Economic Freedom and Growth: Theory and Evidence
by Isaac Leobardo Sánchez Juárez
Fourth Essay Contest Caminos de la Libertad
The nature of this essay is academic and consists in stressing the positive causal relationship between economic growth and economic freedom. The initial hypothesis is that a greater economic freedom creates the conditions (institutional framework) in which underlying variables result in greater economic growth.
This statement, as will be seen, is not only correct but also originates from important scientific research carried out through the years. One of the most relevant is An Inquiry into the Nature and Causes of the Wealth of Nations (hereafter cited as WNS) published in 1776 by Adam Smith. For Smith, free markets, protecting private property, and minimal government interference in the economy lead to prosperity. In an economically free society individuals are able to work, produce, consume and invest in any way they wish, and the State warrants those capacities. Governments in economically free societies have the obligation to allow goods, capital and labor to circulate free from any restrictions.
Moreover, the histories of economic thought and mankind reveal that in free, competitive and open economies there are greater possibilities for improvement, contrary to what happens in economies that are closed to trade and that obstruct economic activity. The basis for economic freedom as a guarantee of prosperity can be found in the work of Smith, who more than two hundred years ago proved that individuals pursuing their own interests are guided by an “invisible hand” to do what is best for all of society.
To be precise, in this essay economic freedom will be understood as the ability to make personal choices (work, leisure, consumption, production, investment, mobility), to protect private property, and the freedom to carry out exchanges. Thus, individuals have economic freedom when the following conditions exist: a) they have acquired their property without using force, fraud or theft and such property is protected from being physically invaded by others; and b) people are free to use, exchange or transfer their property as long as their actions do not violate the identical rights of others (Vega-Gordillo and Álvarez-Arce, 2003, p. 205).
Growth on the other hand, is an objective condition defined as a desirable situation for society, in which the amount of goods and services increases with respect to an initial period of time. Growth means raising the potential for production and consumption of societies that attain it, in addition to more jobs, which in turn leads to greater income and, therefore, higher growth.
Increases in produced goods and services may be the result of the following conditions: 1) an economic organization endowed with a certain level of technology employs previously unused resources; 2) a certain amount of resources are reorganized according to a given state of technology, i.e. mobilizing workers from low to high value-added activities; and 3) technical efficiency of the workforce in an economic organization increases through investment (de Schweinitz, 1957, p. 169). All three conditions are associated with economic freedom.
Within the context described above, this essay has three specific objectives: a) to highlight the relevance of economic freedom for growth and development by explaining the ideas of three great economists, Adam Smith, Milton Friedman and Friedrich Hayek (the theory); b) to revise and summarize existing empirical literature on the relationship between economic freedom and economic growth (the evidence), thus contributing to indirectly test the hypothesis suggested at the beginning of this introduction; and c) to analyze the current state of freedom in the world, with special emphasis on Mexico, using the index jointly produced by The Heritage Foundation and The Wall Street Journal.
This essay includes five sections, the first of which is this brief introduction. The second section consists in a review of three of the most prominent heralds of economic liberalism. The third section addresses evidence found on the complex relationship between economic freedom and economic growth. Most of them favor our hypothesis turning it into a stylized fact of development. Nevertheless, a few works questioning the existence of a positive relationship are also summarized here. The fourth section of this essay discusses the evolution and current state of economic freedom in the world, with a focus on Mexico. The fifth and last section includes final comments.
2. The three great forefathers of economic liberalism
2.1. Adam Smith and the foundation of economic liberalism
Better known as the “father of modern economics”, Smith highlighted the importance of economic freedom for society. In his most famous treatise , WNS, Smith thoroughly explains how an economy guided by free markets would work better than one controlled by government. In his opinion: If all men are allowed to act freely, to work how and where they want, and to charge the prices they wish; if these men are given maximum freedom to try to maximize personal gain; if all men act according to their own interests, pursuing whatever enterprises best satisfy their needs, selfishness and avarice; and if the government keeps its hands off the economy, then the result would not be chaos, anarchy or a jungle of destructive social selfishness, but a harmonic order in which the automatic forces of demand and supply, functioning in an agile and elastic free market, would bring about a more efficient use of resources (labor, land, capital, skills, brains, ingenuity, inventiveness) to offer the largest and most lasting advantages to the nation (Rosten, 1990, p. 8).
For Smith, free, unregulated competition lets private interests act in favor of all of society. He believed governments should stay away from the economy; that freedom is the best guarantee of wellbeing for man, and this wellbeing rests upon a system of benefits driven by the market.
WNS is built around a simple, but extensive argument demonstrating that the best policy of all consists in letting the economy function according to its intrinsic laws, which is the same as letting individuals respond according to their own natural economic incentives. The government should refrain from interfering in any private activity, except when necessary to prevent the use of force, fraud or pillage, as well as to guarantee national defense and maintain the peace in the land.
Proof (of this) is presented throughout the WNS in successive stages. To establish that a free market yields good results, Smith analyzes how it tends to adjust the prices of goods naturally (Book I), and to direct capital towards the purposes most beneficial to society (Book II). Next, he shows that government efforts to improve free market activity are harmful, regardless if they seek to stimulate trade, industry or agriculture (Books III and IV). Natural freedom is not the same as anarchy, so Smith describes the activities a government must undertake to have a civilized community. Many of them cannot be entrusted to private agents who act according to their own incentives to maximize their benefits (Book V) (Letwin, 1990, p. 26).
