Economic Freedom Matters! More Than You Think!

Libertad Economica

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Economic freedom matters to economic development. Indeed, a wide body of empirical literature points to limited governmentsecure property rightsfree tradelow regulationsand sound monetary policies as being generally associated with faster economic growth and higher income levels.

There are skeptics who argue that once “some” economic freedoms are secured, the beneficial effects are trivial, if not negative. Some others argue that the literature suffers from publication bias – only significant results are published. Overall, the claim of skeptics is that the results are upwardly biased for one reason or another.

If there is any bias, however, it is against finding any positive effects of economic freedom on economic development. It is not the first time I make this point on this platform. Now, however, I have a way to show this is not mere speculation.

Why would there be a bias? Because of the quality of the data used for estimating income levels across the world. Generally, we rely on gross domestic product (GDP) statistics as created by government agencies. In liberal democracies, there are few reasons to doubt that these numbers are systematically inflated. In one year, there might be a slight overestimation, followed by a slight underestimation the next year. These errors are more or less random.

In illiberal regimes – autocracies, totalitarian regimes, anocracies – there are fewer reasons to be confident in the data. Rulers of such regimes need to shore up their legitimacy. And what better way to appear legitimate than to show that living standards are increasing as fast (if not faster) than in messy liberal democracies? And so, the lies are piled so high that trust in the numbers should be limited.

These illiberal regimes also tend to limit economic freedom. After all, why would dictators restrict political freedoms but not economic freedoms? There might be some exceptions here and there, but the general rule is that dictators restrict all freedoms.

Because the lies regarding GDP are concentrated in politically and economically unfree countries, any assessment of the importance of economic freedom to living standards will be biased favorably toward illiberal regimes, and against finding an effect of economic freedom.

How big is that bias? Recent work by Luis Martinez of the University of Chicago – and published in the Journal of Political Economy – gives us the means to answer that question by using data about nighttime light intensity collected by satellites orbiting the Earth.

There are two virtues to that data. First, satellites don’t lie.  Second, nighttime light intensity is strongly related to economic development. Normally, when light intensity increases, so does economic activity. One can use the relationship between light intensity and economic development as measured by GDP in democracies – where there are few lies – to estimate how big the lies of dictators are. That is essentially what Martinez did.

From there, it was a small step to produce a set of adjusted GDP numbers from the early 1990s to the mid-2010s. These are the numbers that I employ in a recent working paper with Sean Alvarez and Macy Scheck in order to evaluate the extent to which we underappreciate the importance of economic freedom to development. The idea is that the difference in estimated effects of economic freedom on adjusted GDP numbers, relative to when we estimate with the unadjusted numbers, will capture the bias.

When we use the adjusted GDP numbers, we find that economic freedom has positive effects on income that are 1.1 to 1.33 times greater than when we employ the unadjusted figures, with a median point closer to 1.25 times. Simply put, economic freedom’s effects are roughly 25 percent greater than commonly appreciated.

And this does not apply only to income levels. It applies also to economic growth, if likely to a lesser degree. We find signs that some components of economic freedom indexes – such as the size of government and the security of property rights – have effects that are underestimated by between 4 percent and 45 percent.

These are economically significant results. They tell us that when we discuss the importance of economic freedom to development, we are implicitly discounting it. True, the case is already quite strong given the available empirical evidence, but the available empirical evidence is too pessimistic.

As governments start rolling back interventions deployed during COVID-19, the fear is that we will not return to pre-crisis levels of economic freedom, as governments hold on to some powers. Our underappreciation of the benefits of economic freedom should provide a strong impetus to make sure this does not happen.

This article was originally published by AIER.

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