Economic freedom and human development

An important characteristic of economic institutions is the extent to which they promote economic activity to be coordinated by “personal choice, voluntary exchange, open markets, and clearly defined and enforced property rights,” or in other words, economic freedom (Gwartney Reference Gwartney2009: 939). Organizations such as the Fraser Institute annually publish indexes of economic freedom, distinguishing several aspects such as low government spending and low taxes, protection of property rights, sound monetary policy, free trade and low regulatory stringency of product, labor, and credit markets (for more details, see Table A2).

The literature has argued that economic freedom stimulates GDP per capita. A small government size and low taxes can lead to more efficient allocation of resources (Graafland and Compen, Reference Graafland and Compen2015). A good legal system that secures property rights and contracts provides incentives for innovation, as the protection of property rights ensures that entrepreneurs can reap the fruit of their labor (Nyström, Reference Nyström2008). Property rights ensure that the gains from the trade flow to the investor, which stimulates investments. Moreover, the enforcement of contracts makes it easier to access credit markets, which also fosters investment (Farhadi et al., Reference Farhadi, Islam and Moslehi2015). Stable prices due to sound monetary policy can reduce uncertainty and foster entrepreneurship (Bjørnskov and Foss, Reference Bjørnskov and Foss2008), while trade openness can provide opportunities for economies of scale and facilitate exchange of knowledge (Lucas, Reference Lucas2000). Government regulation may take insufficient account of economic dynamics and cause market rigidity (Friedman, Reference Friedman1999). Various empirical studies have indeed shown economic freedom is positively related to economic growth or GDP per capita (Azman-Saini et al., Reference Azman-Saini, Baharumshah and Law2010; Bennett et al., Reference Bennett, Faria, Gwartney and Morales2017; De Haan et al., Reference De Haan, Lundström and Sturm2006; Farhadi et al., Reference Farhadi, Islam and Moslehi2015; Hall et al., Reference Hall, Sobel and Crowley2010; Justesen, Reference Justesen2008; Murphy, Reference Murphy2016; Spruk and Kešeljević, Reference Spruk and Kešeljević2018).

A few studies have shown that economic freedom is also correlated with the HDI that combines income with education and life expectancy (as an indicator of health). Nikolaev (Reference Nikolaev2014) analyzed the relationship between economic freedom and human development for more than 100 countries for the period 1980–2010. He found that positive changes in economic freedom are related to positive changes in human development.

These findings are supported by other studies that have addressed the relationship between economic freedom and education (Schofer and Meyer, Reference Schofer and Meyer2005). Using data from 1972 to 2011 for 109 countries, Feldmann (Reference Feldmann2017) found a positive relationship between economic freedom and human capital investment. Secure property rights, a low level of taxation, and monetary stability protect economic agents from expropriation and create an incentive to invest in human capital. They also enhance the gains from economic exchange, incentivizing individuals to maximize the return on their human capital. Furthermore, economic freedom stimulates investment in education by facilitating the operation of credit markets. Similar results were found by Stroup (Reference Stroup2007), Aixalá and Fabro (Reference Aixalá and Fabro2009), and King et al. (Reference King, Montenegro and Orazem2012).

As economic freedom has been found to relate to income, and income to health (Frijters et al., Reference Frijters, Haisken-DeNew and Shields2005; Gardner and Oswald, Reference Gardner and Oswald2007), it is expected that economic freedom is also positively related to life expectation, the third dimension of the HDI. Stroup (Reference Stroup2007) argued that the increase in a market place's effectiveness due to economic freedom will not only lead to greater prosperity, but also to choices by individuals that enable them to live longer, healthier lives. Using panel data analysis on a sample of 104 countries during five periods of time (1980, 1985, 1990, 1995, and 2000), he found that economic freedom is positively related to health.

Moderation by generalized trust: three alternative hypotheses

Whereas previous studies tested the influence of economic institutions on economic development, recent theoretical studies have started to analyze the interactive effects of institutions and culture on economic growth (Bisin and Verdier, Reference Bisin and Verdier2017; Bowles, Reference Bowles2011; Masten and Prüfer, Reference Masten and Prüfer2014). For example, Bisin and Verdier (Reference Bisin and Verdier2017) argued that the effects of institutions on economic growth depend on the presence of appropriate cultural traits. Experimental research by McCannon et al. (Reference McCannon, Tokar Asaad and Wilson2018) showed a significant interaction effect between trust and contract enforcement in fostering contract formation. Also literature on interorganizational governance has shown that legal contracts and so-called relational governance (which includes trust) act as complementary (Arranz and Arroyabe, Reference Arranz and de Arroyabe2012; Poppo and Zenger, Reference Poppo and Zenger2002).Footnote ² When contract enforcement is greater, people are more likely to enter into an agreement, and this probability increases when people exhibit high rather than low levels of trust. These findings indicate that trust and contract enforcement are complements rather than substitutes. In this section, we build on this new avenue of research and will argue that the effects of economic freedom on human development are likely to be contingent on generalized trust. In other words, we contend that generalized trust moderates the relationship between economic freedom and human development. Moderation means that the influence of an independent variable on a dependent variable is conditional on a third variable (the moderator) (Preacher et al., Reference Preacher, Rucker and Hayes2007).Footnote ³