Therefore, it is clear that for Smith, preserving the system of natural freedom represented of the most important elements for economic growth. Similar to many modern growth theorists, he assigned a minor role to the State and its agencies. Now it should be kept in mind that in Adam Smith’s time the State subjected its most productive citizens to pillage in the absence of an honest, qualified bureaucracy (sic). His reasoning had a mostly sociological nature and stemmed from the behavioral properties he attributed to men: a) the universal aspiration to have better living standards; and b) the obvious and simple system of natural freedom. These two properties allowed him to assert that man’s desire to improve his condition made it possible to overcome many obstacles, and that he could make even greater progress when he was allowed natural freedom under limited government responsibility (Spengler, 1959, p. 412).
Now, in Smith’s opinion product growth rate and growth level were governed by two sets of forces:
… first, by the skill, dexterity, and judgment with which its labor is generally applied; and, secondly, by the proportion between the number of those who are employed in useful labor, and that of those who are not so employed. Whatever be the soil, climate, or extent of territory of any particular nation, the abundance or scantiness of its annual supply must, in that particular situation, depend upon those two circumstances (Smith, 1776, p. 3).
The first condition is vital to determine growth and depends upon the division of labor, an activity that must be undertaken with complete freedom. The considerable increase in the amount of products that the same number of workers can manufacture (growth) as a result of the division of labor emanates from three different sources: first, the best skill of each worker (specialization); second, saving time frequently lost due to switching from one activity to another; and, finally, the invention of machines that facilitate labor sometimes permitting one man to perform the work of many (Smith, 1776, pp. 10-11).
For Smith, freedom makes it possible to divide work. This in turn permits the multiplication of products in every art, trade or activity, which are then distributed among all classes in society.
Every workman has a great quantity of his own work to dispose of beyond what he himself has occasion for; and every other workman being exactly in the same situation, he is enabled to exchange a great quantity of his own goods for a great quantity, or, what comes to the same thing, for the price of a great quantity of theirs. He supplies them abundantly with what they have occasion for, and they accommodate him as amply with what he has occasion for, and a general plenty diffuses itself through all the different ranks of the society (Smith, 1776, p. 14).
The division of labor, which provides society with so many advantages, does not originate from human knowledge foreseeing and aiming for the general opulence it brings, but results gradually from a certain inclination in human nature: the propensity to barter, exchange and trade one thing for another:
But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages (Smith, 1776, p. 17).
The discovery that self-interest (selfishness) is a more reliable motive than benevolence might seem cynical enough, but nothing could be more mistaken: what Smith meant is that, other than family and friends, no reasonable man can rely on the charity or goodwill of others. The economic system does not treat people kindly or compassionately, but if it operates freely it can reward them for their efforts (Letwin, 1990, p. 27). Hence, Smith establishes as a rule that in order to maximize national income while preserving the order of economic progress and ensuring a better income distribution, the best policy is laissez-faire.
Taken as a whole, the normative components of Smith’s argument may be summarized as follows: When governments refrain from interfering in their operation, markets trend towards stability, which is desirable, and distribute income according to each person’s contribution to generating product. This basis for distribution is fair. The government should not interfere with the free operation of market forces because it would unduly reward a part of society at the expense of another, which is unfair. It could be poorly informed or concerned like any other economic player, so inevitably its efforts would be less efficient and a total waste. Therefore, the best policy is for the government to limit its activities in the economic sphere to strengthening laws, preventing fraud, and supporting (through taxes and public spending) necessary activities such as national defense, primary education, justice and services that cannot be provided by private markets because they produce no benefits to entrepreneurs or cannot be voluntarily purchased by all those who use those services (Letwin, 1990, p. 35).
2.2 Capitalism and Freedom: Milton Friedman
For the purpose of synthesizing Friedman’s thoughts on freedom, we will use one of his most celebrated books, Capitalism and Freedom (1962), which contains the essence of his thinking on the subject. In this book, Friedman states that freedom is a rare and delicate plant that needs extreme care, always threatened as it is by various predators and pests. Of these, one of the most dangerous is the concentration of power as confirmed by our history and our own imagination. In this regard, Friedman considers that the fundamental task of government consists in avoiding it and preserving our freedom; that government should become an instrument through which freedom can be exercised. In an overly simplified manner, his thought can be synthesized into seven principles described below.
As a first principle, he considers that the scope of government should be limited and its primary function should consist in defending freedom from foreign enemies and fellow citizens alike. Government should serve as an instrument used to maintain law and order, to strengthen and safeguard private agreements, and to foster competitive markets.
The second principle establishes the need for the dispersal of government powers. If the government has to exercise its power, it is best for it to do so at the municipal rather than at the state level, and better in a state than in the capital of a country. On this he indicates:
The preservation of freedom is the protective reason for limiting and decentralizing governmental power. But there is also a constructive reason. The great advances of civilization, whether in architecture or painting, in science or literature, in industry or agriculture, have never come from centralized government. Columbus did not set out to seek a new route to China in response to a majority directive of a parliament, though he was partly financed by an absolute monarch. Newton and Leibnitz; Einstein and Bohr; Shakespeare, Milton, and Pasternak; Whitney, McCormick, Edison, and Ford; Jane Addams, Florence
Nightingale, and Albert Schweitzer; no one of these opened new frontiers in human knowledge and understanding, in literature, in technical possibilities, or in the relief of human misery in response to governmental directives. Their achievements were the product of individual genius, of strongly held minority views, of a social climate permitting variety and diversity (Friedman, 1962, pp. 3-4).
