Economic growth and freedom: a causality study.

• Author: Vega-Gordillo, Manuel

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. Dutz and Hayri (2000) find a high correlation between long-term growth and effective enforcement of antitrust and competition policy. FLW (1998) discover a Granger-causal relationship working from economic freedom to economic well-being. Barro (1997) furnishes empirical evidence supporting the idea that free markets and maintenance of property rights foster economic growth. However, not all the literature is so conclusive. Haan and Sturm (2000) maintain that economic freedom brings countries to their steady state level of economic growth more quickly, but does not increase the rate of steady state growth. Haan and Siermann (1998) offer an even more skeptical view: according to these authors, the positive effect of economic freedom on economic growth is not robust, but depends on the indicator of economic freedom used.

The connection between political freedom and either economic freedom or economic growth is much more controversial. FLW (1998) find no evidence of causal relationships working between both freedoms. Friedman (1962) believes that democracy and economic freedom are mutually reinforcing. Under this hypothesis, democracy should facilitate economic growth through the development of an institutional framework more compatible with incentives to engage in productive transactions. In other words, democracy is the political system that allows markets to perform adequately. In his discussion of this question, Rodrik (2000) reaches a suggestive empirical conclusion: participatory democracies favor what he calls "higher-quality growth": more predictable long-term growth rates, greater short-term stability, better resilience to adverse shocks, and a more equitable distribution of wealth. The implication is that democracy helps build better institutions because it works as an efficient meta-institution for eliciting and handling local knowledge.

Democratic institutions can foster growth in a variety of ways. Przeworski and Limongi (1993) hypothesize that democracy should positively influence economic growth through better protection of property rights, which promotes savings and investment. Rodrik's (1999) results indicate that participatory and democratic institutions cushion the impact of negative external shocks on economic growth. Svensson (1999) finds that the long-term impact of international aid on growth depends on the political and civil liberties in the host country. In particular, aid tends to have a positive impact on growth only in countries with democratic governments. But Svensson (2000) and Knack (2001) also provide some evidence that higher aid levels erode institutional quality, as measured by indexes of bureaucratic quality, corruption, and the rule of law.

Mauro (1995) shows the extent to which corruption hinders economic growth. Del Monte and Papagni (2001) provide further evidence in support of this premise. They also point out that corruption may be relevant in underdeveloped countries where society lacks democratic control over government, a possibility investigated by Paldam (2002). According to his results, democracy seems to decrease corruption, and lower corruption rates may provide for higher growth, but the effect is slight and fragile. He also suggests the potential for rent-seeking is large in countries with highly regulated economies--that is, with little economic freedom. The countries also tend to have high corruption, although that link is not clear for Bliss and Di Tella (1997) who present a microeconomie model that shows that increased competition may not reduce corruption.

Democracy is thought to promote gender equality and foster female education, which tends to promote growth by increasing human capital. For instance, Behrman et al. (1999) test the hypothesis that increases in female literacy also enhance the human capital of the next generations. They conclude that, during the green revolution in India, a significant and positive relationship between maternal literacy and childhood schooling reflected the productivity effect of home schooling. Moreover, as Barro (1996) explains, female education reduces fertility and infant mortality, paving the way for increases in growth.

Despite the fact that political freedoms are a fundamental component of human development, social scientists are also aware of the growth-hindering aspects of democracy. Majority suffrage tends to redistribute income and reduce efficiency. Democratic governments that try to maximize tenure must respond to popular demands for greater consumption and spending. Representative legislatures allow well-organized interest groups to lobby and legally appropriate resources at the expense of society as a whole. (3) In their interesting study, Tavares and Wacziarg (2001) find that democracy hinders growth because it reduces investment in physical capital and also because it raises...