Trust can be defined as a psychological state comprising the intention to accept vulnerability based on positive expectations of the intentions or behavior of another person (Rousseau et al., Reference Rousseau, Sitkin, Burt and Camerer1998). The literature distinguishes between particularized trust and generalized trust (Berggren and Jordahl, Reference Berggren and Jordahl2006). The former entails trusting people you know, the latter trusting most people you do not know. Generalized trust indicates an inclusive and tolerant approach to the population at large and is considered to be at the heart of social capital. Generalized trust fosters so-called bridging social capital, which refers to the connections between dissimilar people (Jen et al., Reference Jen, Sund, Johnston and Jones2010).

Trust is an important factor in well-functioning cooperative relationships (Gächter et al., Reference Gächter, Herrmann and Thöni2004; Balliet and Van Lange, Reference Balliet and van Lange2013) and is the glue that builds and maintains longer-term relationships between buyers and sellers (Weitz and Bradford, Reference Weitz and Bradford1999). It is a precondition for social order and social cohesion, without which many forms of social interaction are much more difficult (Bjørnskov, Reference Bjørnskov2007; Helliwell and Putnam, Reference Helliwell and Putnam2004). In an economically free society, there are potentially more opportunities for commerce. Globalization through freeing markets from trade limitations provides more chances of economic interactions with more distant players (Tabellini, Reference Tabellini2008). But the extent that people or companies make use of these potential opportunities is dependent on trust. In order to benefit from these opportunities, it is important that people have generalized trust in distant trade partners (Alesina and Giuliano, Reference Alesina and Giuliano2015).

Trust is particularly important due to the existence of information asymmetries that create moral hazard. Market parties then face the risk that the other party may harm their interests. If people do not trust other people, they will be less likely to cooperate and avail themselves of the commercial gains that economic freedom creates. Although formal contracts specify the duties of both parties, along with penalties for agreement violation, it is often impossible to have a complete contract governing partners’ exchanges and relationships in an agreement (Arranz and de Arroyabe, Reference Arranz and de Arroyabe2012). Trust will safeguard against hazards that are poorly protected by the contract and help overcome the adaptive limits of contracts (Poppo and Zenger, Reference Poppo and Zenger2002). It lowers bargaining, monitoring, and policing costs, thereby increasing economic efficiency and stimulating collective investments in innovation, education, and health. In the absence of trust, transaction costs may become very high and many opportunities for mutually beneficial cooperation may be foregone. This complementary relationship may also function in reverse in the sense that formal contracts complement generalized trust. High trust can lead to “blind faith” that exposes the trusting party to malfeasance of the contract partner. In that case, formal contracts could counter the breach of trust, because they specify a clear scope of the alliance activities, regulate the basic behaviors of partner firms, and specify severe punishments for opportunistic behaviors (Jiang et al., Reference Jiang, Li, Gao, Bao and Jiang2013). Therefore, we expect there to be some complementary or synergic effect when both economic freedom and generalized trust are high. This implies that the positive effects of economic freedom on human development are likely to be stronger when people trust each other. If there is no trust, an economy relies better on government regulation. Fukuyama (Reference Fukuyama1995) postulates that people who do not trust each other only cooperate under a system of formal rules. Therefore, it might be beneficial to set up a system of formal regulatory rules (i.e. less economic freedom) when economic activity is inert to increases in freedom.

