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Public Choice (2009) 141: 103127
DOI 10.1007/s11127-009-9440-0
Hugo J. Faria Hugo M. Montesinos
Received: 21 February 2008 / Accepted: 1 April 2009 / Published online: 1 August 2009 Springer Science+Business Media, LLC 2009
Abstract A positive, statistical and economic signicant relation between growth, income level and the Economic Freedom of the World (EFW) index has been amply documented. Most analyses, however, use OLS methods which, in the presence of endogenous variables do not establish causality and produce biased and inconsistent estimates. This paper uncovers the exogenous component of EFW using IV methods and nds a robust channel from economic freedom to prosperity. The ndings, including instrument validity tests, support the importance of policies and institutions for development and warrants policy advice aimed at increasing economic freedom to foster prosperity.
Keywords Economic freedom Prosperity Policies Institutions Instrumental variables
JEL Classication O1 O43
1 Introduction
Why rich countries are rich and poor countries are poor, measured in terms of income per capita, is arguably the single most important question in economics. Among the rst writers in economics to address this question was Smith (1776). This concern is clearly reected in the title of his best known publication An Inquiry into the Nature and Causes of the Wealth of Nations. Recently and most notably Lucas (1988, p. 5, 2002) pondering about this issue states: The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else.
Since the revival of the economic growth literature in the mid 1980s (Romer 1986; Lucas 1988), the question of what causes prosperity continues to be a very contentious issue. For example, Easterly (2001a), accounts for theoretical misconceptions and numerous policy mistakes committed over the years in the pursuit of inducing growth among less developed countries.
H.J. Faria ( ) H.M. Montesinos
IESA Poba International 646, P.O. Box 02-5255, Miami, FL 33102-5255, USA e-mail: mailto:[email protected]
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Does economic freedom cause prosperity? An IV approach
104 Public Choice (2009) 141: 103127
Easterly and Levine (2003), among others,1 provide evidence indicating that, after controlling for institutions, policies do not matter for growth. Rodrik et al. (2004) conclude that institutions rule and that the distinction between policies and...