Economic freedom and development

Pál Czeglédi–Judit Kapás

ECONOMIC FREEDOM AND DEVELOPMENT

An Austrian economics perspective

Financial support from the Hungarian Scientific Research Fund (contract no. 76615) is kindly acknowledged.

ISBN 978 963 05 9135 5

First edition in English language, 2009

© Pál Czeglédi, Judit Kapás, 2009

© Akadémiai Kiadó, Budapest, 2009

Published by Akadémiai Kiadó

Member of Wolters Kluwer Group

P.O. Box 245, H-1519 Budapest, Hungary

www.akademiaikiado.hu

All rights reserved. No part of this book may be reproduced by any means or transmitted or translated into machine language without the written permission of the publisher.

LIST OF FIGURES

Figure 1. The relationship between political freedom, economic freedom and development

Figure 2. Time series for the EFW index between 1970 and 2004 for 53 countries

Figure 3. Time series for freedom-related, policy and other components of the EFW index between 1970 and 2004 for 53 countries

Figure 4. Time series for fiscal and monetary policy between 1970 and 2004 for 53 countries

Figure 5. Changes in freedom-related, policy and other components of the implied EFW index between 1970 and 2004 for 53 countries

Figure 6. Time series for the three components of the freedom-related measure for 53 countries (averages for years 1980–2004)

Figure 7. Scatterplot between growth rate and policy variable for countries with a freedom-related measure of at least five

Figure 8. Scatterplot between growth rate and policy variable for countries with a freedom-related measure of not more than five

Figure 9. Average GDP per capita for economic freedom quartiles (international dollar 2000 prices)

Figure 10. Average GDP per capita for freedom-compatible quartiles (international dollar 2000 prices)

Figure 11. Average GDP per capita for freedom-non-compatible quartiles (international dollar 2000 prices)

Figure 12. Average economic growth for economic freedom quartiles

Figure 13. Average economic growth for freedom-compatible quartiles

Figure 14. Average economic growth for freedom-non-compatible quartiles

Figure 15. Scatterplot between log GDP per capita and the freedom-non-compatible measure

LIST OF TABLES

Table 1. Empirical investigations on economic freedom

Table 2. Non-coercive governmental activities

Table 3. Coercive governmental activities

Table 4. Empirical investigations on the relationship between economic freedom, political freedom and growth

Table 5. Components of the EFW index according to their relevance to economic freedom

Table 6. Correlations between freedom-related and monetary policy variables

Table 7. The matrix of improvement/worsening of freedom-related institutions and policy

Table 8. Percentile ranks for EFW chain-link index and the freedom-related institutions

Table 9. Correlation between various freedom-related categories

Table 10. Results for equations (3), (4) and (5)

Table 11. Results for the equations with policy subcategories

Table 12. Results for the 2SLS estimation with the freedom-related measure

Table 13. Results for the equations with components of the freedom-related measure

Table 14. Economic freedom, freedom-compatible and freedom-non-compatible ranks and scores for 47 countries

Table 15. Ranking of 47 countries according to three different measures of economic freedom

Table 16. Correlations between the components of the freedom-related and the economic freedom measure

Table 17. Correlations between the components of the freedom-related and the subcomponents of the EFM

Table 18. Correlations between the subcomponents of the economic freedom measure

Table 19. Averages of investment in physical capital (investment as a percentage of GDP) and human capital (as average years of schooling in the total population) for economic freedom quartiles

Table 20. Regression results for the economic freedom measure

Table 21. Regression results for the two components of the economic freedom measure

Table 22. First stage regression results for, and test for exogeneity of the freedom-compatible measure

Table 23. Regression results for the freedom-non-compatible measure

ACKNOWLEDGMENTS

This book is the result of our research project Economic Growth, Institutional Mix and Market Processes carried out with the financial help of the Hungarian Scientific Research Fund (contract no: 49602) from 2005 to 2008. First of all, we are very grateful to the Fund for its support which made our research possible.

Colleagues at our home institution as well as abroad have given us valuable help in writing this book. We would like to express our special thanks to László Csaba, who provided a detailed comment on an earlier draft of the entire manuscript and suggested many important aspects to deal with. He also always encouraged us to continue our work.