Based on these arguments, we predict that:

Hypothesis 1 implies that economic freedom and generalized trust are complementary: they reinforce each other in fostering human development. Another branch of literature has argued, however, that institutions and culture can also function as substitutes (Ahlerup et al., Reference Ahlerup, Olsson and Yanagizawa2009; Jiang et al., Reference Jiang, Li, Gao, Bao and Jiang2013; Knack and Keefer, Reference Knack and Keefer1997; Masten and Prüfer, Reference Masten and Prüfer2014; Poppo and Zenger, Reference Poppo and Zenger2002). When pro-social behaviors are not prevalent and generalized trust is low, economic agents can rely on formal contract arrangements to facilitate trade (McCannon et al., Reference McCannon, Tokar Asaad and Wilson2018). By comparison with other allocation mechanisms (for example, gift exchange or central planning), markets may function tolerably well in the absence of trust. A well-ordered legal system that protects property and contract rights increases the cost of opportunistic behavior, assuring people that self-interested trade partners are not likely to exploit them. The advantages of free market institutions then substitute for the benefits of trust (Bowles, Reference Bowles2011) and economize on virtues such as honesty (Hayek, Reference Hayek1948). By defining and enforcing property rights, economic freedom thus obviates the need for trust. This substitution relationship may also function in reverse: by reducing transaction costs, generalized trust may replace “contracts with handshakes.” If one party trusts the other, there is simply little need for contractually specifying actions (Poppo and Zenger, Reference Poppo and Zenger2002).

This leads to an alternative hypothesis in which the strength of the effect of economic freedom on human development is negatively related to generalized trust: if generalized trust is low, there is more need of free market institutions, whereas if trust is high, there is less need for free market institutions. Hence an increase in economic freedom will have a stronger effect on human development if generalized trust is low. If generalized trust is high, it substitutes for economic freedom and an increase in economic freedom will only have minor effects on human development:

Lastly, one could also argue that the relationship between economic freedom and human development is independent from generalized trust. This possibility arises if generalized trust not only increases the efficiency of market operation, but also fosters the efficiency of government intervention and regulations. In a more trustworthy country, government members are also more likely to be trustworthy and less inclined to abuse their position for personal benefits (Cruz-García and Peiró-Palomino, Reference Cruz-García and Peiró-Palomino2019), and this increases the efficiency of government actions. Moreover, if trust is high, citizens are more likely to comply with tax regulations, because they believe that others will also do so (Rothstein, Reference Rothstein2000). The implementation costs of government policies and regulations are lower where trust is high, as there is no need to create and maintain complex systems of supervision. An example is given by Putnam (Reference Putnam1993), who described a nationwide institutional reform in Italy at the beginning of the 1970s that established regional governments across the country. Although the institutions were virtually equal in setup, the efficiency of these government institutions differed vastly between different regions. The regions endowed with high levels of social capital had superior outcomes regarding all kinds of government services (job-training centers, day-care structures), investment, and environmental standards, compared with those without it. Hence, generalized trust not only enhances the efficiency of free markets, but also the efficiency of government actions and regulations. As a result, the effect of an increase in economic freedom (e.g. reduction in government intervention) on human development might be independent of the level of trust.

Model specification

Based on the previous sections, we propose the following model:

(1)$${\rm HD}{\rm I}_{{\rm i},t} = \alpha + \beta {\rm E}{\rm F}_{i,t} \, ^{\ast}\,{\rm G}{\rm T}_{i,t} + \gamma {\rm E}{\rm F}_{i,t} + \delta {\rm G}{\rm T}_{i,t} + \sum \varepsilon _k{\rm X}_{i,k} + \sum \zeta _n{\rm Z}_{i,n,t} $$

HDI denotes the human development life index, EF economic freedom, GT generalized trust, X (k) time-invariant control variables, and Z (n) time-variant control variables. The index i denotes country and t denotes year. The hypotheses are tested by estimating coefficient β. If β > 0, the results would provide support for hypothesis 1, meaning that trust and economic freedom are complementary. If β < 0, hypothesis 2 is supported, meaning that trust and economic freedom are substitutes. If β = 0, hypothesis 3 is supported, meaning that the influence of economic freedom on human development is independent from generalized trust.

In order to test for moderation, we should control for the linear influences of economic freedom and generalized trust (Preacher et al. Reference Preacher, Rucker and Hayes2007). Therefore, we add linear economic freedom and generalized trust as control variables in the model specification. As time invariant controls, we included geographical factors, regional dummies for Nordic and post-communist countries, a dummy for monarchy, and dummies for religions (Bjørnskov et al., Reference Bjørnskov, Dreher and Fischer2008; Feldman, Reference Feldmann2017; Hofstede et al., Reference Hofstede, Hofstede and Minkov2010; Özcan and Bjørnskov, Reference Özcan and Bjørnskov2011). As geographical variables we used the internal distance (an often-used measure of average distance between producers and consumers in a country) (Mayer and Zignago, Reference Mayer and Zignago2011) and temperature (Bjørnskov et al., Reference Bjørnskov, Dreher and Fischer2008). As time-variant dummies we included political rights and civil liberty, urbanization, the share of the labor force employed in the industrial sector, female labor participation rate, and age structure (Bennet and Nikolaev, Reference Bennett and Nikolaev2017; Feldmann, Reference Feldmann2017; Graafland and Lous, Reference Graafland and Lous2018; Leigh, Reference Leigh2006).

