Is there a growth payoff to economic freedom?

The Cato Institute's 2007 annual report on Economic Freedom of the World has just been published. The report measures "economic freedom" based on the following:  

• Size of Government: Expenditures, Taxes, and Enterprises
• Legal Structure and Security of Property Rights
• Access to Sound Money
• Freedom to Trade Internationally
• Regulation of Credit, Labor, and Business.

The report is full of interesting data, but has to be handled with care. In fact, I look forward to the report every year because it gives me plenty of new evidence to play with (many of which run counter to the conclusions that the report's authors want to draw).

Here is a predictable chart, which shows that richer countries have more "economic freedom."  

No surprise here.

And here is one that shows that the relationship between economic growth and Cato's index of economic freedom  rates is--well, leaving out the basket cases (the bottom quartile), there is no determinate relationship.

How do we make sense of this?

I don't think we should be surprised. What the second picture reveals is the tremendous variance in economic performance among countries that pass a minimum threshold of market-orientedness.  In these countries, the pursuit of ever freer markets is rarely the most appropriate government strategy. The binding constraint often lies elsewhere, and may involve more government rather than less.

A good example is El Salvador, a country that is second only to Chile in Cato's rankings of economic freedom in Latin America. (Please don't get me started on Chile's industrial policies again...) The Salvadoran economy is totally privatized, has free trade and free finance, and is dollarized. Yet it has languished in low-growth hell, and would have been in even worse dire straits if it did not receive a huge amount of remittances from Salvadorans in the U.S.

El Salvador is a prime example of the "build-it-and-they-will-come" fallacy: all you need to do is to get the basics right, and then markets will do the rest. (The analogy is Larry Summers'.) All successful countries have instead required their governments to crowd in private economic activity through inducements of various kinds. Ricardo Hausmann and I make the specific case for El Salvador here.      

Comments

[Na Prática a Teoria é Outra]

Some comments on the second graph:

I don't think it is a very good graph. It compares the change in something (GDP) during a certain period with the state of something else (openess, etc.) at the end of the period. It is very risky to interpret the later as the cause of the first.

Let's say, for instance, that a country had high growth rates for most of the period, but then suffered a severe crisis, and decided to open its economy in the last year of the period. In the graph, its past growth, which happened before market-friendly reforms, would be compared to a level of liberalization that only reached its present level at the last years of the period in question.

I am not saying that this is what happened to any particular country, but I believe that, as a rule, we should not compare change in variable x to the value of variable y at the end of the period, if we are interested in testing the effect of y on x.

[Mike Huben]

CATO is enumerating the freedoms that multinational corporations want. Not real freedoms that individuals want, nor freedoms needed to grow economies.

Nor is CATO at all realistic in its measurements even of its own definitions of freedoms. The 'freest economies in the world' (http://www.atimes.com/atimes/Asian_Economy/EG12Dk01.html) does a pretty good job of pointing this out.

[Mike Huben]

Ooops. Let's see if this link works.

http://www.atimes.com/atimes/Asian_Economy/EG12Dk01.html

[Per Kurowski]

I just read the Ricardo Hausmann, Dani Rodrik paper about those who were left to hold the fort in El Salvador while the rest went elsewhere to produce. The paper is stuck in the old world realities not able to break out from traditional geographical borders since if you to El Salvador’s GNP add what the Salvadorians are earning gross abroad you might discover that El Salvador has been growing faster then China. And why should a Salvadorian working abroad be less Salvadorian than those that work in El Salvador?

What I find really interesting in the paper though is the paragraphs on the need for “Development mechanisms for higher risks finance” and I much commend them for touching on this issue. As a consultant who has walked the streets of a developing country for all my life trying to solve the financial needs and challenges of entrepreneurs I should take the occasion to point out that in my opinion the bank regulations coming out from Basle and that had only the purpose of avoiding bank crisis, effectively castrated the banks as financiers of development and forced them into perceived “low-risk” credits such as consumer financing. Now when bank regulators are being questioned this is a point I will take up during a meeting in the UN on finance for development by the end of October.

[Per Kurowski]

By the way one of the most amazing things for me is to see how the “Cato Institute and its libertarian fellow travelers” have been able to ignore how the financial flows in the world have actually been curtailed by Basle, almost as if unemployed Soviet central planners had taken refuge in Basle.