The third principle notes the two fundamental ways of coordinating the economic activity of millions of people. One is central leadership, involving the use of coercion− under any of its guises−, and the other is voluntary cooperation of individuals (or free market technique). The second is far superior to the first one.
The possibility of coordination through voluntary cooperation rests upon the elementary proposal that both parties to an economic transaction benefit, as long as the transaction is bilateral, voluntary and informed; exchange can therefore bring about coordination without coercion. A society that works through voluntary exchange is recognized as a free private enterprise exchange economy or what is normally termed competitive capitalism.
In its simplest form, a society like this consists of a number of independent households and each of them use the resources they control to produce goods and services, which they later exchange for other goods and services produced by other families, on terms mutually acceptable to both parties to the negotiation.
In this manner, families are enabled to satisfy their wants indirectly by producing goods and services for others, rather than producing all goods they need for immediate consumption. The incentive to adopt this indirect route is, of course, increased product brought about by division of labor and specialization of function. Because every household always has the alternative of producing directly for itself, it need not enter into any exchange unless it benefits from it. Therefore, exchanges will not take place unless both parties benefit. Cooperation is achieved without coercion, thereby promoting freedom.
The fourth principle sets forth that specialization of function and division of labor would not go far if households were the ultimate productive unit. A modern society has to go beyond that. We have introduced enterprises, which act as intermediaries between individuals as suppliers of services and buyers of goods. Similarly, specialization of function and division of labor would not go far if they still relied on product-for-product barter. Consequently, money has been introduced as a means to facilitate exchanges, and to separate sales from purchases.
Friedman contends that, as in a simple exchange economy model, so in a complex economy with enterprises and money, cooperation is strictly individual and voluntary, provided: a) enterprises are private; i.e. the contracting parties are individuals; and b) individuals are free to take part, or not, in any particular exchange.
This takes us to the fifth principle. It indicates that one of the major objections to a free economy is precisely that it does its tasks so well. It gives people what they want instead of what a good or ill-intentioned group of persons think they ought to want. Friedman realized that many of the arguments against free markets ultimately resulted from a lack of belief in freedom.
Nevertheless he accepted (sixth principle) that the existence of a free market does not eliminate the need for government. Government is essential as a forum to determine the rules of the game, and as an arbiter to interpret and strengthen the rules agreed upon. What markets do is that they greatly reduce the number of issues to be settled by political means, thus minimizing the direct participation of government in the economic activity game. Besides, the market affords the great advantage of allowing for great diversity. It is, in political terms, a system of proportional representation in which every person can vote and openly express what they wish to maximize their wellbeing. Friedman writes:
It is this feature of the market that we refer to when we say that the market provides economic freedom. […] The fundamental threat to freedom is power to coerce, be it in the hands of a monarch, a dictator, an oligarchy, or a momentary majority. The preservation of freedom requires the elimination of such concentration of power to the fullest possible extent and the dispersal and distribution of whatever power cannot be eliminated […]. By removing the organization of economic activity from the control of political authority, the market eliminates this source of coercive power. It enables economic strength to be a check to political power rather than a reinforcement (Friedman, 1962, p. 15).
For Friedman a government that maintains law and order, that defines property rights, that becomes a means to modify property rights and other rules of the economic game, that settles disputes by interpreting the legal framework, reinforces contracts, encourages competition, provides a monetary framework, engages in activities to counteract monopolies, suppresses negative effects for society, and that protects the needy, is clearly a liberal government.
The seventh principle establishes that although freedom is tenable objective, it can only become a reality in responsible individuals. He does not believe that ill-intentioned persons and children can correctly exercise freedom, so he proposes the need to draw a line between responsible individuals and the rest. This points to an essential ambiguity in the ultimate objective of freedom. Therefore, paternalism is vital to those he labels “irresponsible”.
In summary, according to Friedman’s ideas, organizing economic activity through voluntary exchange (freedom) implies efficiency since it avoids coercion and allows every one to choose what is best for their wellbeing. Economic freedom, together with a dispersed and reduced liberal State, will lead to higher growth and stability.
2.3 Friedrich von Hayek and the Road to Freedom
Hayek was a prolific thinker regarding the subject of freedom and many others in the social sciences. In 1947 his passion for freedom led him to found the Mont Pelerin Society in Switzerland. It survives to this day. Milton Friedman was a founding member.
As for the topic of this essay, two of the most important books in which Hayek laid down his ideas about freedom were The Road to Serfdom (1944) and The Constitution of Liberty (1960). In the first one his central thesis is that any form of collectivism inevitably leads to tyranny. Hayek considered that even a small amount of economic planning requires a coercive apparatus to act according to established plans. He states that instead of treating people equally, socialist planners tend to treat them as tools for the success of their economic plan.
In his second book, he sets forth the basis of the ideal of freedom, which in his opinion has, in part, founded modern western societies. He divides his argument into three sections. The first one contains the foundations: the nature of freedom, its value and relationship to other values and objectives. The second section shows his position on the constitution of the pivot of freedom: rule of law, its essential characteristics and vicissitudes. The third section is titled "Freedom in the Welfare State" and consists in a series of applications of the principles he developed for policy issues (Robbins, 1961, p. 66).
From the arguments expounded in both books, it is possible to conclude that for Hayek, freedom is found in spontaneity and the absence of coercion. Thus, he reaffirms the principles of liberalism in modern terms. In both treatises, he demonstrates that societies are complex, beyond the understanding of individual minds, and, therefore, impossible to plan. In his opinion, individual freedom is necessary, and any attempt to inhibit it will violate the social order. Freedom is the only way to allocate resources efficiently and to overcome challenges and problems. Freedom consists in treating persons as equals instead of considering them mere pawns of the economic game.
