Download impact of economic freedom on real gdp growth

IMPACT OF ECONOMIC FREEDOM ON REAL GDP GROWTH EMPIRICAL STUDY (CASE OF GEORGIA)
Vakhtang Chkareuli1
Ivane Javakhishvili Tbilisi State University, Georgia
[email protected]
ABSTRACT
Almost twenty-five years have passed since dissolution of Union of Soviet Socialist
Republics and it may be asserted that, market economies have been established in almost
all of the former USSR countries with varying degrees of success.
From early 1990s’ Georgia was a victim of several civil wars, revolutions or even later
Russian occupation. There was a great need of institutional changes to turn “Soviet
Mentality Society” into rationally forward-thinking people. In this case, economic freedom
was becoming more and more popular through post-communist countries.
Improving economic freedom shows the positive relationship between different social and
economic parameters, bringing greater prosperity, cleaner environments, human
development, democracy etc.
In this Paper, I am going to examine impact of economic freedom on real gdp growth,
using different macroeconomic parameters.
Keywords: Economic Freedom, Economic Growth, Real GDP Growth.
1
Chkareuli, Vakhtang, PhD Candidate - Faculty of Economics and Business Administration, Ivane Javakhishvili
Tbilisi State University, Tbilisi, Georgia.
INTRODUCTION - BRIEF REVIEW OF FREE SOCIETY AND GEORGIAN
RECENT ECONOMY
“Fundamentally, there are only two ways of coordinating the economic activities of millions.
One is central direction involving the use of coercion—the technique of the army and of the
modern totalitarian state. The other is voluntary co-operation of individuals—the technique of
the market place.” - Milton Friedman
In an economically free society every individual controls the fruits of his/her own labor and
initiative. In such kind of society people succeed or fail based on their individual effort and
ability, institutions do not discriminate either or in favor of individuals to any factor unrelated
to individual merit, government decision-making is characterized by openness and
transparency. The rule of open market is quite fair, the allocation of resources for
production/consumption is based on the open competition so that every individual gets the
chance to succeed.
When we are talking about economic freedom, people see a critical relationship between
individuals and government. Generally, state action or government control that interferes with
individual autonomy limits economic freedom, but the goal is not simply an absence of
government coercion or constraint but creation of a mutual sense of liberty for all. The
government has its exclusive role in this layout. It must provide the framework for the whole
system, so that every individual has to follow the principles of “fair play”.
After dissolution of USSR economic freedom was becoming more and more popular through
post-communist countries. Though it was very difficult to change the mentality of the people
who were born and grown up on communistic principles and lived under centrally planned
economic system. Every country of former Soviet Union which accepted the new challenges
of the modern world had to implement a lot of institutional changes.
The most important institutional changes in Georgia began in 1992, when the process of
privatization started, but due to high level of corruption it had not brought the fruits that
where expected, though important steps forward had been taken. After gaining independence,
there was developing a convenient environment for free trading regime, e.g. in 1992-1996
there were abolished some restrictions on import and in 1995 there was cancelled a quotation
system what leaded Georgia to WTO2 as on 14th of June, 2000 Georgia became 137th member
of the organization. (Papava 2013)
At those times, the main barrier for Georgian economy was lack of investments and high
levels of corruption, what was caused by several reasons (unstable geo-political environment,
shadow economy etc.). In 1990’s the level of Foreign Direct Investment (FDI) was
insignificant, until the beginning of building Baku-Supsa Pipeline3 what raised investment
ratio to GDP up to 7.3 percent, but then there was a big fall to 2 percent. This parameter was
2
The World Trade Organization (WTO) is an intergovernmental organization which regulates international
trade. The WTO deals with regulation of trade between participating countries by providing a framework for
negotiating trade agreements and a dispute resolution process aimed at enforcing participants' adherence to WTO
agreements, which are signed by representatives of member governments
3
The Baku–Supsa Pipeline is an 833-kilometre long oil pipeline, which runs from the Sangachal
Terminal near Baku to the Supsa terminal in Georgia.
normalized only in 2003 (sustained 8.4 percent to GDP), what was caused by the new project
known as Baku–Tbilisi–Ceyhan (BTC) Pipeline4. (Papava 2013)
The “New Era” in Georgia started after “Rose Revolution” in November, 2003, when there
were taken strict changes to the whole economic system, what resulted to reduced level of
bureaucracy and corruption, improved private property, reduced incidence of taxation etc.
Georgia became one of the top reformer countries as it was simplified starting business,
registering property or getting credit. It was a great incentive exceptionally to small and
medium businesses and entrepreneurs to start a new business and grow.