Who can understand how authorities that so much preach the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies, and which of course must be setting us up for the mother of all systemic errors?

[Justin Rietz]

Dani

Taking my standard Devil's Advocate position, I disagree with the interpretation of the data from the Cato report. Moreover, I found several aspects of the paper ("Discovering El Salvador's Production Potential") less than convincing.

RE: Blog Post

In the same vein as an earlier post, neither of these graphs are telling in and of themselves for a multitude of reasons.

1. Growth of GDP per capita is misleading. For instance, a 100% gain from $100 to $200 is less significant then going from $15,000 to $30,000. A more accurate picture would require some type of a normalized statistic based upon both the dollar amount and growth rate.

2. Using the EFW as a whole obfuscates the relative importance of each factor. In fact, in the Cato report, the authors state "we make no attempt to weight the components in any special way when deriving either area or summary ratings" (Chapter 1, page 12). I have often argued that property rights and corruption are of key importance. On these elements, El Salvador ranks lower.

3. Timing: I think Na Prática a Teoria é Outra captures the issue (comment above) quite well. It is debatable how a country’s current economic freedom level is related to a growth rate that looks back 15 years.

4. While I haven't seen the GDP data used to calculate the growth percents displayed in the second chart, most likely the lower quartiles are skewed by the fact that some of the poorest countries do not have adequate GDP data. This is only conjecture on my part, but I noted that this is an issue with UN GDP data for the same time period. (http://unstats.un.org/unsd/cdb/cdb_series_xrxx.asp?series_code=29922).

Also unclear to me is whether or not the quartile number is an average of each country's annual growth rate or an average of the growth rate of the cumulative GDP per capita for all countries in that quartile.

5. I have plotted the 1970-2005 average 5-year score for "Legal Structure and Security of Property Rights" against 2005 GDP per Capita (PPP). I use this EFW stat as a proxy for corruption and assume a time lag between corruption and GDP per Capita (hence the average). The correlation is evident though admittedly correlation does not equal causation. Nonetheless, I think it is interesting.

No scaling: http://willfulblindness.net/wp-content/uploads/2007/10/gdp_pc.jpg
Log scaling: http://willfulblindness.net/wp-content/uploads/2007/10/gdp_pc_log.jpg

I am also in the process of analyzing and graphing several other data cuts and will post the results when I am finished.

(Note that some countries did not have EFW stats going back to 1970. In this case, I used the average of the years available).

RE: "Discovering El Salvador's Production Potential" (DPP) Paper

1. The DPP paper states that one of the larger issues facing El Salvador is a lack of investment/development in new lines of business. However, the paper only pays slight attention to the fact that foreign investment is limited by the El Salvador government in several sectors, including banking. Moreover, foreign investors must receive the government's approval for investments in railroads, piers, canals, public services and other public works. While I can't speak to the rigidity of the restrictions, given the need for increased infrastructure development in El Salvador, this is an unfortunate roadblock. (Source: Heritage Foundation, http://alca-ftaa.iadb.org/eng/invest/SLV~1.HTM).

2. The DPP paper claims that the exemption of maquilas from import duties on capital equipment, income taxes, municipal taxes, etc., is a form of government subsidy or intervention. In fact, this is a more extreme case of government NON-intervention. Only relative to continued government taxation of other businesses could this be considered a subsidy, and even that position is questionable.

It is twisted logic to argue that government "action" to withdraw from a certain business sector, and the beneficial results, supports government action to become _more_ active in other business activities. A more fitting conclusion overlooked by the DPP paper is the possibility that government withdrawal from more business activities may be beneficial to the economy.

3. On the first page of the DPP paper, a chart is shown for years 1960 - 2000 that depicts GDP per capita growth leveling off in 1998. However, GDP per capita adjusted for PPP in 1999 was $3,200 and in 2006 was $4,900, an annual increase of 6.3%.

Furthermore, the chart of GDP per capital (PPP) for 1999-2006 (http://www.indexmundi.com/g/g.aspx?c=es&v=67) shows that there was continual growth until 2005 - the year El Salvador was hit by a hurricane that caused damages in excess of $300M or approximately 1% of GDP. However, GDP per capital in 2006 jumped back up to 2004, pre-hurricane levels.

