Economic Freedom Variables Endogenous to Business Cycles

Abstract

A large empirical literature has found positive effects of economic freedom on economic outcomes, such as output and per capita growth. However, several variables in the index are very likely to decline in conjunction with recessions. In the absence of these variables, does the well-studied positive relationship between economic freedom and economic output hold? This paper makes use of a dynamic panel to compare the performance of economic freedom with and without these variables, which pertain to levels of government spending, rates of inflation, government borrowing, and interest rates. Two specifications fall in their statistical significance from the 1% to the 10% level when variables relating to inflation are omitted. The worst case considered finds one specification size of the effect is still 66.3% of the effect size of the standard measure of economic freedom. These findings are consistent with this kind of endogeneity being a minor problem with the data set when imperfect identification strategies are employed, but the issue should be strongly considered when business cycles are pertinent to a research question using economic freedom data.