Freedom for Hayek means a state in which men are not subject to coercion by the arbitrary wishes of others. The free or liberal society he aspires to is one in which subjugation of the individual to the desire of others and coercion are minimized. According to Hayek, there are at least three reasons that justify a liberal attitude: 1) ignorance, 2) progress and use of knowledge, and 3) the fact that complexity needs freedom.
Regarding the first situation, he points out that the main justification for freedom lies in our inevitable ignorance of the many and varied factors affecting the extent of our welfare and our objectives. We do not know exactly how our actions and our institutions contribute to the organization of society, or what a change in them might mean. Forcing individuals to act in a certain manner may, therefore, interrupt the complex mechanism that brings us benefits. Even though eliminating freedom and organizing a society according to a central plan may promise certain benefits, the results would be probably disastrous. On this point, in The Road to Serfdom he tells us:
There can be no doubt that the promise of greater freedom has become one of the most effective weapons of socialist propaganda and that the belief that socialism would bring freedom is genuine and sincere. But this would only heighten the tragedy if it should prove that what was promised to us as the Road to Freedom was in fact the High Road to Servitude (Hayek, 1944, p. 27).
Concerning progress and use of knowledge, Hayek believes that freedom is essential to accommodate the unpredictable: accidents are, on occasion, good accidents. In fact, when they do occur they often allow us to create new ways of doing things better than before. In this way society learns and improves its use of available knowledge. Hence, progress cannot be planned; the best one can do is to create the conditions that make new discoveries possible. Those who believe everything must be planned, favor predicting and controlling events, which actually opposes any progress in economic activity.
It must be acknowledged that creative powers only appear in a free society, where individuals may act according to their own rules. Freedom affords people the chance to explore and experiment new ways of doing things. New ideas can be developed, new tools can be employed, and changes in particular characteristics of the environment can be adjusted. Welfare brought by the possibilities of human progress is one of the most solid arguments for freedom and one of the strongest cases against attempts to surrender human society to central planning and control.
The essential point is that freedom allows people to conduct their own experiments to find out what is valuable or worthwhile and test new ideas. We are not wise enough to know beforehand what new ideas or plans will work in the future. Therefore, we trust in the independent and competitive efforts of many people to bring forth new developments. There is no one individual or government office that is better equipped to produce new and useful ideas. Individuals should be allowed to perform their own experiments and take their own risks so that useful ideas are adopted. Progress must not be steered, yet its growth should be encouraged.
Knowledge (technical progress) generated by freedom results - as one would expect - in benefits that spread quickly, provided knowledge also remains free. Hence, knowledge becomes one of the greatest contributions to be made by developed countries or regions with greatest technological advantages to the less developed. This is why Hayek opposes privileges like patents, copyrights, trademarks and anything promoting monopolies.
As for the third point, Hayek proposes that any attempts at planning will fail due to the extreme complexity of reality. He opposes those who believe that complexity should be addressed by planning the production of goods and services. In his opinion, unplanned societies are capable of greater complexity, which is desirable.
For example, increased industrial manufacturing production constitutes a primary component of economic growth. But for Hayek, economies that entrust industrial infrastructure growth to central planning never achieve the degree of complexity, differentiation and flexibility they are capable of (e.g. industrialization due to import-substitution in Latin America). Freedom should not aim for predicted developments, but rather unpredictable and novel ones.
As to its applications, Hayek considers freedom can be employed in an infinite number of ways. It could even be used to develop things or undertake activities that most people disapprove of, or that upset the majority. The latter should not encourage the restriction of freedom, however, as it may well be that in the long run such activities yield lasting benefits of great value for all. Trust in freedom does not rest upon predictable results under particular circumstances, but on the belief that overall it will render greater good than evil. Freedom is associated with uncertainty.
With respect to coercion, Hayek considers it consists in forcing individuals to serve the ends of others, by intimidating them using threats that cannot be completely avoided because the only way to prevent coercion is to respond with coercion. And so, even in a free society some means of coercion is likely to exist. Free societies have usually granted the monopoly of coercion to the State, creating rules to restrict its use.
Without State coercion, individuals would be able to threaten others with violence and blackmail coercing them into activities such as theft or fraud, all of which harm the community. Coercive power in a society does not constitute the means to make people act in a certain way, but the means to prevent citizens from breaking the rules and engaging in certain negative activities. People can act freely within the boundaries of behavior guided by rules; only those who break the rules are subject to coercion.
An additional point: Hayek considers that a free society is not led by an authority, but that it rests upon its members’ accepting the general rules of action and prevailing opinion about what is fair and unfair. It is from this system of rules that the law in its true sense, develops (Butler, 1983, pp. 22-23). Therefore, the law is not a set of rules dictated by government, but the discovery and determination of norms of fair conduct.
Lastly, we present below a few of Hayek’s key ideas regarding freedom and the economic system:
• Markets vs. planning. Market exchanges jobs because people value things differently; by contrast, a planned economy assumes that individuals agree with how and what they produce.
• The importance of prices. The price system reflects the imbalance between demand and supply and automatically directs resources to where they are most needed without requiring planners to discover, understand and correct these imbalances.
• We are all planners. We all plan and do so with our own knowledge of local conditions. Much more current and useful information can be found in this scattered knowledge than in any collected by a central planning agency.
