The contribution of economic freedom to world economic growth, 1980-99.

• Author: Cole, Julio H.

Since 1986, a group of researchers associated with the Fraser Institute have focused on the definition and measurement of an internationally comparable index of economic freedom (Easton and Walker 1992; Gwartney, Block, and Lawson 1996). This work has resulted in the development of a numerical index that now ranks 123 countries in terms of their degree of economic freedom, as measured by a composite of 38 indicators grouped in five major categories: size of government, legal structure, monetary and banking policy, international trade, and regulation (Gwartney and Lawson 2002). One important finding is that the degree of economic freedom, as measured by the Economic Freedom of the World (EFW) index, is highly correlated with both the level and the rate of growth of real per capita GDP (Table 1).

These comparisons, though striking, nonetheless suffer from two limitations: they are simple two-variable correlations, and they are average results for groupings of countries.

Analyzing the results for countries grouped in quintiles averages out much of the actual dispersion in the data, and ignoring the effect of other explanatory variables biases the results due to an "omitted variables" effect. The purpose of this study is to evaluate the incremental explanatory power of the EFW index in the context of more general models of economic growth. The period chosen for study is 1980-99, and the economic growth regressions are estimated for a sample of 106 countries. (1)

Convergence and Economic Freedom

At first glance, the results in Table 1 seem to contradict at least some aspects of neoclassical growth models, since the high EFW countries are not only richer than low EFW countries but also grow faster, contrary to the "convergence" predictions of the standard models, which imply that high-income countries will tend to have lower rates of growth due to diminishing returns on physical capital (Solow 1956). However, these two effects are not necessarily mutually exclusive. In principle, both effects can hold because, as Barro and Sala-i-Martin have pointed out, the convergence effect is actually a ceteris paribus prediction (Barro and Sala-i-Martin 1992, Barro 1994, Sala-i-Martin 1996). What the neoclassical models predict is that, other things being equal, countries with higher initial income will have slower growth, and vice versa.

Therefore, a direct test of the existence of both effects would be to regress the growth rate of real per capita GDP against (1) the log of initial-year PPP-adjusted per capita GDP, (2) the EFW index, and (3) a set of additional explanatory variables, as suggested by some prior theoretical framework. The convergenee effect predicts that the first variable should have a negative coefficient, and the interpretation of the regression is straightforward: Other things being equal, (1) if two countries have the same level of economic freedom, as measured by the EFW index, the country with the higher initial income will tend to have a lower growth rate due to the convergence effect; (2) if two countries start out with the same income level, the country with more economic freedom will tend to grow faster.

The usefulness of the EFW index as an explanatory variable for economic growth can be evaluated by examining its performance under different model specifications. One possibility is to include EFW in a growth regression based on the augmented Solow growth model (Mankiw, Romer, and Weil 1992; Knight, Loayza, and Villanueva 1993). Models following this approach usually include initial income, investment share in GDP, a measure of population growth, and some measure of human capital. Another option is to include EFW in a simplified version of a model recently proposed by Gallup, Sachs, and Mellinger (1999), explaining per capita income growth in terms of the convergence effect and three geographic variables. Estimating the effect of EFW in the context of these two different models is quite a strong test of robustness for this variable, because it would be hard to imagine characterizations of the growth process that differ as much as these do. If it turns out that EFW is significant in both regressions, then one could conclude that economic freedom is indeed a significant factor in economic growth, regardless of...