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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 Ayal, Eliezer B., and Georgios Karras. "Components of Economic Freedom and Growth: An Empirical Study." Journal of Developing Areas, Vol. 32, No. 3, 1998: 327-338. 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. National Bank of Georgia. 06 15, 2016. https://www.nbg.gov.ge/index.php?m=304. National Statistics Department of Georgia. 06 15, 2016. http://www.geostat.ge/index.php?action=page&p_id=374&lang=eng. Papava, Vladimer. Economic Reforms in Post-Communist Georgia: Twenty Years After. New York: Nova Science Publishers, 2013. The Heritage Foundation. 06 15, 2016. http://www.heritage.org/index/explore. Wooldridge, Jeffrey M. Introductury Econometrics: Modern Approach. 4th Edition. Mason, OH: South-Western Cengage Learning, 2009.