• Human action but not human design. Social order is like language: a product of human action but not something that can be deliberately designed. It evolves and changes, and persists because we find it useful.
• The fatal consequences of arrogance. The totalitarian disasters that occurred due to utopian attempts to redesign society according to rational plans prove how little we know about the complex system of rules the social order is built upon.
3. Empirical evidence of the relationship between economic freedom and growth
As expressed previously, the second part of this essay contains the theoretical references leading to the assertion that economic growth and prosperity are associated with economic freedom. This third section reviews existing international empirical literature. We will find that there are elements that tentatively confirm the hypothesis that economic growth is a positive function of economic freedom.
First of all it should be pointed out that this research makes it possible to conclude that in contrast with other subjects, there exists a great deal of statistical evidence for the relationship between freedom and growth. It is consequently necessary to organize, interpret and, above all, select this evidence. The information shown below was sorted and selected under five criteria: 1) It had to be in English; 2) (the author had) personal access to information (scientific journals databases); 3) the information sources were reliable and reputable; 4) they avoided bias; and 5) time span (mainly from 1990 to date).
The author chose articles from different electronic databases: SpringerLink, Jstor, ScienceDirect, Ebsco, and others, following the criteria stated above. A total of 49 research reports were found in 23 journals.
3.2 Summary of international evidence
Table 1 shows the articles examined in chronological order to verify that economic freedom truly causes economic growth and social wellbeing. The table includes the sign, the method followed to verify the nature of the relationship, time and spatial sample, and how economic freedom was measured.
ECONOMIC FREEDOM AND GROWTH
SUMMARY OF INTERNATIONAL EVIDENCE *
Author Sign Method Time Period Spatial (# countries) EF Index
1 Scully (1988) + OLS 1960-1980 115 Gastil
2 Spindler (1991) + OLS 1982, 1960-1980 140 Wright Rankings and Gastil
3 de Vanssay and Spindler (1994) + OLS 1985-1988 100 Scully and Slottje (1991)
4 Goldsmith (1995) + OLS 1980-1990 59 Freedom House
5 Abrams and Lewis (1995) + TLS, MLE 1968-1987 90 Gastil, Scully and Slottje and Humana
6 Islam (1996) + OLS 1980-1992 94 Fraser
7 de Haan and Siermann (1996) N.A. OLS 1963-1988 97 Gastil
8 Easton y Walker (1997) + OLS 1985-1992 57 Fraser
9 Goldsmith (1997) + OLS 1985-1994 90 Fraser, Freedom House and Heritage
10 Gwartney, Holcombe and Lawson (1998) + OLS 1960-1996 23 Level and change
11 Johnson and Lenartowicz (1998) + OLS 1985-1994 38 Fraser
12 Nelson and Singh (1998) + PDF 1970-1980 67 Fraser
13 Ayal and Karras (1998) + OLS 1975-1995 58 Fraser
14 Farr, Lord and Wolfenbarger (1998) + GCT 1975-1995 78 Fraser
15 Dawson (1998) + PDF, TLS and OLS 1975-1990 N.A. Fraser and Gastil
16 de Haan y Siermann (1998) N.A. EVS 1980-1992 114 and 78 Scully and Slottje (1991)
17 Gwartney, Holcombe and Lawson (1999) + OLS 1975-1995 82 Fraser
18 Wu and Davis (1999) + LLM 1975-1992 100 Fraser
19 Heckelman (2000) + GCT 1994-1997 94 Heritage
20 Chong and Calderón (2000) + TS and GCD 1972-1995 55 BERI and ICRG
21 Heckelman and Stroup (2000) + OLS 1980-1990 49 Fraser
22 de Haan and Sturm (2000) N.A. EVS 1975-1990 58 Fraser and Heritage
23 de Haan and Sturm (2001) N.A. OLS, MLS and RLS 1975-1995 82 Fraser
24 Prokopijevic (2002) + Comparative 1970-1999 and
1995-2002 123 and 156 Fraser and Heritage
25 Gounder (2002) + EVS 1968-1996 Fiji Gastil and Fraser
26 Scully (2002) + OLS and IV 1975-1990 26 Fraser
27 Adkins, Moomaw and Savvides (2002) + SPF and MLE 1975-1990 73 and 76 Fraser and Freedom House
28 Ali and Crain (2002) + EVS 1975-1989 119 Gastil and Fraser
29 Carlsson and Lundström (2002) N.A. EVS 1975-1995 74 Fraser
30 Cole (2003) + OLS 1980-1999 106 Fraser
31 Dawson (2003) + GCT 1970-2000 82 Fraser
32 Comeau (2003a) + OLS and EVS 1975-1995 82 Fraser
33 Ali (2003) + OLS 1974-1994 and
1975-1995 90 and 50 BERI, ICRG and Fraser
34 Assane and Grammy (2003) + OLS 1985-1990 110 Scully and Slottje (1991)
35 Vega-Gordillo and Álvarez-Arce (2003) + GCT 1975-1995 45 Fraser and Freedom House
36 Bengoa and Sánchez-Robles (2003) + SPF and REP 1970-1999 18 Fraser
37 Comeau (2003b) + OLS 1972-1989 21 Fraser
38 Fidrmuc (2003) + OLS 1990-2000 25 EBRD
39 Norton (2003) + OLS 1985-1995 115 Fraser and ICRG
40 Paldam (2003) + Comparative 1970-1999 5 Fraser
41 Powell (2003) + Correlation 1987-2000 Ireland Fraser
42 Gwartney, Holcombe and Lawson (2004) + OLS 1980-2000 99 Fraser
43 Erdal (2004) + TS and GCT 1960-2000 Italy Author elaboration
44 Berggren and Jordahl (2005) + OLS, EVS, RLS and ALS 1970-2000 78 Fraser
45 Cole (2005) + OLS 1980-1999 92 Fraser
46 Doucouliagos and Ulubasoglu (2006) + MEA, OLS, PDF 1970-1999 82 Fraser
47 Weede (2006) + OLS 1980-2000 102 Fraser
48 us Swaleheen y Stansel (2007) + AMM 1995-2004 60 Fraser and Heritage
49 Santhirasegaram (2007) - OLS 2000-2004 70 Heritage
OLS: Ordinary Least Squares
TLS: Total Least Squares
MLE: Maximum Likelihood estimate
PDF: Panel Data, Fixed Effects
GCT: Granger's Causality Test
EVS: Extreme Value Sensitivity Analysis
LLM: Log-linear Model
TS: Time Series
GCD: Geweke Convergence Diagnostic
MLS: Mean Least Squares
RLS: Reweighted Least Squares
IV: Instrumental Variables
SPF: Stochastic Production Frontier
REP: Random Effects Panel
ALS: Adjusted Least Squares
AMM: Arellano Moreno Method (1991)
BERI: Business Environment Risk Intelligence
ICRG: International County Risk Guide
EBRD: European Bank for Reconstruction and Development
Source: The author, based on his research.