We are indebted to Péter Földvári and József Gáll, who helped us carry out our empirical investigations and interpret the results. A number of other colleagues at the Faculty of Economics and Business Administration of the University of Debrecen, especially those who participated in a seminar at which we presented parts of this book, contributed critical comments and discussions at various stages.

A part of this book was written while Judit Kapás was a research fellow at the International Center for Economic Research (ICER), Turin, Italy. She would like to thank Enrico Colombatto, the director of ICER for making it possible for her to carry out research in Turin. Discussions with fellows at ICER were also very fruitful in improving the quality of the book.

Parts of this book were published in various journals whose referees provided valuable comments. We thank them, together with the scholars who participated in and gave us suggestions at the conferences where we presented chapters of this book. These include the participants of the Prague Conference on Political Economy in 2007 and 2008; the 4th Conference on Developments in Economic Theory and Policy in Bilbao; the 2008 Annual Conference of the European Public Choice Society; the Academic Conference on Economic Modernization and Globalization in Moscow organized by the Higher School of Economics and the World Bank, and the 2008 Annual Conference of the International Society for New Institutional Economics.

We owe special thanks to George Seel, our English proofreader, who read through and corrected our manuscript very scrupulously.

Finally warm thanks go to our family members and friends, who have supported us in various ways.

1. INTRODUCTION

1.1. WHY THIS BOOK?

The question of what drives economic growth, or to put it differently, what makes some nations become rich and others remain poor is the most important question of economics – a question which has been answered in different ways in the past 200 years since Adam Smith first raised it in 1776. Since he gave his own answer emphasizing exchange, specialization (the division of labor) and the system of natural liberty, where “[e]very man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of men”[1], economists have continuously provided newer and newer answers. These answers have formed the bulk of “growth theory” which has become one of the most respected branches of contemporary economics. At the same time, the formal explanations of economics, and more particularly those of the recent past have followed a different course than the one Adam Smith seems to have thought of as being the best explanation of why some nations are able to reach higher and higher levels of “opulence”.[2] These models of growth theory attribute the primary role to accumulation, even if more and more attention is paid to the role of innovation.

Since the mid 1980s, a new literature on economic growth has emerged and developed different kinds of models[3] to address the main questions of growth theory: namely, why there is growth at all, and why not all countries grow. The starting point of every growth theory, the Solow model (Solow 1956, 1957) does not provide any positive answers to these questions: it determines the factors which cannot make growth sustainable in the long run. Solow (1956, 1957) and more recently other authors (Olson 1996, Easterly and Levine 2001) have shown that factor accumulation cannot account for economic growth; there must be something else in place, that, for simplicity’s sake, is usually called “technology”, or the “Solow-residual”; but the term adopted by Abramovitz (1956: 11) gets closer to what it really is when he calls it the “measure of our ignorance”.

The New Growth Theory[4], developed since the mid-1980s has come closer to lifting the veil of ignorance covering the process of growth. This literature has tried to find a positive answer to the question of what causes growth, by developing models in which the growth rate is endogenous and possibly positive in the long run. We do not aim here to summarize this literature, which would fill another volume; we simply intend to highlight the main insights to point out the course we follow in order to add something to the literature by this book.

One answer to the question raised by Smith is that it is human capital and different knowledge spillovers that matter. Human capital has special features, the most important of which is that human capital is produced with a technology that makes intensive use of human capital itself (Lucas 1988, Rebelo 1991), a phenomenon which can eliminate the effect of the decreasing returns of physical capital. In addition, capital accumulation can have positive externalities, making each player in the economy more efficient without incurring costs to them (Lucas 1988, Romer 1986, Arrow 1962). These effects can counterbalance the effects of decreasing returns pointed out by the Solow model, but they can hardly be the whole story since growth is obviously also driven by the innovations that are carried out intentionally by the players for profit. These processes are developed in the second branch of growth theory, which emphasizes the role of research and development (Romer 1990; Aghion and Howitt 1992, 1998; Jones 2005). In these models, innovation is not a side-effect of accumulation but a result of purposeful actions on the part of the players; that is, innovation is carried out like any other production activity, which is expressed in the fact that innovation is captured by a production function and represents a sector in the model economy.

