Influence of Selected Institutional Factors on the Economic Growth ...

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ScienceDirect Procedia Economics and Finance 30 (2015) 702 – 709

3rd Economics & Finance Conference, Rome, Italy, April 14-17, 2015 and 4th Economics & Finance Conference, London, UK, August 25-28, 2015

Influence of Selected Institutional Factors on the Economic Growth: Case Open Markets Pavel Procházkaa, Klára Čermákováa a

University of Economics, nam. W. Churchilla 4, Prague 3, 130 67, Czech Republic

Abstract This article's goal is to judge impacts of selected institutional factors on economic growth. Institutional economics, which started developing its modern approach after 1990 is closely in connection with Index of Economic Freedom presented by The Heritage Foundation. The article shows comparison of selected institutional variables (Open Market category) with economic development of particular countries' both theoretical framework and empiric analysis. Empiric section uses data of The Heritage Foundation on which the connection between selected indicators and economic progress (represented by income per capita) is compared. Markets) on the economic growth. The research part concentrates on testing selected basic preconditions that countries striving for economic growth should meet. These requirements are defined by the Heritage Foundation organization and published under the abbreviation IEF. After the economic crisis of 2008/09 the index became a target of criticism and its methodology was doubted by many. Influence of these factors have been tested several economists with positive results. This study, however, did not confirm theory about positive correlation between trade openness and economic growth in mid-term horizon. Similarly, there is no direct connection between influence of FDI inflow and economic development. On the other hand, study showed positive correlation between R&D expenditures and economic growth. Similarly, economics with friendly business environment reach better economic condition. © 2015 The The Authors. Published by Elsevier B.V. This is an open access article under the CC BY-NC-ND license © 2015 Authors. Published by Elsevier B.V. (http://creativecommons.org/licenses/by-nc-nd/4.0/). Peer-review under responsibility of IISES-International forEconomics Social and Economics Sciences. Peer-review under responsibility of IISES-International Institute forInstitute Social and Sciences. Keywords: Institution economics; Economic growth; Trade, Investment freedom

1. Introduction Institutional economics in its modern form began to develop after 1990 and related to the works of de Soto (1989) and North (1991). It offered a new approach to the problematic of economic growth based on so-called rules of behaviour of institutions (i.e. factors) such as legal framework or religion. Such factors used to be neglected in the economic theory; however, these very factors may be the cause of uneven economic growth, intensity variation of convergence and inequality among countries and people, as measured by income or GDP per capita. Compared to the

2212-5671 © 2015 The Authors. Published by Elsevier B.V. This is an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/).

Peer-review under responsibility of IISES-International Institute for Social and Economics Sciences. doi:10.1016/S2212-5671(15)01319-2

Pavel Procházka and Klára Čermáková / Procedia Economics and Finance 30 (2015) 702 – 709

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beginning of the industrial revolution when the difference between the richest and the poorest countries, measured in GDP per capita, was negligible, in the 1960s it grew 68 times and now it is 456 times higher. In some countries, the pace of growth also changed. The era of doubled GDP per capita in the first half of the 20 th century seemed promising and lasted from 30 to 50 years. However, in the second half of the century it failed to exceed 20 years (Parente, Prescott, 2000 in Parente, 2008). S. Kuznets called this development the “modern economic growth” (Parente, 2008, p. 24). Although economists have been trying to find causes of growth, factors that influence it and conditions of its sustainability for a very long time, to this day we have no satisfactory answers. It could be partly caused by concentration on what is called hard growth factors (e.g. investment and technologies) or omission of the fact that growth factors are not stock but flow variables. Conditions, under which the economy grows, therefore change. That means so-called soft growth factors, which include institutions, are important for explanation of the growth as well as its convergence and inequality among countries and people*. The aim of the present paper is to demonstrate the influence of selected institutional factors (Trade Freedom, Investment Freedom). The research proceeded from data published by The Heritage Foundation for 2013. 2. Used Methods and Methodologies IEF is crucial indicator of potential growth for many economists. To the importance of IEF showed in their studies Hansson (2009), Joreiman (2004), Skaaning (2010), Xu (2011), Durlauf (2008), Parente (2008), Baumol (2007), Mitchell (2013), Lewis (2005), Barro (2009, 2013), Chao (2010) or Ortiz (2009). The aim of the approach adopted is to verify Ortiz’s thesis about positive influence of Open Markets parameters, especially openness in international trade and capital flow on economic growth. In his research, Ortiz (2009) demonstrated that country (economy) more involve in international trade and capital flow reaches higher economic growth. To support his theory we use data of IEF. Indicators will most often be compared with GDP per capita (prices of 2000 in USD), year-on-year change in growth, or average growth rate in medium-term period (as for this paper it is a period of 5 years, 2008–2012). The reason for choosing this methodology stems from dependence of the indicators of IEF and GDP per capita, as indicated in Figure 1, which compares GDP per capita and the degree of freedom in individual countries (represented by the points in the graph). The 2012 values show that there is a relatively strong correlation between the two variables, which proves that both these indicators are significant. The relationship between the two parameters can be demonstrated with the help of regression analysis. The correlation coefficient can also be used to define the degree of dependence between the observed parameter and economic development. The correlation coefficient measures the relative significance of two variables (in our case it means one of the ten variables in correlation with GNI per capita). 3. The Influence of Institutional Factors on the Economic Growth: Open Markets In this part of the paper we present results of testing selected parameters of the aforementioned Index of Economic Freedom (IEF). IEF evaluates individual countries according to 10 parameters divided into 4 groups: Rule of law (Property rights, Freedom from corruption), Limited government (Government spending, Fiscal freedom), Regulatory efficiency (Business freedom, Labour freedom, Monetary freedom) and Open markets (Trade freedom, Financial freedom, Investment freedom). These results provide a set of suggestions concerning reforms in fields that need to be reformed in order to boost the economic growth. From the factors in question we chose group 4, which falls within Open Markets, as factors of this group have been studied for the longest time.