This review allows us to conclude that there is proof to assert that greater economic freedom leads to greater economic growth. In the countries examined, we found a positive and statistically significant association between both variables. Nevertheless, this statement needs to be considered in context. In general most of the research provided information within so-called “growth regressions”, which are usually extensions of the growth model proposed by Solow (1956). Many of the studies not only evaluated the role of economic freedom in growth, but also examined the contribution of human capital, physical capital, and labor as primary inputs.
It is especially relevant that a great part of this research evaluates the relationship between economic and political (democracy) freedom, and in turn the relationship of these two with economic growth. Most of the research consists of cross-sectional regressions for a sample of countries, normally grouped into development categories and using data that at least cover the period from 1975 to 1990. In all of the sources, there is consensus about the importance of institutional factors. They underscore, as North first did (1990) the importance of an institutional framework for growth. They also recognize the need to create an ideal environment for economic activity to develop, hence the importance of economic freedom and its related components.
To provide for further discussion, the twenty most prominent papers appear below in chronological order . The first one, by Islam (1996), explores the relationship between economic freedom and economic performance in low (28), middle (43) and high (23) income countries using cross-sectional data and ordinary least squares. The results of his regressions show a direct relationship between the economic freedom index (Fraser index) and per capita income only in the case of the low-income countries and the entire sample, but not in the case of middle and high-income countries. Evidence also indicates a direct relationship between the economic freedom index and the per capita income growth rate in high-income countries and in the entire sample, but not in low and middle-income countries. Finally, it was found that increases in per capita income reduce economic restrictions in low-income countries and in the entire sample, but not in middle and high-income countries.
A year later Goldsmith (1997) used the Fraser, Heritage and Freedom House indexes to explore the relationship between economic rights and development in 90 nations. He found that developing countries with higher rankings in protecting economic freedoms tend to grow faster and score higher in human development. He also found that contrary to expectation, political decentralization has no significant relationship with the degree of economic freedom. According to Goldsmith’s findings, stagnation in less developed nations is mostly due to low promotion of economic freedom, especially in terms of the robustness of the institutions in charge of enforcing law and justice.
Ayal and Karras (1998) took individual components of the Fraser index to study their impact on economic growth. They identified six statistically significant components of freedom related to multifactorial productivity and capital accumulation. The six components are: a low currency growth rate; the limited role of state-owned companies; an infrequent truly negative interest rate; slight differences between official and black market currency exchange rates; a large commercial sector; and citizen liberty to engage in capital transactions with foreigners. Additionally, small inflation variations and low tax rates to trade were statistically significant in some of the regressions. According to the authors, their results are more reliable than those using aggregate index scores of economic freedom. In political terms, identifying the components of economic freedom that promote growth is thought provoking.
Farr, Lord and Wolfenbarger (1998) offer information about the direction of causality among measures of economic freedom, political freedom and growth between industrialized and non-industrialized countries. They measure economic freedom with the Fraser index, while the Granger Causality Test allowed them to prove that in both, industrialized and non-industrialized countries, results are similar: economic freedom is a Granger cause of the level of economic welfare (measured by per capita GDP). Moreover, the level of economic welfare is a Granger cause of economic freedom, suggesting feedback or an endogenous relationship. They also found that the level of economic welfare is a Granger cause of political freedom but not the other way around (the Lipset hypothesis). They did not find a direct relationship between political and economic freedom. Their findings indicate that economic freedom strengthens economic wellbeing, and therefore has an indirect impact on political freedom.
Meanwhile, de Haan and Siermann (1998) used several measures of economic freedom built by Scully and Slottje (1991), and found that the link between economic freedom and economic growth depends on the measure utilized. There appears to be strength in certain freedom indicators that does not exist in others. In addition they determined that investment is not related to freedom indicators.
For Heckelman (2000) literature on freedom and growth has consistently shown that nations with few restrictions on private agents and transactions tend to show high levels of economic growth. However it is not clear whether freedom leads to growth, growth leads to freedom or if both are jointly determined. To evaluate these possibilities he performed a Granger Causality Test using the annual freedom indicators published by the Heritage Foundation and national growth rates. He also analyzed each component in the index. Econometric analysis suggests that the average level of the economic freedom in a country, and many of its components, cause growth. Growth, however, causes one of the components of the index (government intervention), and no relationship was found between growth, trade policy, and taxes.