The emphasis given to the accumulation of different kinds of capital by these new models of growth theory does not mean that the course Adam Smith thought economic growth must follow disappeared from economics for ever. This way of thinking received new impetus from the literature of the New Institutional Economics (NIE), which brought historical thinking into the economics of growth (North 1990, North and Thomas 1973), and highlighted that the “rules of the game in society” – that is, institutions – are more fundamental than accumulation because these rules determine the payoffs of different activities, including the accumulation of productive resources. The authors in this camp do not think of themselves as taking issue with the more formal models mentioned above, but they see their explanations as complementing them. Nevertheless, formal models do not operate in a vacuum; therefore, the NIE supposes the previous existence of various institutions. Thus, the above views are not revolutionary but mainstream today, followed by researchers at Harvard and MIT, whose views have been per definitionem the mainstream in economics for decades. Thus, the simple question of whether institutions matter is not very much debated. More relevant is the question of how their effect operates (Csaba 2007a: 368).

As a result of these developments, growth theory is a much more interesting and challenging discipline than ever; and it seems to integrate traditional formal models, insights from development economics and NIE, as well as economic history[5].

However, we believe that something is missing from this literature. We know that if the institutions of free exchange are in place, the outcome of the process will be efficient, but does this mean growth? Why should a system of natural liberty increase the size of the pie and also ensure that we leave no slice of it on the table? To provide answers to these and similar questions means we have to take seriously the effects of the Smithian system of natural liberty. Au fond, what we miss is a coherent understanding of how the Smithian system of natural liberty leads to economic growth. In modern parlance, it is about the effects of economic freedom on growth.

In a world of maximizing agents, dynamism must be supposed somehow: there is no growth in the Solow model without supposing exogenous technological change; there is no economic growth even in Romer’s innovation-based model as elaborated by Jones (2005) if we do not suppose that population is growing and if one has to avoid the unrealistic implication of strong scale effects; and there is no economic growth in the Schumpeterian growth models if we do not suppose that innovation just happens, albeit accidentally. We argue that this somewhat mechanistic view of the growth process prevents economists from realizing the role economic freedom plays in economic growth. There is a theoretical puzzle that while the Smithian–institutionalist view of growth is becoming more and more popular and accepted in economics, the role of economic freedom is still not clear; or more precisely, the way economic freedom provides the system with the dynamism which economists like to call economic growth or, more broadly, economic development is yet unclear.

We propose to see economic freedom as a distinct factor of economic growth. In order to do this, we must have a better understanding of the market process. As explained by Buchanan and Vanberg (2001: 112), market institutions are more than incentives to accumulate resources: it is too narrow to think of the market as an “allocative process”. To understand its role fully, one has to understand that a market is also a “discovery process” that solves the knowledge problem, as explained by Hayek (1978), and a “creative process that exploits man’s creative potential” (Buchanan and Vanberg 2001: 112). This creativity must be somehow linked to the understanding of economic growth. This is what we aim to do with this volume.

In our attempt, we apply the approach of modern Austrian economics. We believe that insights from Austrian economics help us better explain the process of growth by allowing the return of dynamism[6] to economics, as in Smith (1776), as well as the importance of economic freedom that was realized by Smith under the rubric of natural liberty. The Austrian theory of entrepreneurship and of the market process, as well as of institutions, as we attempt to show throughout this book, are elaborations on the Smithian view of the market economy. This Smithian–Austrian–institutionalist framework gives us the possibility to examine the role of economic freedom as a dynamic concept. We will not develop here a growth theory explicitly; rather, we will focus on the role economic freedom plays in economic development, which requires in the first place a clear understanding of economic freedom itself. Therefore, we will focus especially on developing a framework for an understanding of economic freedom. Thus, we approach the question of growth starting from the theory of economic freedom, and not vice versa as traditional growth theory does, when, starting with a parsimonious model, it tries to integrate more and more institutions to provide a better explanation. In this respect, our work is in harmony with a recent framework for “interpreting recorded human history” developed by North et al. (2006) which provides a path-breaking way of thinking about social orders[7]. This framework, at the same time, also suggests a new perspective for an understanding of economic development.

Recorded human history has witnessed two kinds of social orders: limited access and open access orders (North et al. 2006). The limited access order, also called the natural state, emerged about 10,000 years ago and dominates even today. In this social order, the political system manipulates the economic system to create rents for the elite so as to control violence and sustain order. The open access order appeared first about 200 years ago. It relies on competition and open access both in the political and economic systems to sustain order. Open access orders have developed in about two dozen countries and all are both economically and politically developed. Thus, the major problem is how to transform a limited access order into an open access order.

