Academic journal article The European Journal of Comparative Economics

A Random Walk to Economic Freedom?

Academic journal article The European Journal of Comparative Economics

A Random Walk to Economic Freedom?

Article excerpt

1. Introduction

What causes economic growth has been a perennial question in economic theory dating back at least to Adam Smith. In response to the claim that freedom is related to economic growth, indices that measure economic freedom have been developed and the role of freedom in determining economic growth has been investigated extensively. While there is a great deal of research on the relationship between economic freedom and economic growth there are only a few studies on the underlying causes of economic freedom.

The major shortcoming in the literature is that economic freedom is often used as an independent variable but only rarely, and recently, used as a dependent variable. In this study, we wish to bridge this gap in the literature by attempting to forecast changes to economic freedom with a variety of potential determinants. Because changes to economic freedom are so poorly understood much of the literature has ambiguous results regarding the impact of economic freedom on economic growth or other characteristics. By forecasting economic freedom we can avoid endogeneity issues and establish causation instead of correlation.

To determine the causes of economic freedom we establish a modeling framework to forecast economic freedom using economic fundamentals of the underlying economy. This is notably different from other research which tries to examine the historical and cultural environments of the economies to determine their level of economic freedom. Because the historical/cultural environment is already determined, we choose to examine the evolution of economic freedom instead. Initial levels of observed economic freedom may be highly impacted by past events, cultural aspects and colonial history but what causes economic freedom to change?

Brown and Alm (2006) show that most of the world's proven oil lies in countries with less economic freedom. Is this another resource curse? Do countries with a growing mining/oil industries lose economic freedom? Cavalcanti and Tavares (2008) show that lower prices for household appliances causes an increase in the rate of female labor force participation. If countries have increased access to household appliances, or other relevant goods, then is more economic freedom demanded?

Using the Economic Freedom Index of the World from the Heritage Foundation we show that changes to economic freedom are difficult to forecast. We also see that levels of economic freedom follows a near random path. The literature suggests that economic freedom is correlated with development and economic growth. If economic growth follows a random pattern, as suggested by Easterly et al (1993), then economic freedom may also be highly random. Empirically, new methodologies have been specifically designed to test for unit roots in panel data sets. Given that we examine economic freedom from a forecasting perspective it's important that the prospect of a random walk, at least, be tested (Diebold and Killian, 2000).

With a newly designed method from Westerlund and Larsson (2012) we are unable to reject the hypothesis that levels of economic freedom follow a near random walk. Statistically significant determinants of the changes of economic freedom from one year to the next are highly dependent on model specification. This suggests that Type I error, accepting a variable as being a significant determinant of economic freedom when it is actually insignificant, is a real possibility. Additionally, statistically significant determinants to changes in economic freedom have very small coefficients and are not very economically significant.

One robust result shows that changes to economic freedom are partially reversed; countries with increases of economic freedom in one year are likely to see decreases in the next year. Even controlling for country and time fixed effects the most complete regression specification is capable of forecasting only 20% of the changes to the overall level of economic freedom. …

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