The Impact of Economic Freedom on Business Cycle Fluctuations

Abstract

Economics as a science, has not adopted one comprehensive explanation of how economic freedom affects economic fluctuations. Views rooted in Keynesian paradigm opt for steering the economic growth to mitigate depressions. On the opposite side, liberal views drawn from classical theories, point out self-regulating mechanism of a free market. There is also scarcity of empirical research in this area, as researchers tend to focus on economic growth rather than on fluctuations, while economic freedom measures have been published only since mid-1990’s. The aim of this dissertation is to fill in that gap, by investigating the impact of economic freedom on business cycle fluctuations. Scope of the research includes 34 countries (mostly OECD) and 92 quarters (1996-Q1 – 2018-Q4). Fluctuations are measured by deviation cycles of real GDP per capita, decomposed with extraction filters: Hodrick-Prescott’s filter with 3 different smothering parameters, Baxter & King’s, and Christiano & Fitzgerald’s. Because ‘economic freedom’ is a non-homogenous measure of the market economy, the study tests the relationship on its overall level and its components. In this study Index of Economic Freedom (IEF) is employed. In total, 20 econometric models are created. Fixed effects regression models with time dummies and control variables include structural factors to ensure robustness of the results. The study indicates that, despite limitation for practical implication resulting from non-homogeneity of the IEF, there is a negative effect of economic freedom on business cycle volatility. Each point of IEF inversely stands for 6% of the business cycle deviation as compared to its trend line (non-linear effect was not investigated in this study). There is also a cumulative effect of IEF components, – high scores in several categories result in total higher impact on economic stabilization. Of all components, monetary freedom (stable inflation, government not intervening in price mechanism) has the highest stabilizing effect amounting to 4%. Business freedom ( ease of doing business) as well as financial freedom (government not interfering in the financial/banking sector) also have stabilizing effect, which amounts to 1%. In terms of government size, tax policy was confirmed to act as an automatic stabilizer (amounting to 2%), but its effect is decreased by government spending, which in fact increases deviation cycle volatility by 1%. Legal system efficiency, market openness (ease of international trade), and investment freedom (constraints on capital investments) were found to have no statistically significant impact. Research result found its theoretical confirmation mainly in liberal economic doctrines. This insight is important for academic discussion, policy makers and their economic advisors.

Celem niniejszej pracy jest zbadanie, jaki jest wpływ stopnia wolności gospodarczej na przebieg cyklu koniunkturalnego. Zakres badania obejmuje 34 kraje (głównie OECD) w okresie 92 kwartałów (1996-Q1 – 2018-Q4). Fluktuacje gospodarcze wyrażone są jako cykl odchyleń realnego PKB per capita, uzyskanego przy pomocy filtrów: Hodrick-Prescott z 3 różnymi parametrami wygładzającymi, Baxter-King, oraz Christiano-Fitzgerald. ‘Wolność gospodarcza’, rozumiana jako miara wolnego rynku, nie jest pojęciem homogenicznym. Niniejsze badanie bada więc jej wpływ na poziomie ogólnym, jak i poszczególnych jej komponentów. Wykorzystany jest tu Indeks Wolności Gospodaczej (Index of Economic Freedom – IEF). Badanie opiera się na 20 modelach efektów stałych wraz ze zmiennymi zero-jedynkowymi czasu i, dla zapewnienia odporności statystycznej wyników, zmiennymi kontrolnymi biorącymi pod uwagę także czynniki strukturalne. Otrzymane wyniki znajdują potwierdzenie teoretyczne głównie wśród liberalnych doktryn. Niniejsza praca może nie tylko wzbogacić dyskurs akademicki, lecz stanowić także praktyczną wartość dla decydentów politycznych i ich doradców ekonomicznych.