From their comparison of two economic freedom indicators (the Fraser and Heritage indexes), de Haan and Sturm (2000) concluded that although they differ in coverage, their rankings are similar for the countries examined. In their opinion, some of the elements in these measures are questionable. Regarding the statistical association between economic freedom and growth, they concluded it is positive. Nevertheless, they found that the level of steady-state growth is not related to economic freedom. A year later, the same authors used a different econometric method and reached similar conclusions: changes in the economic freedom index are strongly tied to growth, whereas the level of economic freedom is not.
According to Carlsson and Lundstöm (2002), despite the fact many studies have found a positive relationship between product growth and freedom, problems arise when choosing a measure for economic freedom. A simple measure fails to reflect the complexity of the economic environment and a highly aggregated index makes it difficult to derive policy conclusions. In this article, the authors researched specific types of measures of economic freedom that are important for growth. The results were carefully analyzed for reliability because of the multicollinearity that arises from disaggregating an index. Results show that economic freedom is important for growth, but this does not mean that an increase in economic freedom, as defined in general terms, is an asset for economic growth due to the insignificance of some index categories (monetary policy and price stability) and the negative effects of a few significant variables (government size and freedom to trade with foreigners). The only variables in the economic freedom index with a positive and robust relationship to growth are private property, legal structure, and the freedom to use alternative currencies.
Recognizing the impact that institutions have on economic performance, Adkins, Moomaw and Savvides (2002) used panel data to estimate the stochastic production frontier and sources of inefficiency in a sample of 76 countries. They estimated the parameters of the stochastic production function and determinants of inefficiency with the Maximum Likelihood method. Their results suggest that institutions promoting great economic freedom encourage efficiency and thereby, economic growth.
Ali (2003) pointed out that until recent times many growth studies failed because they didn’t consider the importance of institutions (sic). His article highlights their importance to growth and development, and evaluates the empirical results of institutional effects on growth and investment. It provides ample evidence that the institutional environment in which economic activity takes place determines economic growth, and looks at alternative measures of institutional quality to explain growth differences among countries. Ali’s empirical results reveal that countries with high levels of economic growth also feature high levels of economic freedom, judicial efficiency, low corruption levels, effective bureaucracy, and protection of private property rights.
Vega-Gordillo and Álvarez-Arce (2003) explored the causal link between economic growth and political and economic freedom in a series of 45 countries in the period 1975-1995. They used a panel model as a basis and a Granger Causality test, and found that countries concerned with economic growth benefit from institutional reforms promoting market liberalization. Moreover, their results indicate that a solid democracy can result in faster growth and higher levels of economic freedom: political freedom and economic freedom mutually reinforce each other.
Bengoa and Sánchez Robles (2003) added a new ingredient to the studies above by empirically exploring the relationship among economic freedom, foreign direct investment and economic growth. They analyzed panel data from a sample of 18 Latin American countries covering the period from 1970 to 1999, and obtained two basic results: first, economic freedom (Fraser index) in the country receiving resources is a positive determinant of larger foreign investment cash flows. Therefore, a high level of economic freedom increases the appeal of a country to potential investors. Second, their results suggest that foreign direct investment is positively related to the economic growth of the host countries included in the sample. They attribute such empirical regularity to the idea that foreign direct investment contributes to disseminating technology from developed to less developed countries. In order for this to happen, however, the empirical analysis highlights the need for a certain level of human capital, economic stability and free market in the host country, so it may enjoy the benefits of large inflows of foreign capital.
Cole (2003) used the Fraser index disaggregating its components to conclude that economic freedom represents a significant factor for economic growth. He emphasizes the impact of the following variables on efficiency: inflation rates, taxes, public expenditure, state-owned companies, state-led investment, tariff protection, non-tariff barriers, price controls, and labor and credit market distortions.
Focusing on causality in the relationship between different types of institutions − namely, economic and political freedom − and economic growth, Dawson (2003) performed multiple Granger Causality tests to study freedom vs. growth and freedom vs. investment using the Fraser index and disaggregating it into its components whenever possible. His results suggest that the degree of economic freedom appears to cause growth. A few of the components of economic freedom that stand out as most relevant are those related to market use and property rights. Dawson’s results stress the importance of economic freedom, especially the role of free markets and property rights, to encourage long-term prosperity.
Furthermore, his findings suggest that both levels and changes in freedom measured by government size are the result of growth rather than a cause. Changes in the international finance component of the index apparently result from growth. Freedom, measured as currency and price stability by levels and changes, is jointly determined with growth. Applying the Granger Test to the relationship between economic freedom and investment shows that levels and changes in freedom scores lead to investment.
Because of the difficulty to examine country particularities in many of these indexes, Erdal (2004) built an economic freedom index for the Italian economy and then analyzed time series. The bivariate relationship between economic growth and economic freedom was studied with a Granger Causality Test. Erdal’s empirical results suggest that economic freedom has a significant impact on the growth of the Italian economy. Freedom seems to operate through its effects on human capital and on total factor productivity, as well as indirectly on investment.
As for economic freedom components, limiting government size in an economy leads to greater resources for the private sector, speeding economic growth. Fewer market restrictions benefit growth. A stable monetary and financial system with low inflation and interest rates is positive, but not statistically significant. Trade promotes growth while the capital markets variable had a negative but not significant impact on growth.