*

Under the term “development” in this text we understand a number of indicators such as improving living conditions, environment, happiness and satisfaction, security and freedom. Under “growth” we understand GDP per capita and its derivatives.

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This group involves Trade Freedom indicators that measure the scope of barriers on imported goods according to the extent of tariffs. Non-tariff barriers (quantitative restrictions, requirements for specific quality etc.) are also taken into consideration and fall within categories of Investment Freedom and Financial Freedom. Investment Freedom measures restrictions on foreign capital and the possibility of investors to invest in whatever sector they like. Financial Freedom measures independence of the banking sector, share of the state in the banking sector, influence of the government on bank’s lending policies etc. 3.1. Trade Freedom The Trade Freedom indicator, which is probably the oldest of all indicators, is used to deduce wealth of a country from its integration into international trade. Such deductions were already made by classics of economy, Smith (1776) and Ricardo (1817). From the historical point of view, the most developed countries were those that were engaged in trade. As an example we can name prosperous medieval Italian cities or cities of the Hanseatic League. During the Great Depression the USA adopted the Smooth-Hawley Tariff Act (1932) which increased import tariffs by 60%. Soon after that, European countries introduced the same countermeasures. As a result, export from the USA to Europe declined immediately by two-thirds and the crisis even deepened (Chao, 2010). The Trade Openness indicator can be used for empirical observation of the importance of trade. It measures the degree of openness of the country, or more precisely, involvement of the country into international trade. It is defined as a share of exports of goods and services (% GDP) to imports of goods and services (% GDP). The data source was the database of the World Bank. Economies of countries that have greater trade openness (and therefore higher ratio of exports to imports) are more likely to grow (Ortiz, 2009).

GDP Growth (%)

20,0 R2 = 0,4624 Correlation = 0,18

15,0 10,0 5,0 0,0 -5,0 0,0

5,0

10,0

15,0

20,0

25,0

30,0

Tariff Rate (%) Fig. 1.Development of the GDP growth rate in the mid-term horizon depending on tariff barriers Source: 2013 Index of Economic Freedom, our own adjustment

Analysis of openness of the economy can be also assessed through the comparison of tariff barriers extent with GDP per capita or with average growth rate in the medium-term horizon (Figure 1). The data show that countries that have lower tariffs achieve higher living standard. As for the relation to the average growth rate, the situation has been ambiguous in last five years. A regressive analysis has not proven a direct dependence between GDP growth and the rate of import surcharges, the reason being the existence of many bilateral (or multilateral) agreements on free trade. Duty-free policy creates a distorted picture of trade barriers.


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3.2. Investment Freedom Under investment freedom the IEF understands freedom of capital movement and the extent of the state’s supervision over it. This indicator includes a survey of openness of the country to foreign investors and restrictions against the capital inflow. The underlying assumption is that an economy that is more open to foreign capital achieves higher IEF. Such country would be considered safer for investors and there would be greater inflow of capital. Figure 2 shows that there is a moderate positive correlation between these two parameters. FDI Inflow (log scale)

6 5 4 3 2 1

R2 = 0,1245 Correlation = 0,35

0 0,0

20,0

40,0

60,0

80,0

100,0

Index of Openess Fig. 2. Correlation between FDI inflow (log scale) and IEF Source: 2013 Index of Economic Freedom, our own adjustment

Business activities are represented by the third group of the IEF – Business Openness. They are in direct relation with investment freedom. The influence of entrepreneurs on the economic growth has been known for quite a long time. For example Schumpeter (1942, p. 83) considered business activities an essential element without which economy would stagnate: “The fundamental impulse that sets and keeps the capitalist engine in motion comes from the consumer’s goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.” Schramm (2008) decided to follow Schumpeter’s way and was another one to study the business environment. He expanded the necessity of business activities to labour market mobility. Schramm (2008) considered market mobility crucial as it allows individuals to be motivated to start their own business.†

†

This issue is more of a digression from the microeconomic part and represents a key aspect of economic freedom, which Schramm (2008) called fluidity. The degree of economic freedom (and growth) in any society reflects the ability of institutions to adapt to market conditions. Yet, Schramm (2008) was not the first one to embed the business sector into micro level. This privilege belongs to Hernando de Soto (1989), whose vision of improving the country’s economic situation is a bottom-up process based on creation of business environment from which everyone will eventually benefit.

