Skip to main content

Does economic freedom cause prosperity? An IV approach

Abstract

A positive, statistical and economic significant relation between growth, income level and the Economic Freedom of the World (EFW) index has been amply documented. Most analyses, however, use OLS methods which, in the presence of endogenous variables do not establish causality and produce biased and inconsistent estimates. This paper uncovers the exogenous component of EFW using IV methods and finds a robust channel from economic freedom to prosperity. The findings, including instrument validity tests, support the importance of policies and institutions for development and warrants policy advice aimed at increasing economic freedom to foster prosperity.

This is a preview of subscription content, access via your institution.

References

  • Acemoglu, D., & Johnson, S. (2005). Unbundling institutions. Journal of Political Economy, 113, 949–994.

    Article  Google Scholar 

  • Acemoglu, D., Johnson, S., & Robinson, J. (2001). The colonial origins of comparative development: an empirical investigation. American Economic Review, 91, 1369–1401.

    Article  Google Scholar 

  • Acemoglu, D., Johnson, S., & Robinson, J. (2002). Reversal of fortune: geography and institutions in the making of the modern world income distribution. Quarterly Journal of Economics, 117, 1231–1294.

    Article  Google Scholar 

  • Acemoglu, D., Johnson, S., Robinson, J., & Thaicharoen, Y. (2003). Institutional causes, macroeconomic symptoms: volatility, crises and growth. Journal of Monetary Economics, 50, 49–123.

    Article  Google Scholar 

  • Alesina, A., Baquir, R., & Easterly, W. (1999). Public goods and ethnic divisions. Quarterly Journal of Economics, 114, 1243–1284.

    Article  Google Scholar 

  • Andrews, D., & Stock, J. (2005). Inference with weak instruments (Cowles Foundation Discussion Paper No. 1530).

  • Andrews, D., Moreira, M., & Stock, J. (2006). Optimal two-sided invariant similar tests for instrumental variables regression. Econometrica, 74, 715–752.

    Article  Google Scholar 

  • Beck, T. (2008). The econometrics of finance and growth (World Bank Working Paper No. 4608).

  • Beck, T., Demirgüc-Kunt, A., & Levine, R. (2003a). Law and finance: why does legal origin matter? Journal of Comparative Economics, 31, 653–675.

    Article  Google Scholar 

  • Beck, T., Demirgüc-Kunt, A., & Levine, R. (2003b). Law, endowments and finance. Journal of Financial Economics, 70, 137–181.

    Article  Google Scholar 

  • Bound, J., Jaeger, D., & Baker, R. (1995). Problems with instrumental variables estimation when the correlation between the instruments and the endogenous explanatory variable is weak. Journal of the American Statistical Association, 90, 443–450.

    Article  Google Scholar 

  • Bloom, D., & Sachs, J. (1998). Geography, demography and economic growth in Africa. Brookings Papers on Economic Activity, 2, 207–273.

    Article  Google Scholar 

  • Carlsson, F., & Lundstrom, S. (2002). Economic freedom and growth: decomposing the effects. Public Choice, 112, 335–344.

    Article  Google Scholar 

  • Cole, J. (2003). The contribution of economic freedom to world economic growth. Cato Journal, 23, 189–198.

    Google Scholar 

  • Dawson, J. (1998). Institutions, investment and growth: new cross-country and panel data evidence. Economic Inquiry, 36, 601–619.

    Article  Google Scholar 

  • Dawson, J. (2003). Causality in the freedom-growth relationship. European Journal of Political Economy, 19, 479–495.

    Article  Google Scholar 

  • De Haan, J., & Siermann, C. (1998). Further evidence on the relationship between economic freedom and economic growth. Public Choice, 95, 363–380.

    Article  Google Scholar 

  • De Haan, J., & Sturm, J. (2000). On the relationship between economic freedom and economic growth. European Journal of Political Economy, 16, 215–241.

    Article  Google Scholar 

  • Djankov, S., La Porta, R., Lopez-de-Silanes, F., & Shleifer, A. (2002). The regulation of entry. Quarterly Journal of Economics, 117, 1–37.

    Article  Google Scholar 

  • Djankov, S., La Porta, R., Lopez-de-Silanes, F., & Shleifer, A. (2003). Courts. Quarterly Journal of Economics, 118, 453–517.

    Article  Google Scholar 

  • Easterly, W. (2001a). The elusive quest for growth. Cambridge: MIT Press.

    Google Scholar 

  • Easterly, W. (2001b). The lost decades: developing countries’ stagnation in spite of policy reform. Journal of Economic Growth, 6, 135–157.

