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Institutional Distortions, Economic Freedom, and Growth
By Abdiweli M. Ali and W. Mark Crain
Introduction
Two developments in the 1980s revived interest in growth theory and modified the way most economists study the determinants of growth. First, the contributions by Romer (1986) and Lucas (1988) launched a host of new growth models that abandoned the neoclassical tenet of diminishing returns to capital and introduced monopolistic competition as the underlying market form. Second, the contributions by North (1990) focused attention on institutions that shape the incentive structure which may either propel or impede productive activity within society. North and others emphasize that the existence of an implicit incentive structure drives both traditional growth models and the new models built around increasing returns. These developments laid the foundation for a large body of empirical work: some studies examine and compare the aggregate growth patterns, and others seek to identify the specific factors that correlate with growth. The latter studies include numerous attempts to measure empirically the effect of institutional factors on economic development (e.g., Barro 1991, Sachs and Warner 1997).
A common thesis in the new institutional literature maintains that societies that have adopted infrastructures that favor production over diversion have typically done so through effective government (e.g., a strong judiciary and policies that secure property rights). As a result the empirical literature on institutions devotes considerable attention to the connection between economic performance and political regimes, predominantly using the measures of political freedom and civil liberty generated by Gastil. These studies offer an ambiguous and inconclusive picture as described in the survey article by Przeworski and Limongi (1993). The empirical evidence that political regimes matter for growth remains weak despite the intuitive appeal of integrating political regimes into the analysis.
This paper extends the investigation of the relationship between economic growth and freedom by distinguishing between the growth effects of political freedom versus economic freedom. The approach follows the method employed by Levine and Renelt (1992), a study that evaluated the robustness of various factors that appear to be correlated with growth. This paper evaluates the robustness of the often-used Gastil indices of political freedom and civil liberty and a relatively recent index of economic freedom. The analysis evaluates both the direct effect of the political and economic freedom measures on growth as well as their indirect effects on investment for a large sample of countries. The models investigate the possible interactions between growth, political freedom, and economic freedom. Finally, the findings regarding economic freedom are related to recent studies by Easterly (1993), Mauro (1995), and Knack and Keefer (1995) that examine specific policies and institutions that distort relative prices and resource allocation.
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