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GDP per Capita

To show the importance of friendly conditions for entrepreneurship we proceed from Doing Business Index. As you can see bellow (Figure 3), there is mild positive correlation between GDP per Capita and openness for entrepreneurs. $70 000 $60 000 $50 000 $40 000 $30 000 $20 000 $10 000 $0

R² = 0,4082

0,0

50,0

100,0

150,0

Doing Business Index Figure 3 Correlation between GDP per Capita and Doing Business Index Source: 2013 Index of Economic Freedom, 2013 Doing Business, our own adjustment

Ability to act freely, to sets a new entrepreneurship leads to nature and causes of the wealth of nations. Innovation – the creation of new knowledge and applications that flow from it – and entrepreneurship. For importance of innovations see Schumpeter (1942), Romer (1990), Lewis (2005), Baumol (2007) etc. Common question is what determines innovation? Schramm (2008) offers an explanation in the term of fluidity: „Fluidity, then, is that condition of a loose yet stable alignment of institutions, organizations, and individuals that facilitates the exchange and networking of knowledge across boundaries“ (Schramm, 2008: 17). This fosters both innovation and its propagation through entrepreneurship (Ibid). A you can see bellow (Figure 4), there is strong correlation between R&D expenditures (% GDP) and GDP per Capita (R2 = 0.952). It is obvious that country (economies) with higher share of R&D expenditures generates higher personal income. 3

High income

R&D (% GDP)

2,5

R² = 0,9523

2 1,5 1 0,5 0

EU

Middle income Upper middle Low & middle Lower middle 0

10000

20000

30000

High income: OECD

40000

50000

GDP per Capita (USD) Fig. 4. Correlation between GDP per Capita and share of R&D expenditures (% GDP) Source: The World Bank, our own adjustment


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Global Innovation Index

A similar conclusion can be reached through the Global Innovation Index, published by Cornell University and World Intellectual Property Organisation.‡ On the basis of the values (Figure 5) can be seen a fairly strong correlation between the two variables. 100,0 R² = 0,6234

80,0 60,0 40,0 20,0 0,0 0

20 000

40 000

60 000

80 000 100 000 120 000

GDP per Capita (PPP) Fig. 5. Correlation between GDP per Capita and Potential of Innovation

Source: The Global Innovation Index, The World Bank, our own adjustment

When talking about institutions, the so-called fluidity is a particular importance. It indicates the company’s ability to adapt to changing market conditions and to absorb these changes efficiently. Therefore it also depicts the openness of the market to new ideas. Institutions work as “research gateways” or “durable systems of established and embedded social rules that structure social interactions” (Hodgson, 2004 in Schramm, 2008). This concept of fluidity is a parallel to the work of Phelps (2007), who dealt with the concept of “dynamism in economy”. His aim was to clarify differences in economic performance across countries. According to Phelps (2007, p. 15): “The level of dynamism is a matter of how fertile the country is in coming up with innovative ideas having prospects of profitability, how adept it is at identifying and nourishing the ideas with the best prospects, and how prepared it is in evaluating and trying out the new products and methods that are launched onto the market… A country's economic model determines its economic dynamism… There are two dimensions to a country's economic model. One part consists of its economic institutions… The other part of the economic model consists of various elements of the country's economic culture.” Difficulties of some countries may not necessarily lie in absence of the institutions but in their inability to adapt to changing market conditions. This is confirmed, among others, by researches carried out by Fairlie (2007) and Baumol (2002, 2007). These works indicate that on one hand, a high degree of business activity is desirable, but on the other hand, it is not a condition sufficient enough to stimulate performance of the economy towards high industry.§ 4. Conclusion The aim of the present paper was to assess the influence of selected institutional factors (Open Markets) on the economic growth. The research part concentrates on testing selected basic preconditions that countries striving for economic growth should meet. These requirements are defined by the Heritage Foundation organization and published under the abbreviation IEF. After the economic crisis of 2008/09 the index became a target of criticism and its methodology was doubted by many.

‡

Více o studii inovačního potenciálů jednotlivých zemí viz The Global Innovation Index 2014 – The Human Factor in Innovation, World

Intellectual Property Organization. § There are other theories and factors that may influence the growth potential. For example Hall (1997) considers appropriate infrastructure to be a crucial element of economic performance as it stimulates production.

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