Based on North et al. (2006), more recently North et al. (2007) redefine the problem of economic development. In contrast to the current literature, they argue that economic development is not an incremental process. Instead, economic development is the movement from a limited access order to an open access order, which is very difficult to engineer and which has been very rare in human history. This transformation takes place through the creation of what they call the doorstep conditions. They themselves see the rule of law for elites as the major doorstep condition. As will be clear throughout our book, the rule of law is the core concept in our framework for economic freedom. Consequently, we believe that the issue of economic freedom is of crucial importance for a better understanding of the details of the transition from a limited access to an open access order.

However, North et al. (2006) are silent about how economic development occurs within an open access order. Here, our work seems to be useful: continually improving the institutions of economic freedom (among them the rule of law) leads to economic growth. As a matter of fact, the rule of law, or more broadly the institutions in which economic freedom is embodied, plays a crucial role in fostering economic development.

All this underpins the argument we emphasized above, namely that economic freedom should be placed at the center of the theory of economic development. In addition, the concept of economic freedom is broad enough to serve as an explanatory variable for development as understood in North et al. (2006) and as we extended it involving development within an open access order.

This book is not aimed at giving practical advice on economic policy. But the message of the book is, of course, not independent from the historical and geographical context in which it was written. Two decades have already passed since people “tore down the wall” with the message in their mind that “freedom leads to prosperity”[8], but this conviction seems to be losing its force, at least in Hungary. We would see it as a success of this book if some of its readers would regain this view, if indeed they lost it.

1.2. FROM THE CONCEPT OF NATURAL LIBERTY TO THE THEORY OF ECONOMIC FREEDOM

Although Adam Smith raised the importance of natural liberty 200 years ago, this issue was a subject of little interest among economists for a relatively long period. However, since the mid-1990s the concept of economic freedom has attracted more attention. This is due to the emergence of indexes (see Chapter 2.1) ranking countries according to a scale running from the least free to the freest.

The reason why more attention is paid to economic freedom is that researchers have found empirical evidence for the fact that economic freedom affects long-run income. If one looks at the ranking of countries, one can see that rich countries are among the freest (see Table A.1 in Appendix A). Moreover, the successful transition of a particular group of post-socialist countries also sheds light on the importance of economic freedom: between 1995 and 2005 a huge improvement occurred in the field of economic freedom in these countries. Romania was the best improver with a 59.9 percent improvement while China’s economic freedom increased by 11.5 percent (see Tables A.2 and A.3 in Appendix A).

However, we think the value of economic freedom lies not only in its positive effect on a particular country’s economic development, but on other countries’ too. As Hayek (1960: 32) argued: “The benefits of freedom are therefore not confined to the free. … There can be no doubt that in history unfree majorities have benefited from the existence of free minorities and that today unfree societies benefit from what they obtain and learn from free societies”. This means that in the global economy the existence of dominant and pioneering free economies is of paramount importance in improving growth rates everywhere. The long history of economic freedom in the West offers advantages of backwardness that China, India, and Vietnam currently exploit (Weede 2006). Put differently, economic freedom spills over. As Sobel and Leeson (2007) show, there are two major channels through which economic freedom spreads: geography and international trade. That is, on the one hand, broad regional changes in economic freedom do have a significant impact on surrounding countries; and on the other hand, by liberalizing trade an economically free country can exert a positive impact on economic freedom in less free countries.

Realizing the importance of economic freedom, authors of the empirical literature on economic freedom (see Chapter 2.2) usually refer to economic freedom as a “short-cut key” for a certain mix of economic policies and institutions. To put it briefly, economic freedom in the dominant literature means secure property rights, a low level of government spending and taxation, a low level of state intervention and regulation (including international trade), a stable price level and so on. In this conceptualization, on the one hand, economic freedom has very much to do with sound economic policy, and on the other hand, it is a composite concept consisting of various “good things”. If this is the case, why do we use the expression of economic freedom at all? Why do not we say simply that secure property rights, a low inflation rate, low government spending, etc. spur growth instead of saying that economic freedom does this? Is there anything which makes economic freedom a useful concept for a better understanding of economic development?

