Economic Freedom, Growth, and What Might Have Been

by Matt Mitchell on September 16, 2016

in Economic Freedom, Economic Growth

Economists are obsessed with growth. And for good reason. Greater wealth doesn’t just buy us nicer vacations and fancier gadgets. It also buys longer life spans, better nutrition, and lower infant mortality. It buys more time with family, and less time at work. It buys greater self-reported happiness. And as Harvard economist Benjamin Friedman has argued, wealth even seems to make us better people:

Economic growth—meaning a rising standard of living for the clear majority of citizens—more often than not fosters greater opportunity, tolerance of diversity, social mobility, commitment to fairness, and dedication to democracy.

For much of my lifetime, brisk economic growth was the norm in the United States. From 1983 to 2000, annual growth in real (that is, inflation-adjusted) GDP averaged 3.67 percent. During this period, the U.S. experienced only one (short and mild) recession in the early ‘90s. The era was known among macroeconomists as the “great moderation.”

But starting around the turn of the millennium, things changed. Instead of averaging 3.67 percent growth, the U.S. economy grew at less than half that rate, 1.78 percent on average. To see the effect of this deceleration, consider the chart below (data are from the BEA). The blue line shows actual GDP growth (as measured in billions of chained 2009 dollars).

The red line shows what might have happened if we’d continued to grow at the 3.67 percent rate which prevailed for the two previous decades. At this rate, the economy would have been 30 percent larger in 2015 than it actually was.

This assumes that the Great Recession never happened. So to see what would have happened to GDP if the Great Recession had still occurred but if growth had resumed (as it has in every other post-WWII recession), I calculated a second hypothetical growth path. The green line shows the hypothetical path of GDP had the economy still gone through the Great Recession but then resumed its normal 3.67 percent rate of growth from 2010 onward. Under this scenario, the economy would have been fully 8 percent larger in 2015 than it actually was.


(Click to enlarge)

So what happened to growth? One answer is economic freedom—or a lack thereof. Just yesterday, the Fraser Institute released its annual Economic Freedom of the World report. Authored by Professors James Gwartney of Florida State University, Robert Lawson of Southern Methodist University, and Joshua Hall of West Virginia University, the report assesses the degree to which people are free to exchange goods and services with one another without interference. As Adam Smith might have put it, it measures the degree to which we live under “a system of natural liberty.”

As the chart below shows, economic freedom was on the steady rise before 2000. This coincided with modest deregulation of a few industries under Carter and Reagan, tax cuts under Reagan and Clinton, free trade deals, and restrained growth in the size of government. But from 2000 onward, U.S. economic freedom has been in precipitous decline. This coincides with major new financial regulations under both Bush II and Obama, significant growth in government spending, and a steady erosion in measures of the rule of law.


(Click to enlarge)

As I’ve noted before, the research on economic freedom is quite extensive (nearly 200 peer-reviewed academic studies use economic freedom as an explanatory variable). Moreover, meta-studies of that literature find “there is a solid finding of a direct positive association between economic freedom and economic growth.”

Perhaps the two charts have something to do with one another?



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