BODY OF PAPER - IMPACT OF ECONOMIC FREEDOM ON REAL GDP
GROWTH, DESCRIPTION AND ESTIMATION THE MODEL
Data used in our empirical study covers 1995 - 2015 period and was collected from the three
main sources. Economic freedom index rates were collected from the Heritage Foundation
and the inflation rates, real gdp, budget deficit, expenditures on education where collected
from National Bank of Georgia and National Statistics Department of Georgia. (Table 1)
Table 1 - Data for empirical study (National Statistics Department of Georgia, National Bank
of Georgia, Heritage Foundation)5
4
Year
Overall Index
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
44.1
46.5
47.9
52.5
54.3
58.3
56.7
58.6
58.9
57.1
64.5
69.3
69.2
69.8
70.4
70.4
59.4
72.2
72.6
73.0
Budget
Deficit/Real
GDP
-0.067
-0.080
-0.062
-0.071
-0.030
-0.015
-0.018
-0.018
-0.003
-0.026
-0.034
-0.048
-0.062
-0.092
-0.066
-0.036
-0.035
-0.028
-0.022
-0.020
Real GDP
5334.440
5895.57
6078.624
6253.035
6367.988
6673.998
7039.322
7817.737
8275.648
9070.081
9921.170
11169.21
11461.09
11032.28
11716.40
12558.28
13362.07
13805.69
14443.97
14844.78
Real
Expenditures
on Education
2.695
2.950
2.950
3.450
3.765
3.822
3.927
3.457
3.828
3.745
4.243
3.759
4.063
4.872
4.852
5.006
4.854
5.153
5.085
4.894
Inflation Rate
0.394
0.071
0.036
0.192
0.040
0.047
0.056
0.048
0.057
0.082
0.092
0.092
0.100
0.017
0.071
0.085
-0.009
-0.005
0.031
0.040
The Baku–Tbilisi–Ceyhan (BTC) Pipeline is a 1,768 kilometers long crude oil pipeline from the Azeri-ChiragGuneshli oil field in the Caspian Sea to the Mediterranean Sea.
5
http://www.geostat.ge/index.php?action=page&p_id=1145&lang=eng - National Statistics Dep. of Georgia
https://www.nbg.gov.ge/index.php?m=304 - National Bank of Georgia
http://www.heritage.org/index/explore - Heritage Foundation
Let us begin by analyzing the effect of economic freedom on log of Real GDP by using an
overall index of economic freedom. The log of Real GDP will simplify the interpretation of
the model in that it will allow us to see the percentage effects of each independent variable on
Real GDP. Also, in our model we will use economic freedom index calculated by the wall
street journal and heritage foundation. For analytical understanding and presentational clarity
let’s briefly discuss the economic freedom index calculated by heritage foundation.
The overall index consolidates ten different economic freedoms which are divided into four
broad categories:

Rule of Law – property rights; freedom from corruptions,

Government size – fiscal freedom; government spending,

Regulatory efficiency – business freedom; labor freedom; monetary freedom,

Market openness – trade freedom, investment freedom, financial freedom.
Ranked countries are given a score ranging from 0 – 100 on each of ten components of
economic freedom, and these scores are then averaged (using equal weights) to compute
country’s final score.
For this study I will use log of real GDP as a depended variable, and the explanatory variables
will be log of an overall index, expenditures on education to GDP ratio and lagged variable.
At the first stage, it was interesting to put in effective labor and capital as explanatory
variables in the research, but due to the incomplete statistical information it could harm the
degree of explanatory power of the model.
I will use Error Correction Model (ECM) to analyze influence of economic freedom index on
economic growth. Assume that the factors which have some influence on GDP in a long run
period are: Overall Index and Real Expenditure on Education.
The long term part of our model is as follows:
log(𝑅𝑒𝑎𝑙𝐺𝐷𝑃) = 𝛼0 + 𝛼1 𝑂𝑣. 𝐼𝑛 + 𝛼2 𝐸𝑑𝑢𝑐𝐸𝑥𝑝. (−1) + 𝜀𝑡
(Model 1)
Where log(RealGDP) is natural logarithm of the real GDP, Ov.In is of overall index of
economic freedom, EducExp. is real expenditures on education and εt is an error term (there
should be some combinations of structural innovations, such as ARMA process).
If I accept the intuition underlying the basic macroeconomic model for GDP, I expect that any
components of the model 1 that would likely increase consumption, investments, government
spending, or net exports will probably have a positive relation to real GDP, so an overall
index is expected to have a positive relation to GDP, as well as the level of education.
Estimation of this model yields the following results (Table 2)
Table 2 - Estimation of the Model 1
Dependent Variable: LOG(GDP)
Method: Least Squares
Date: 06/16/16 Time: 17:01
Sample (adjusted): 1996 2015
Included observations: 20 after adjustments
Variable
C
OVERALL_SCORE
EDU
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
Prob(F-statistic)
Coefficient
Std. Error
t-Statistic
Prob.
