credible commitment that the policies will be maintained in the future. Public policy must be designed to implement what Mancur Olson (2000) has referred to as "market-augmenting government." (1)

A third approach to identifying factors that lead to prosperity looks at geographical factors. During the last several years, Jeffrey Sachs has promoted the idea that geography and location are major determinants of cross-country differences in income levels and growth. …

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