    Article  Google Scholar 

  • Easterly, W. (2006). The white man’s burden. Baltimore: Penguin.

    Google Scholar 

  • Easterly, W., & Levine, R. (1997). Africa’s growth tragedy: policies and ethnic divisions. Quarterly Journal of Economics, 112, 1203–1250.

    Article  Google Scholar 

  • Easterly, W., & Levine, R. (2003). Tropics, germs, and crops: how endowments influence economic development. Journal of Monetary Economics, 50, 3–39.

    Article  Google Scholar 

  • Engerman, S., & Sokoloff, K. (1997). Factor endowments, institutions, and differential paths of growth among New World economies. In How Latin America fell behind (pp. 260–304). Stanford: Stanford University Press.

    Google Scholar 

  • Engerman, S., & Sokoloff, K. (2002). Factor endowmens, inequality and paths of development among New World economies. Economica, 3, 41–102.

    Google Scholar 

  • Engerman, S., & Sokoloff, K. (2005). The evolution of suffrage institutions in the New World. Journal of Economic History, 65, 891–921.

    Article  Google Scholar 

  • Farr, W., Lord, R., & Wolfenbarger, J. (1998). Economic freedom, political freedom, and economic well-being: a causality analysis. Cato Journal, 18, 247–262.

    Google Scholar 

  • Glaeser, E., La Porta, R., Lopez-de-Silanes, F., & Shleifer, A. (2004). Do institutions cause growth? Journal of Economic Growth, 9, 271–303.

    Article  Google Scholar 

  • Granger, C. W. J. (1969). Investigating causal relations by econometric models and cross-spectral methods. Econometrica, 37, 424–438.

    Article  Google Scholar 

  • Gwartney, J., & Lawson, R. (2001). Economic freedom of the world: 2001 annual report. Vancouver: Fraser Institute.

    Google Scholar 

  • Gwartney, J., & Lawson, R. (2002). Economic freedom of the world: 2002 annual report. Vancouver: Fraser Institute.

    Google Scholar 

  • Gwartney, J., & Lawson, R. (2003). Economic freedom of the world: 2003 annual report. Vancouver: Fraser Institute.

    Google Scholar 

  • Gwartney, J., & Lawson, R. (2004). Economic freedom of the world: 2004 annual report. Vancouver: Fraser Institute.

    Google Scholar 

  • Gwartney, J., Lawson, R., & Block, W. (1996). Economic freedom of the world: 1996 annual report. Vancouver: Fraser Institute.

    Google Scholar 

  • Gwartney, J., Lawson, R., & Samida, D. (2000). Economic freedom of the world: 2000 annual report. Vancouver: Fraser Institute.

    Google Scholar 

  • Gwartney, J., Holcombe, R., & Lawson, R. (2004). Economic freedom, institutional quality, and cross-country differences in income and growth. Cato Journal, 24, 205–233.

    Google Scholar 

  • Gwartney, J., Holcombe, R., & Lawson, R. (2006). Institutions and the impact of investment on growth. Kyklos, 59, 255–273.

    Article  Google Scholar 

  • Hall, R., & Jones, C. (1999). Why do some countries produce so much more output per workers than others? Quarterly Journal of Economics, 114, 83–116.

    Article  Google Scholar 

  • Hansen, L. (1982). Large sample properties of generalized method of moment estimators. Econometrica, 50, 1029–1054.

    Article  Google Scholar 

  • Hausman, J. (1978). Specification tests in econometrics. Econometrica, 46, 1251–1271.

    Article  Google Scholar 

  • Hayek, F. (1960). The constitution of liberty. Chicago: University Chicago Press.

    Google Scholar 

  • Kaufmann, D., Kraay, A., & Zoido-Lobaton, T. (1999). Aggregating governance indicators (Working Paper No. 2195). World Bank Research.

  • Landes, D. (1998). The wealth and poverty of nations. New York: Norton.

    Google Scholar 

  • La Porta, R., Lopez-de-Silanes, F., Shleifer, A., & Vishny, R. (1998). Law and finance. Journal of Political Economy, 106, 1113–1155.

    Article  Google Scholar 

  • La Porta, R., Lopez-de-Silanes, F., Shleifer, A., & Vishny, R. (1999). The quality of government. Journal of Law, Economics and Organization, 15, 222–279.

    Article  Google Scholar 

  • La Porta, R., Lopez-de-Silanes, F., Pop-Eleches, C., & Shleifer, A. (2004). Judicial checks and balances. Journal of Political Economy, 112, 445–469.