7.743837
0.016057
0.000933
0.181708
0.004100
0.000193
42.61681
3.916851
4.835743
0.0000
0.0011
0.0002
0.970749
0.967308
0.061241
0.063758
29.10516
282.0915
0.000000
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat
9.122073
0.338706
-2.610516
-2.461156
-2.581360
1.034934
See the interpretation of the Model 1 below:
log(𝑅𝑒𝑎𝑙𝐺𝐷𝑃) = 7.74 + 0.16𝑂𝑣. 𝐼𝑛 + 0.001𝐸𝑑𝑢𝑐𝐸𝑥𝑝. + 𝑒
𝑒~𝐴𝑅(1)
(Model 2)
Notice that the model has high explanatory power, as R2 equals to .9707, meaning that
approximately 97.07 percent of the sample variation in Real GDP is explained by independent
variables.
Correlogram - Q-statistics show that there is first order autocorrelation in the model 2 (caused
by stationary AR(1) error term). I tested the null hypothesis the model is homoscedastic. A
rejection of null hypothesis would imply that the model is heteroscedastic6, but failure to
reject null hypothesis indicated that model is homoscedastic. (Table 3)
Table 3 - Heteroskedacticity Test
Heteroskedasticity Test: Breusch-Pagan-Godfrey
F-statistic
Obs*R-squared
Scaled explained SS
6
1.177323
2.433158
1.732341
Prob. F(2,17)
Prob. Chi-Square(2)
Prob. Chi-Square(2)
0.3320
0.2962
0.4206
heteroscedasticity (also spelled heteroskedasticity) refers to the circumstance in which the variability of a
variable is unequal across the range of values of a second variable that predicts it.
Also Jarque-Bera test showed failure to reject null hypothesis the model is normal, what
means that residuals describing structural shocks of our model is normal. (Figure 1)
Figure 1 - Histogram normality test
7
Series: Residuals
Sample 1996 2015
Observations 20
6
5
4
3
2
1
Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
1.19e-15
0.003483
0.134921
-0.112135
0.057928
0.203681
2.970857
Jarque-Bera
Probability
0.138994
0.932863
0
-0.10
-0.05
0.00
0.05
0.10
0.15
Now, we have to prove that results of Model 2 are sustainable. When there is a correlation
between any variables in a long run period, one have to examine and find out if this
correlation is sustainable. For instance, when the long run equilibrium breaks down,
correlated variables should return to the status quo independently if the correlation level is
strong enough. As we have already assumed, long term factors do not have short term
impacts, so, for short term dynamic, we have to use other variables which are not having any
effects in the long run period, such are inflation and fiscal deficit over GDP.
In our ECM model, dependent variable is differential of log GDP (percent change) and
explanatory variables are structural shocks of the Model 2, change in Overall Index7, inflation
and fiscal deficit over GDP.
To make sure that this model qualifies as ECM, consider following ECM:
Equation 1
∆𝑦𝑡 = 𝛾(𝑦𝑡−1 − 𝛼1 𝑥1𝑡−1 − 𝛼2 𝑥2𝑡−2 ) + 𝛽1 ∆𝑥1𝑡 + 𝛽2 × ∆𝑥2𝑡
Imposing following over-identified restrictions: α2 = 0; β1 = 0 gives new equation.
Equation 2
∆𝑦𝑡 = 𝛾(𝑦𝑡−1 − 𝛼1 𝑥1𝑡−1 ) + 𝛽2 ∆𝑥2𝑡
Where 𝑥1 is long term factor and 𝑥2𝑡 is short term factor.
Hence, a new model is as follows:
7
We only include Overall Index differential in the model, because differential of expenditure on education does
not have statistically significant impact.
∆ log(𝑅𝑒𝑎𝑙𝐺𝐷𝑃) = 𝛽0 + 𝛽1 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙(−1) + 𝛽2 ∆𝑂𝑣. 𝐼𝑛 + 𝛽3 (𝜋) + 𝛽4 𝐵𝑢𝑑. 𝐷𝑒𝑓 + 𝜖
(Model 3)
Where Residual(-1) is the deviation from the long run equilibrium in (t-1) period (residual of
long-run model), 𝜋 is the inflation rate, Ov.In is an overall economic freedom index and
Bud.Def is the budget deficit/GDP.
Estimation with Ordinary Least Square (OLS) leads to the following results. (Table 4)
Table 4 - Estimation of Model 3
Dependent Variable: DLOG(GDP)
Method: Least Squares
Date: 06/16/16 Time: 17:29
Sample (adjusted): 1998 2015
Included observations: 18 after adjustments
Variable
Coefficient
Std. Error
t-Statistic
Prob.
RESID01(-1)
D(OVERALL_SCOR
E)
𝜋
Bud. Def.
