Economists have examined the effects of economic freedom on economic outcomes such as growth, income inequality, and quality of life. Yet, economists have not examined one of the chief criticisms of market capitalism: unstable growth. In this paper I examine the link between market capitalism, as measured by an economic freedom index, and short run macroeconomic performance. Regression results provide no evidence that economic freedom increases fluctuations in the business cycle, but instead support the hypothesis that economic freedom decreases these fluctuations. Economic freedom appears to not only raise material standards of living, but also to mitigate fluctuations around those standards.
Modern bourgeois society with its relations of production, of exchange and of property, a society that has conjured up such gigantic means of production and exchange, is like the sorcerer, who is no longer able to control the powers of the nether world whom he has called up by his spells.... It is enough to mention the commercial crises.... In these crises there breaks out an epidemic that, in all earlier epochs, would have seemed an absurdity--the epidemic of over-production. Karl Marx and Friedrich Engels, Manifesto of the Communist Party, 1848. ... your system was liable to periodic convulsions.... these business cataclysms became more frequent, till, in the latter part of the nineteenth century, there were two years of bad times to one of good.... If you would see how needless were these convulsions of business ... and how entirely they resulted from leaving industry to private and unorganized management, just consider the working of our [centrally-planned] system. Dr. Leete to Julian West in Edward Bellamy, Looking Backward: 2000-1887, 1888. Critics of market capitalism levy many charges. Market allocation of resources and private ownership of property are blamed for many social and economic ills ranging from the concentration of economic power in the hands of "big business" to environmental degradation, and from income inequality to the vicissitudes of the business cycle.
Economists have addressed many of these charges. As Friedman (1962) argues, market capitalism disperses economic power rather than concentrating it. Using indexes of economic freedom as quantitative proxies for market capitalism, economists have addressed other concerns as well. Norton (1998b) provides evidence that secure property rights, a key component of aggregate economic freedom, increase the share of a country's population with safe water and sanitation while also raising life expectancy. Eposoto and Zaleski (1999) corroborate Norton's findings on the link between economic freedom and life expectancy and add that economic freedom is also associated with higher literacy rates. Other research provides evidence that economic freedom reduces poverty (Norton 1998a) and income inequality (Berggren 1999, Scully 2002) and may also reduce the gap between male and female life expectancy (Mixon and Roseman 2003). Moreover, an impressive body of research indicates that economic freedom leads to higher rates of economic growth and higher per capita incomes (Olson 1996, Farr, Lord, and Wolfenbarger 1998, Wu and Davis 1999, Gwartney, Lawson, and Holcombe 1999, Heckelman 2000). (2)
Yet, economists have barely begun to investigate the effects of economic freedom on short run macroeconomic performance. Questions of macroeconomic stability may lack the gravity they did when the Great Depression held sway, making Marx and Engel's predictions of capitalism's ultimate collapse seemly apparent. Nevertheless, economists, politicians, and the general public remain concerned about short run economic performance. For academic economists, the topic is of keen interest. Mankiw (1990) in his article titled "A Quick Refresher Course in Macroeconomics," focuses entirely on short run macroeconomic issues and questions, (3) and papers in a 1997 American Economic Association session titled "Is There a Core of Practical Macroeconomics That We Should All Believe?" are almost wholly concerned with short run economic fluctuations and policy responses. (4) Bolch (1998) remarks that "the perfectionist Keynesian vision remains so taken for granted in the vast majority of undergraduate macroeconomics courses, government control of the business cycle is treated as both proper and efficacious" (495).
Despite this broad concern, the effect of economic freedom on economic fluctuations has received little attention. In a specific analysis of equity market liberalization and capital market openness, Bekaert, Harvey, and Lundblad (2004) find no evidence that financial market liberalization raises consumption variability and that, if anything, depending upon model specification, it reduces consumption variability at statistically significant levels. Similarly, Davidson (2005) examines stock market returns from 65 countries from December 1996 to December 1998 and finds that the Asian financial crisis was not the result of contagion, but rather of rational investors who attacked the currencies and financial markets of countries with mismatched (inconsistent) economic and political-civil freedoms, and managed or pegged exchange rates.
At a more general level, Stiglitz (2002) blames adoption of the "Washington Consensus," (5) for a wide array of economic ills. In particular, he blames the Washington Consensus for bubbles, capital flight, a credit crunch, and depression in East Asia. Lindsey (2002) offers a differing perspective, consistent with that of Davidson, arguing that underdeveloped markets and bad government policies, including cronyism, industrial policy, a lack of transparency, bank-dominated finance, pegged exchange rates, and IMF policies are to blame for the East Asian collapse.
The objective of this paper is to examine the effect of economic freedom on short run macroeconomic performance using a cross section of countries from 1970 to 2000. I find no evidence that economic freedom leads to less stable macroeconomic performance, as measured by the standard deviation of per capita real GDP, and instead find strong support for the hypothesis that economic freedom leads to more stable macroeconomic performance.
Before examining this evidence, I briefly explain economic freedom as a theoretical concept and measured variable. Next, I turn to theoretical arguments to explain the link between economic freedom and short run macroeconomic performance. After explaining the data and methodology, I examine regression results that test the direction and significance of the link between economic freedom and economic stability. I offer some final thoughts in the conclusion.
The Meaning and Measure of Economic Freedom
In simple terms, economic freedom is a conceptual measure of the private ownership and market allocation of resources, in lieu of government ownership and control. Expressing the sentiment of many, including the originators of the economic freedom index, Berggren (2003) defines economic freedom as "the degree to which an economy is a market economy--that is, the degree to which it entails the possibility of entering into voluntary contracts within the framework of a stable and predictable rule of law that upholds contracts and protects private property, with a limited degree of interventionism in the form of government ownership, regulations, and taxes" (194). Similarly, in their definition of economic freedom, De Haan, Lundstrom, and Strum (2006) emphasize personal choice, private property, and freedom of exchange. They add that economic freedom entails well-defined and limited roles of government: to establish and protect property rights and to enforce contracts. By expanding the concept to include open trade and capital flows, economic freedom also serves as a proxy for the extent to which a country embraces globalization.
Attempts to quantify economic freedom are problematic, but economists have constructed useful measures. The measure employed in this study is the Fraser Institute's Economic Freedom of the World index (EFW index). As De Haan, Lundstrom, and Strum (2006) note, the EFW index measures a mixture of institutions and policies. Specifically, it assesses a country's economic freedom by examining five broad criteria: government size, legal structure and property rights security, monetary policy, openness to trade, and the regulatory climate. Each of these broad components is measured by sub-components. In all, 38 sub-components are considered. These components are given a rating from zero (the least economic freedom) to ten (the greatest economic freedom). Each broad component's sub-components are averaged (equal weights), and then the broad components are averaged (equal weights) for a summary rating. (6)
Economic Freedom as a Determinant of Macroeconomic Stability
Although the current state of macroeconomics leaves many questions unanswered, macroeconomists have reached a consensus on some important issues. (7) First, macroeconomists generally agree that fluctuations in aggregate demand rather than in aggregate supply cause most economic instability. Second, monetary policy does affect real variables in the short run, though it is not the source of most economic shocks and does not have an impact on real variables in the long run. Third, wages and prices are sticky in the short run, so shifts in aggregate demand, whatever their source, can have significant and prolonged effects on real variables.
These generalizations imply that aggregate demand shocks, the primary source of fluctuations in real output, can result from government policies, particularly monetary policy. In addition, exogenous shocks can cause significant fluctuations in real output apart from policy.