In this book, we will argue that economic freedom is a(n) (unique) economic category in its own right, which is conceptually different from the usual categories of economic policy, and even more importantly it is more than simply the sum of various “good things”. We will argue that economic freedom plays a distinct and important role in the process of economic growth and development. In this spirit, we will develop our own conceptualization of economic freedom. In this endeavor, as argued above, we follow the Smithian line of economics, the theoretical foundations of which were developed by the Scottish philosophers of the Enlightenment. Although neither Locke nor Hume used the term “economic freedom” explicitly, they both developed insights which, in fact, are related to economic freedom.

John Locke’s Second Treatise on Civil Government (Locke 1690) founded a coherent and powerful intellectual tradition, in which he provided the first coherent justification for private property as the foundation of social order (Rabushka 1991: 27). According to Locke, private property was essential to preserve the individual freedom that individuals enjoyed in the state of nature[9]. Based on this, he argued that the primary goal of government is the defense of property under the rule of law. In this way, he argued for the institutions of laissez faire capitalism where the government’s role was little more than a night-watchman’s. David Hume (1739) reinforced Locke’s views. According to Hayek (1988: 34), Hume was the first to formally identify the institutional characteristics that are necessary for promoting the socially beneficial economic behavior of individuals. These are the recognition of private property rights and the application of the rule of law to govern private transactions.

Both Locke and Hume argued for the type of government that in modern parlance is called “limited government”: Locke’s idea was that the proper role of the government is to protect the natural rights of individuals, while Hume’s view was that the government is legitimate as long as it serves a particular purpose, namely securing peace and property rights. The government, in the state of nature, cannot act arbitrarily (Locke 1690). Clearly, both called for the primacy of the individual. All these views are to some extent echoed by Adam Smith (1776). What they mean by “limited government” is very close to what we mean by “economic freedom”.

The important lesson we drew from these ideas is that government and economic freedom are not contradictory per se, unlike the view which is to a certain extent suggested by the indexes of economic freedom; however, they will be contradictory if government expands beyond certain limits[10]. What these limits are will be the major issue of this book. Thus, our argument is that economic freedom is compatible with government, but not with any kind of government. Clearly, when it comes to economic freedom it is not the size of the government that matters, but rather what government is allowed to do and how. Accordingly, economic freedom relates to the character of government actions, rather than the volume of government actions. Based on these considerations, our framework for an understanding of economic freedom developed in this book rests on the Hayekian idea of freedom, the rule of law being a core concept within it.

Clearly, we were driven by theoretical considerations when conceptualizing economic freedom, which, as a way of proceeding, is exactly the opposite of the method adopted by the Fraser Institute and the Heritage Foundation (see Chapter 2.1). Since the explicit aim of the two organizations was to measure economic freedom, this determined the way the concept of economic freedom was formulated: their conceptualization was largely driven by operational and empirical (measurement) considerations. However, as argued above, we believe that economic freedom is a concept in its own right, and this being the case, a theoretical framework is first needed for a full understanding of the concept. Subsequently, whether this theoretically-based concept of economic freedom may or may not be measurable is another question. Thus, our position is: “theoretical framework first, measurement after, if possible”.

We will argue throughout this book that a clear-cut concept of economic freedom is, first of all, important for developing new substantive results as regards the way economic freedom affects growth. The point is that while an impressive literature (see Chapter 2.2) indicates that economic freedom positively affects long-run income, in the framework of this literature we do not know exactly how. In other words, in our view the major problem with the literature on economic freedom lies in the fact that it does not put economic freedom at the center of a theory of growth, something which would be necessary in order to investigate the causes of “the wealth of nations”. Accordingly, the empirical investigations into how economic freedom affects growth have only very weak theoretical interpretations, preventing researchers from taking the research further and from concluding more than the simple fact that economic freedom increases economic growth.

Yet we believe an advantage of our Austrian economics framework of economic freedom is that it can be integrated into a theory of growth, via the theory of entrepreneurship (Kirzner 1973) since it is through entrepreneurship that economic freedom deploys its beneficial effects (Harper 2003, Kreft and Sobel 2005). The mechanisms through which entrepreneurship leads to growth are revealed by Boettke and Coyne (2003) and Holcombe (1998, 2003a, 2003b, 2003c), and our theory may contribute to a better understanding of the other side of the coin, namely the relationship between economic freedom and entrepreneurship. Yet, the question of which institutions lead to growth is equivalent to the question of which institutions are “good”[11]. In this respect, our two concepts related to economic freedom, namely the freedom-compatible and freedom-non-compatible institutions prove themselves useful tools in analyzing the process of economic growth, especially the relationship between economic freedom and growth. In this way, by bundling up the institutions promoting economic freedom we will be able to add some new insights to the “primacy of institutions” view (Hall and Jones 1999, Acemoglu, Johnson and Robinson 2001, Rodrik, Subramanian and Trebbi 2004, Easterly and Levine 2001).