-0.269507
0.124104
-2.171617
0.0476
0.006017
0.380348
0.866515
0.003282
0.120698
0.192988
1.833558
3.151241
4.489989
0.0881
0.0071
0.0005
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.478867
0.367195
0.029084
0.011842
40.39728
2.106967
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
0.051303
0.036561
-4.044142
-3.846282
-4.016860
See the interpretation of model 3 below:
log(𝑅𝑒𝑎𝑙𝐺𝐷𝑃) = −0.27𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙(−1) + 0.01∆𝑂𝑣. 𝐼𝑛 + 0.38𝜋 + 0.87𝐵𝑢𝑑. 𝐷𝑒𝑓
(Model 4)
Differential of economic freedom index equaled to .006, what proves statistically significant
positive impact of the overall index on GDP growth.
Correlogram - Q-statistics show that there is no autocorrelation in the Model 4. I tested the
null hypothesis the model is homoscedastic. A failure to reject null hypothesis indicated that
Model 4 is homoscedastic. (Table 5)
Table 5 - Heteroskedascisity Test
Heteroskedasticity Test: Breusch-Pagan-Godfrey
F-statistic
Obs*R-squared
Scaled explained SS
0.786272
3.506428
1.651775
Prob. F(4,13)
Prob. Chi-Square(4)
Prob. Chi-Square(4)
0.5542
0.4769
0.7995
Also histogram normality test showed failure to reject null hypothesis the model is normal,
what means that our model is normal. (Figure 2)
Figure 2 - Histogram normality test
5
Series: Residuals
Sample 1998 2015
Observations 18
4
3
2
1
0
-0.04
-0.02
0.00
0.02
0.04
Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
0.001765
-0.002797
0.050377
-0.035597
0.026331
0.686064
2.363910
Jarque-Bera
Probability
1.715508
0.424114
0.06
The most important finding in the Model 4 is the meaning of coefficient of Residual (-1) = 0.27, it proves the main objective about sustainability of a long run model: every next year,
model compensates deviation from long run equilibrium in the previews year by 27%.
CONCLUSION
The main objective of the paper was to show relation between economic freedom and the
most important macroeconomic parameter - Real GDP growth, also we had to discuss an
importance of economic freedom in transition period.
An empirical study proved our sense about sustainable correlation between freedom and
growth in a long term. Model 4 clearly defined that, if in the period t, there are any shocks
causing disequilibrium, in the period t+1 (ceteris paribus), they will be reduced to 0.26, in the
period t+2, to 0.262 and it gradually disappears.
It must be underlined that differential of the overall index (in Model 4) showed positive
impact on gdp growth but education did not. This was expected due to several reasons. As it
was mentioned above, an overall index consolidates 10 different components which influence
different macroeconomic parameters. For instance the components which are gathered in the
category of MARKET OPENESS (trade freedom, investment freedom, financial freedom)
are expected to have short and midterm impacts on gdp, so as soon as the level of economic
freedom goes down, firms immediately reduce investments, households start to save etc.
Transformation period from centrally planned economic system to market economy is hardly
to be implemented without mistakes. The heritage from the USSR was high level of
corruption and crime and civil wars in Abkhazia and South Ossetia. After dissolution of
USSR some of the countries had to start from the bottom, but Georgia was even below. It was
too difficult to concentrate on institutional changes when the future of the country was
blurred. More or less Georgia made some steps forward, but due to the low level of economic
freedom the results were poor.
Free society is doubly important in this case, but the point is that we must not confuse
freedom and chaos. Government still has a significant role to guarantee fair frameworks to
each individual who decides to enter the market. The only danger throughout transition period
is the lack of knowledge of how to act, as in the beginning individuals with irrational
expectations and irrational behavior can simply harm not only themselves but the overall
system.
As Adam Smith has mentioned many years ago, “the only fair is laissez-faire”, so every
government itself must be limited. Maybe in the exceptional cases we can approve
government interventions, but it should be strictly limited and unavoidable. Government’s
core functions are maintaining defense, keeping order, building infrastructure or promoting
education. It should keep market economy open and free and not act in ways that distorts it.
As the only thing that creates progress is open competition and economic freedom is a vital
factor for it.
References
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Carlsson, Frederik , and Susanna Lundstrom. "Economic Freedom and Growth: Decomposing the
Effects." Public Choice, Vol 112, No. 3/4, 2002: 335-344.
Cebula, Richard J., J.R. Clark, and Franklin G. Mixon. "The Impact of Economic Freedom on Per
Capita Real GDP: A study of OECD Nations." The Journal of Regional Analysis & Policy, 2013: 3441.
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National Statistics Department of Georgia. 06 15, 2016.
http://www.geostat.ge/index.php?action=page&p_id=374&lang=eng.
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