The results presented by Gwartney, Holcombe and Lawson (2004) demonstrate that differences in institutional quality between countries, measured by the Fraser index, have a great impact on income and long term growth rates. Countries with institutions and policies more consistent with economic freedom grow more rapidly and attain higher income levels. Their analysis suggests that it takes between 5 to 10 years to fully register the effects of improvements in institutional quality.
Two years after the previous study and using data from 102 countries for the period 1980-2000, Weede (2006) demonstrated that freedom has a positive impact on growth, although he also highlights the impact of other variables such as the initial level of development and the amount of human capital.
Using the Heritage index for a panel of 60 countries, Swalheen and Stansel (2007) found that in countries with low economic freedom (where personal economic choices are limited), corruption reduces growth. Nevertheless, in countries with high economic freedom, corruption increases economic growth. These results contradict the general view that corruption reduces growth; they even appear strange in light of the composition of the index. As per their findings, the degree of economic freedom participants in the market have, will condition corruption and its economic effects.
The last research article in our analysis came from Santhirasegaram (2007), whose study mainly consisted in finding out whether or not economic freedom (Heritage index) and public policies promote growth in developing countries. He employed ordinary least squares to estimate the effects of freedom. Unlike other studies, this one found a strong negative relationship between political freedom and economic growth in more than 70 developing countries in the period from 2000 to 2004. In addition, economic freedom is negatively related to economic growth, but its effect is not significant. His results markedly differ with most of the studies indicating the transcendence of democratic institutions and economic freedom as prerequisites for economic growth.
4. The Current State of Economic Freedom: Mexico and the World
This last section of the essay presents the evolution of economic freedom in the world (selected countries have been grouped into six regions.) Special attention is given to Mexico. The author of this essay chose the index built by The Heritage Foundation and The Wall Street Journal because of its consistency and frequent updates, although it covers a short series (1995-2009). The multidimensional nature of the concept of economic freedom makes it difficult to measure and so caution must be exercised when making conclusions or offering policy recommendations based on the information provided by these approaches to freedom.
4.1 Economic freedom in the world
The six regions examined were: I) North America (United States, Canada, and Mexico); II) Europe (Ireland, Denmark, United Kingdom, the Netherlands, Germany, Spain, Norway, France, Italy, and Russia); III) Central and South America (Chile, El Salvador, Costa Rica, Panama, Cuba, Venezuela, Peru, Colombia, Paraguay, Bolivia, Nicaragua, Brazil, and Argentina); IV) Middle East and North Africa (Israel, Oman, Qatar, Kuwait, Saudi Arabia, Egypt, Morocco, and Iran); V) Asia-Pacific (India, China, South Korea, Japan, Malaysia, Taiwan, Australia, Singapore, and Hong Kong); and VI) Sub-Saharan Africa (South Africa, Kenya, Ghana, Senegal, Nigeria, Mauritius, and Cameroon). The index scores for these regions are shown in Table 2, where values closer to 100 mean greater freedom.
ECONOMIC FREEDOM IN DIFFERENT WORLD REGIONS
Region 1995 2000 2005 2008 Average
I 69.7 68.7 73.7 75.8 72.0
II 65.1 66.5 68.5 70.4 67.6
III 59.5 63.7 59.1 58.3 60.2
IV 60.0 59.9 59.8 60.7 60.1
V 71.0 70.8 70.2 71.3 70.8
VI 53.9 58.7 57.7 60.0 57.6
Source: Compiled by the author with data from The Heritage Foundation.
Economic freedom has increased almost all over the world in the past 14 years. The regions with the greatest economic freedom include North America, Europe and Asia-Pacific. In the first region, the economies of the United States and Canada foster freedom; in the second, the economies of the United Kingdom, Denmark, Netherlands, and Germany; while in the third it is the economies of Hong Kong, Singapore, Australia, and Japan. The region of Central and South America has the worst performance in economic freedom due to the setbacks in the economies of Venezuela, Cuba, and Bolivia. Chile is the leader in the region with an average score above 75, similar to the most advanced countries. The region of the Middle East and North Africa slightly increased its global score, but not enough due to barriers to economic freedom in Morocco and Iran. With time, the situation in Sub-Saharan Africa has relatively improved to a large extent due to the performance of South Africa.
ANNUAL GROWTH RATES IN THE INDEX OF ECONOMIC FREEDOM BY REGION
Source: The author with data from The Heritage Foundation.
Examining annual growth rates instead of the actual scores of economic freedom confirms that far from a positive trend in all the series, there is extreme volatility. With the exception of years 1998 and 1999, economic freedom decreased in at least one region from 1995 to 2008. Estimates of the average annual growth rates between 1995-2008 yield a meager 0.59% growth in economic freedom for North America, 0.58% for Europe, -0.14% for Central and South America, 0.08% for Middle East and North Africa, 0.03% for Asia-Pacific, and a 0.77% for Sub-Saharan Africa. No region reaches even one percent.
Chart 2 includes the economic freedom indexes for each region in 2009. North America retains the world leadership in economic freedom followed by Europe, Central and South America, Middle East and North Africa, Asia-Pacific and finally Sub-Saharan Africa. It should be noted that the region with the largest human population is not the one with the greatest economic freedom. Conversely, the two regions with the greatest freedom (North America and Europe) triple the average per capita income weighted by the population of the other regions. The regions with more liberty also enjoy the lowest unemployment and inflation rates, albeit they have not been the regions to show the highest growth in the past five years (see Table 3).