Economic freedom matters! More than you think!

Economic freedom is important for economic development. Indeed, a large body of empirical literature indicates limited government, secure property rights, free exchange, weak regulation, and sound monetary policies as being generally associated with faster economic growth and higher income levels.

There is the skeptics WHO argue that once “certain” economic freedoms are guaranteed, the beneficial effects are trivial, otherwise 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 biased upwards for one reason or another.

If there is a bias, however, it is against find 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 that this is not mere speculation.

Why would there be a bias? Due to the quality of the data used to estimate income levels around the world. Generally, we rely on gross domestic product (GDP) statistics created by government agencies. In liberal democracies, there is little reason to doubt that these numbers are systematically inflated. In a year there could be a slight overstatement, followed by a slight underestimation the following year. These errors are more or less random.

In illiberal regimes – autocracies, totalitarian regimes, anocracies – there are fewer reasons to trust data. The leaders of these regimes must strengthen their legitimacy. And what better way to appear legitimate than to show that the standard of living is rising as fast (if not faster) than in messy liberal democracies? And so the lies are stacked so high that confidence 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 may be a few exceptions here and there, but the general rule is that dictators restrict all freedoms.

Because lies about 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 this 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 this question using night light intensity data collected by satellites orbiting the Earth.

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

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

When we use the adjusted GDP figures, we find that economic freedom has positive effects on income that are 1.1 to 1.33 times larger than when we use the unadjusted figures, with a midpoint closer to 1.25 times. Simply put, the effects of economic freedom are about 25% greater than generally appreciated.

And this doesn’t just apply to income levels. This also applies to economic growth, if likely to a lesser degree. We find evidence that some components of economic freedom indices – such as size of government and security of property rights – have underestimated effects of 4 to 45%.

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

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