An additional advantage of our framework for an understanding of economic freedom lies in the fact that it can be operationalized, that is, measured. This allows us to make some empirical investigations with our own measure of economic freedom which, in addition, provides support for our theory.

Finally, our framework, we think, may highlight additional aspects of, and/or complement, the views developed in the huge literature on the “proper role of the government”. A seminal contribution of this body of the literature is that of Djankov, Glaeser, La Porta, Lopez-de-Silanes and Shleifer (2003), in which the authors analyze the trade-off between the costs of disorder and dictatorship. Both disorder and dictatorship are related to the expropriation of individuals’ private property, but while disorder refers to private expropriation, dictatorship refers to an expropriation by the state. Then Djankov, Glaeser, La Porta, Lopez-de-Silanes and Shleifer (2003) determine a combination of disorder and dictatorship which minimizes the social losses from both. In this framework, in fact, what is determined is an efficient governmental institutional setting. Our framework, we believe, complements this model by introducing a new criterion into the analysis, namely that of economic freedom.

Although Djankov, Glaeser, La Porta, Lopez-de-Silanes and Shleifer (2003) do not use the term “economic freedom”, both disorder and dictatorship as they define them have to do with economic freedom as we understand it because both refer to an infringement of property rights. In this way, economic freedom as a unique criterion also provides an important aspect for determining which institutional setting is better.

What we are suggesting here is that the criterion of “efficiency” and that of “economic freedom” are two separate criteria as far as the actions of the government are concerned. These two very often overlap, but not necessarily. The significance of our categorization of government actions as freedom-compatible and freedom-non-compatible ones allows us to provide a clear-cut criterion for determining whether a particular governmental action concerns economic freedom, or it only has to do with efficiency. This distinction does not exist in the literature, which is thus prevented from separating the effects of these two factors. Thus, as we will argue, economic freedom is crystallized in various institutions, while efficiency can primarily be affected by “good” economic policy. It follows that economic freedom has not much to do with economic policy (see Chapter 3).

Our aim was not to give recommendations on economic policy – that would be a different task. But we think that our results may have implications for economic policy. Namely, we hope to show that economic freedom is a valid criterion for the evaluation of governmental actions, even if it may not be evident how to apply this criterion in specific policy prescriptions. To decide whether a certain action of the government contributes to economic freedom is not only important when one views things through the lens of freedom, but also when one sees development as a primary objective.

1.3. THE STRUCTURE OF THE BOOK

Besides developing new ideas as regards economic freedom, our aim in this book is also to summarize and reinterpret the existing literature on economic freedom. In this spirit, in Chapter 2 we introduce and describe the two indexes of economic freedom that are widely used in the literature, and then we review and criticize the empirical literature using these indexes. We organize our review around three questions which are at the core of empirical analyses in this literature. These are as follows: (1) what is the relationship between economic freedom and growth? (2) what is the mechanism of this effect? (3) which component of economic freedom is the most important? We also want to give a comprehensive summary of empirical papers analyzing the relationship of economic freedom and growth: structured around the above three questions, in Table 1 we list all papers known to us, and highlight the main questions, the methods and the results of the investigations.

In Chapter 3, we develop a framework for an understanding of economic freedom, on which we rely throughout this book when developing new insights. First, we lay down the cornerstones of a coherent theory of economic freedom. Here, relying on the idea partly shaped by Locke (1690) and Hume (1739), and explicitly by Hayek (1960) according to which economic freedom should be understood within the existence of a state, we highlight the relationship between coercion, state and economic freedom. The concluding argument concerning this relationship, namely that only coercive governmental activities relate to economic freedom, has a paramount implication for our framework. We also show why the rule of law should be considered a core concept in economic freedom. Then, as we step forward in developing our framework, we propose to conceptualize economic freedom in terms of kinds of governmental actions. Since only coercive actions relate to economic freedom, these should be separated from non-coercive governmental actions. Here, we argue that while non-coercive actions do not concern economic freedom, they affect the size of the government, and accordingly, efficiency. At this point, it becomes clear why we emphasize so strongly that the criterion of economic freedom and that of efficiency are two separate criteria which need to be considered separately. Distinguishing between freedom-compatible and freedom-non-compatible actions within the category of coercive governmental actions allows us to conceptualize how economic freedom is reduced, which serves as a theoretical basis for our measure of economic freedom which we develop in Chapter 7.