4. Unemployment during this same time period went from 7.0% (1999) to 6.0% (2006) a 14% decrease. (Sources: http://unstats.un.org/ and https://www.cia.gov/library/publications/the-world-factbook/print/es.html)

5. I find the argument that entrepreneurial activity in El Salvador is hampered by "competitive subsidizing" rather weak. Isn’t this often the case with innovation? For example, the software industry is notorious for the ability of competitors to quickly copy a successful product or service. However, Silicon Valley is arguable one of the most innovative economic regions in the U.S., if not the world (recognizing that there are other factors at play).

As has often been pointed out on this blog, there are cases in which such government incubation (for lack of a better word) has been successful. However, the risk of going down this path is great. It requires that the government avoid corruption and over-regulation through self-restraint in the form of laws and/or the creation of sound institutions. There are many cases in which governments have been unable to do so (Venezuela comes to mind). A crude corollary is that some gamblers win, and a few win big, but the majority lose. The most rational choice is not to gamble at all.

[Justin Rietz]

Additional note on the robustness of the Cato data:

Taking the bottom half of countries as ranked by 1990 GDP per Capita PPP (80 countries from the UN database), 15 are not covered by the Cato report. Of the remaining 65 countries, 15 did not have a "Legal Structure and Security of Property Rights" score in 1990, leaving only 50 countries., or less than 2/3 of the total.

[liberal]

Of course, the big problem lies in the phrase "Legal Structure and Security of Property Rights."

"Property rights," when used by libertarians, usually means the freedom to collect economic rents (in exchange, of course, for no contribution to production).

Economic reasoning, as well as historical examples, shows that government-granted titles to land (with no or low accompanying land taxes) _hinder_ economic growth, as well as being unjust.

[Bob Lawson]

I posted this comment on my blog (http://divisionoflabour.com/archives/004102.php):

Dani Rodrik takes notice of the Economic Freedom of the World report.

He is more favorable to us than I'd expected, but does criticize us for overselling the case,

El Salvador is a prime example of the "build-it-and-they-will-come" fallacy: all you need to do is to get the basics right, and then markets will do the rest.

This criticism may have some merit. I do tend to believe that if a group of people (e.g., a nation state) gets the institutions and policies consistent with some notion of economic freedom, then that group of people will grow and prosper economically. I don't believe this is a "day follows night" kind of thing however, and freely admit that some countries could do well for a time without a lot of economic freedom and some with a lot of economic freedom could do poorly. There are long and variable lags and other things matter.

But having said that I see El Salvador differently. First, I see a nation with a history of low economic freedom and political stability with little credibility in the eyes of domestic and foreign investors. It has only recently begun to stabilize and improve its economic institutions. I would not expect it to grow quickly immediately. These things take time. I would predict things to improve only after some degree of credibility is earned. In El Salvador's case, this could take a long time.

Second, maybe El S will never grow for some reason. Maybe the culture is messed up. Maybe the climate is a killer. Maybe God hates them. I don't know. Maybe El S will defy my world view that economic freedom leads to growth and prosperity. I doubt it (see the first point) but it could happen. Does this invalidate the general model? Sure a lot of examples like El Salvadors would force us to question the general model, but there are very few exceptions to the general rule that economic freedom and growth/prosperity are related.

Part of the problem is the construction of the one graph from our book that he cites. It relates the level of economic freedom with growth. We are careful in the book to qualify these graphs accordingly,

we are not necessarily arguing that there is a direct causal relation between economic freedom and the variables considered below. In other words, these graphics are no substitute for real scholarly investigation that controls for other factors. Nonetheless, we believe that the graphs provide some information about the contrast between the nature and characteristics of market-oriented economies and those of controlled economies. At the very least, these figures suggest potential fruitful areas for future research.

I wouldn't argue that the level of economic freedom alone correlates with growth. I would include the change in economic freedom and other variables too. Statistically, there is a lot of evidence that economic freedom, especially increases in economic freedom, is powerfully related to economic growth.

Outliers like El Salvador may exist but citing them is hardly evidence that an important general pattern doesn't exist.