Academic journal article The Cato Journal

Economic Freedom and Financial Development: International Evidence

Academic journal article The Cato Journal

Economic Freedom and Financial Development: International Evidence

Article excerpt

This article arises from two related research programs. One examines the relationship between financial development and economic growth. The basic conclusion from this work is that countries that experience greater financial development also experience faster rates of economic growth and higher levels of income per capita (King and Levine 1993a, 1993b; Levine and Zervos 1998; Rousseau and Wachtel 1998; Levine et al. 2000; and Levine 2003). Under this umbrella also are studies that test for the role of property rights and regulation on financial development. Shehzad and De Haan (2008) find that financial liberalization--a reduction in regulations--reduces the probability of a banking crisis and, therefore, promotes economic growth. Baier et al. (2012) find that countries with relatively low levels of regulation--more economic freedom--are less likely to experience a financial crisis in the near future (five years out) than countries with more regulation. Like De Haan et al. (2009), Baier et al. find that in the period immediately following a crisis there generally is a diminution of economic freedom that steins from increased regulation, portending slower economic growth in the future.

The other line of research investigates the institutional sources of economic growth. In addition to physical and human capital, researchers have considered a number of institutional factors as diverse as colonial background and religious preferences (overviews can be found in Sala-i-Martin 2002, Barro and Sala-i-Martin 2004, and Loayza and Soto 2002). A number of studies also have employed indexes of economic freedom to proxy for the socio-economic institutions that may affect economic growth. The weight of evidence from this work suggests that countries with higher levels of economic freedom experience faster economic growth (Gwartney et al. 2006, Weede and Kampf 2002, Weede 2006).

The question addressed in this article is whether greater economic freedom leads to a higher level of financial development. While there is evidence that more economic freedom is associated with improvements in credit allocation at the micro level (Hartarska and Nadolnyak 2007, Crabb 2008, Enowbi-Batuo and Kupukile 2009) and to better sovereign credit ratings (Roychoudhury and Lawson 2010), there does not appear to be any study that explicitly tests for the link between economic freedom and financial development.

The next section discusses the methodology and data used. It considers the role of economic freedom within the framework used by Levine et al. (2000) to explain the development of financial intermediaries across countries. Regression results are presented in the third section followed by a concluding section. Looking ahead, the results of this article do not reject the hypothesis that countries with higher levels of economic freedom are more likely to experience greater development of their financial intermediaries in subsequent years. Given previous research, this article thus identifies a path through which improving social institutions ultimately affect economic growth.

Methodology and Data

To assess the role that economic freedom plays in explaining differences in financial intermediary development across countries, I adopt the approach used by Levine, Loayza, and Beck (2000; hereafter, LLB). To explain observed differences in financial intermediary development, LLB estimate the regression

(1) [FINANCE.sub.i] = [alpha] + [beta]1 [LEGAL.sub.i] + [beta]2 log ([RGDPCAP.sub.i]) + [[epsilon].i]

where FINANCE represents a measure of financial development for the ith country, LEGAL represents the origin of the ith country's legal system, RGDPCAP is the ith country's per capita real GDP in the initial year of the sample period, [alpha] and the [beta]s are parameters to be estimated, and [epsilon] is the error term. Because the financial measures used in LLB are averages for the period 1960-95, initial per capita real GDP is the value in 1960. …

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