    Article  Google Scholar 

  • La Porta, R., Lopez-de-Silanes, F., & Shleifer, A. (2008). The economic consequences of legal origins. Journal of Economic Literature, 46(2), 285–332.

    Article  Google Scholar 

  • Lucas, R. (1988). On the mechanics of economic development. Journal of Monetary Economics, 22, 3–42.

    Article  Google Scholar 

  • Lucas, R. (2002). Lectures on economic growth. Cambridge: Harvard University Press.

    Google Scholar 

  • Machiavelli, N. (1519). Discourses on Livy. London: Oxford University Press.

    Google Scholar 

  • Maddala, G. S. (1992). Introduction to econometrics. New York: Macmillan.

    Google Scholar 

  • Mahoney, P. (2001). The common law and economic growth: Hayek might be right. Journal of Legal Studies, 30, 502–525.

    Google Scholar 

  • Mauro, P. (1995). Corruption and growth. Quarterly Journal of Economics, 110, 681–712.

    Article  Google Scholar 

  • Montesquieu, C. S. (1748). The spirit of laws. Cambridge: Cambridge University Press.

    Google Scholar 

  • Morreira, M. (2003). A conditional likelihood test for structural models. Econometrica, 71, 1027–1048.

    Article  Google Scholar 

  • Muller, J. (2002). The mind and market: capitalism in modern European thought. New York: Knopf.

    Google Scholar 

  • Murray, M. (2006a). Avoiding invalid instruments and coping with weak instruments. Journal of Economic Perspectives, 20, 111–132.

    Article  Google Scholar 

  • Murray, M. (2006b). The bad, the weak, and the ugly: avoiding the pitfalls of instrumental variables estimation (Working Paper). Bates College.

  • Nelson, C., & Startz, R. (1990). The distribution of the instrumental variables estimator and its t-ratio when the instrument is a poor one. Journal of Business, 63, S125–S140.

    Article  Google Scholar 

  • Rodrik, D., Subramanian, A., & Trebbi, F. (2004). Institutions rule: the primacy of institutions over geography and integration in economic development. Journal of Economic Growth, 9, 131–165.

    Article  Google Scholar 

  • Romer, P. (1986). Increasing returns and long-run growth. Journal of Political Economy, 94, 500–521.

    Google Scholar 

  • Rothenberg, T. (1984). Approximating the distributions of econometric estimators and tests statistics. In Z. Griliches & M. Intriligator (Eds.), Handbook of econometrics (pp. 881–935). Amsterdam: North Holland.

    Google Scholar 

  • Sachs, J. (2001). Tropical underdevelopment (NBER Working Paper No. 8119).

  • Sargan, D. (1958). The estimation of economic relationships using instrumental variables. Econometrica, 26, 393–415.

    Article  Google Scholar 

  • Smith, A. (1776). The wealth of nations. New York: Random House.

    Google Scholar 

  • Staiger, D., & Stock, J. (1997). Instrumental variable regressions with weak instruments. Econometrica, 65, 557–586.

    Article  Google Scholar 

  • Stock, J., & Yogo, M. (2005). Testing for weak instruments in linear IV regression. In D. Andrews & J. Stock (Eds.), Identification and inference for econometric models: a festschrift in honor of Thomas Rothenberg (pp. 80–108). Cambridge: Cambridge University Press.

    Google Scholar 

  • Stock, J., Wright, J., & Yogo, M. (2002). A survey of weak instruments and weak identification in generalized method of moments. Journal of Business and Economic Statistics, 20, 518–529.

    Article  Google Scholar 

  • Sturm, J. E., & De Haan, J. (2001). How robust is the relationship between economic freedom and economic growth? Applied Economics, 33, 839–844.

    Article  Google Scholar 

  • Vega-Gordillo, M., & Alvarez-Arce, J. L. (2003). Economic growth and freedom: a causality study. Cato Journal, 23, 199–215.

    Google Scholar 

  • Weede, E. (2006). Economic freedom and development: new calculations and interpretations. Cato Journal, 26, 511–524.

    Google Scholar 

Download references

Author information

Authors and Affiliations

Authors

Corresponding author

Correspondence to Hugo J. Faria.

Rights and permissions

Reprints and Permissions

About this article

Cite this article

Faria, H.J., Montesinos, H.M. Does economic freedom cause prosperity? An IV approach. Public Choice 141, 103–127 (2009). https://doi.org/10.1007/s11127-009-9440-0

Download citation

  • Received:

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11127-009-9440-0

Keywords

  • Economic freedom
  • Prosperity
  • Policies
  • Institutions
  • Instrumental variables

JEL Classification

  • O1
  • O43