Economic freedom, by referring to individuals’ entrepreneurial actions, is connected with entrepreneurship. This explains why we discuss the issue of entrepreneurship in Chapter 4. In addition, a coherent framework for an understanding of economic freedom must explain how economic freedom leads to economic growth because, as we show here, the major path through which economic freedom affects growth is entrepreneurship. In this spirit, first we analyze the neoclassical growth theories with a special emphasis on how they did or did not integrate entrepreneurship into their models. The final conclusion is that the neoclassical framework is not appropriate to develop and understand the relationship between entrepreneurship and growth. However, revealing this mechanism is a very natural feature of Austrian economics. So, we present the original Kirznerian concept of entrepreneurship (Kirzner 1973) and we extend it in such a way as to highlight how entrepreneurship leads to growth. This latter involves a discussion of what the favorable conditions for entrepreneurship are. We think the discussion of entrepreneurship in this chapter will justify the beneficial character of economic freedom, and at the same time, it mill provide an explanation for how economic freedom deploys its beneficial effects.

In Chapter 5, we deal with the relationship between economic and political freedom. This relationship comes immediately to mind when analyzing the kinds of institutions which are supportive of economic freedom: is the political freedom embodied in various political institutions a precondition of economic freedom or not, and what in fact is the relationship between these two kinds of freedom? Here, our concern is broader than simply analyzing the role of certain political institutions (e.g., federalism) in enhancing economic freedom. We are interested in exploring the general relationship between political and economic freedom. On the one hand, we summarize the literature dealing with this issue, which consists primarily of empirical studies, and on the other hand, by reinterpreting Friedman’s (1962) and Hayek’s (1944 [1971]) views as regards the relationship between political and economic freedom, we develop our own understanding of this relationship. Similarly to what we do in Chapter 2, here we also aim to list all studies analyzing the question, see Table 4.

In Chapter 6, we turn to empirical investigations based on the Fraser Institute’s Economic Freedom of the World (EFW) Index. We think that before putting forth our own concept of the measurement of economic freedom in Chapter 7, it is worth “first-testing” our theory by doing some rough empirical analysis based on the EFW index. So, first we evaluate the Economic Freedom of the World Index according to whether its components measure what we mean by economic freedom. In practice, this evaluation is based on our schema for the categorization of governmental actions developed in Chapter 3. In this way, we classify the components into the following categories: “freedom-related”, “policy” and “others”. Our argument here is that the components of the index that are not “freedom-related” do not concern economic freedom as we understand it. In our empirical investigations we use the Mankiw, Romer and Weil (1992) model to examine how various variables affect income. We arrive at showing that using the freedom-related components of the index (which is more in line with our concept of economic freedom) instead of the index itself may lead to even more plausible propositions than those provided by the index.

In Chapter 7, we explore the way our framework for understanding government actions developed in Chapter 3 leads us to propose an alternative concept of the measurement of economic freedom. First, we develop our theoretical concept of the measurement of economic freedom; then we operationalize this concept and describe it in a precise way. Finally, we carry out some analysis based on our own measure; comparisons and trends, on the one hand, and regression examinations, on the other. The final conclusion we can draw is that the relationship between income and economic freedom is more complicated than a simple positive relationship between an exogenous economic freedom measure and the resulting per capita income – contrary to what is very often claimed in the dominant literature. Some elements of economic freedom, namely freedom-compatible institutions, are shaped by factors outside the process of development, and they have a significant effect on long-run income, and this effect is exogenous. However, some elements including freedom-non-compatible institutions in our terminology, seem to be the result of development itself, i.e., they are partly endogenous, which can be explained in terms of the theory of interventionism (Mises 1940 [1998], 1929 [1996]); Ikeda 1997).

In Chapter 8, we summarize the major conclusions as regards our overall research on economic freedom and shed light on possible future research lines in this field.

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