Does Economic Freedom Determine Economic Growth?

Abstract

The purpose of this thesis is to examine the data and methodology used in constructing the Heritage Foundation’s Index of Economic Freedom. The historical development of the index (1995 – 2012) and the trends in the movements of its freedom categories are analyzed in order to assess the quality of the index as an aggregate measurement of economic freedom. This study examines the significance of the index in economic research and its applications in growth literature. The index aggregation methodology is evaluated using principal component analysis and factor analysis in order to reduce and summarize the large number of variables included in the index to a few orthogonal constructs which explain as much of the variation in the original data as possible. Finally, Granger causality tests are applied to the index data and annual real GDP growth rates in order to explore the direction of causality between freedom and growth and identify the freedom categories which contribute to growth and the ones which deter growth.

The contribution of this thesis is twofold. First, the results of analyzing the factors and principal components of the Index of Economic Freedom indicate that economic freedom is not one dimensional and that attempts to aggregate many variables into a single summary index might result in misrepresentation of economic freedom. Second, it establishes that not all freedom categories contribute to growth. In particular, I find that Fiscal Freedom, Government Spending, and Monetary Freedom precede growth, whereas the remaining categories are either not related to growth or are jointly determined by a third factor, suggesting that not all economic freedom categories can be aggregated into a summary overall freedom index without distorting the relationship between economic freedom and prosperity.