As a robustness test, we also estimated a simpler specification of the model, which we will test for two different samples, one consisting of high trust countries (β_h) and one of low trust countries (β_l):

(2a)$${\rm HD}{\rm I}_{i,t} = \alpha + \beta _h{\rm E}{\rm F}_{i,t} + \sum \varepsilon _k{\rm X}_{i,k} + \sum \zeta _n{\rm Z}_{i,n,t} $$

(2b)$${\rm HD}{\rm I}_{i,t} = \alpha + \beta _l{\rm E}{\rm F}_{i,t} + \sum \varepsilon _k{\rm X}_{i,k} + \sum \zeta _n{\rm Z}_{i,n,t} $$

In this model, hypothesis 1 is supported if β_h is significantly higher than β_l, hypothesis 2 is supported if β_h is significantly lower than β_l, and hypothesis 3 is supported if β_h does not significantly differ from β_l.

Complication: the link between generalized trust and economic freedom

We end this theory section by highlighting a complication that we have bypassed till now concerning the interdependency between generalized trust and economic freedom, and addressing the implications for our research. Generalized trust is based on a mixture of control, with dimensions as legal enforcement, and personal characteristics grounded in people's emotional bonds and moral attitudes, including civic virtues such as trustfulness, integrity, honesty, reliability, and justice (see also Beugelsdijk, Reference Beugelsdijk2006). A well-developed legal system that protects property rights and enforces contracts in a free economy reinforces a climate of generalized trust because there is every reason to believe that the chance of people getting away with deceiving others is small. Although generalized trust as a concept is distinct from control (and hence from various elements of economic freedom), it is likely to be highly related to the institutional context. If there is little variance in micro sources relating to personal characteristics between different countries and over time, generalized trust might empirically be largely determined by institutional differences and this might bias the results due to multicollinearity between economic freedom and generalized trust. In sections 3 and 4 we will therefore analyze the degree of correlation between economic freedom and generalized trust.

Bivariate correlation analysis

Table 2 reports the results of the bivariate correlation analysis. Table 2 shows that economic freedom, generalized trust, and the HDI are significantly related to each other. Furthermore, we found that the HDI is positively related to internal distance, the dummy for Scandinavian countries, monarchy, Christianity, political rights, civil liberty, urbanization, and the female labor market participation rate. The HDI is negatively related to the dummy for post-communist countries, Islam, the share of labor in industry and the share of youth population in total population.

Table 2. Bivariate correlation analysis

Note: Pearson correlation coefficients; italics p < 0.05; bold p < 0.01. The correlation coefficients for the bivariate relationship with the various control variables are available upon request with the authors.

Multiple regression analysis

Table 3 reports the results of the multiple regression analysis of random and fixed effects models for the HDI as specified by equation (1). The Hausman test shows that the fixed effects model is more reliable for life expectancy (and probably also for income), whereas the random effects model is preferred for HDI and education.

Table 3. Estimation results of moderated model

^a Change in AIC and BIC caused by inclusion of interaction term of economic freedom and generalized trust.

RE: random effects. FE: fixed effects. Robust standard errors. Significance: * p < 0.05, ** p < 0.01, *** p < 0.001. Number of observations: 91. Number of countries: 29.

We find that economic freedom is significantly and positively related to the HDI as well as to its three underlying components, income, education, and life expectancy. The interaction term of economic freedom and trust is positive and significant. These findings provide support for hypothesis 1 and reject hypotheses 2 and 3. As standardized trust ranges from -2 to + 2, the estimation results in column 1 of Table 3 imply that the marginal effect of economic freedom on the HDI varies from about 0.05 (0.49–0.44) for low trust countries to 0.93 (0.49 + 0.44) for high trust countries.

In order to test whether the models with interaction terms provide better explanations than the models without these effects, we calculated the AIC and BIC.Footnote ⁷ In all models, dropping the interaction term substantially increased the AIC and BIC for all models, which shows that the models with the interaction term have better explanatory power. We find no significant effects for linear trust or for most other control variables. Only for age structure do we find a negative effect, whereas urbanization incidentally has a positive effect on human development in random effects models.

Table 4 reports the estimation results for the simpler model specification (2) for high trust countries and low trust countries. We define high (low) trust countries as countries for which average trust during 1990–2015 is higher (lower) than the mean value of trust during 1990–2015. Using this distinction for all years during 1990–2015, the total number of observations increases from 91 to 242.

Table 4. Estimation results: high and low trust countries

Note: Controlled for all control variables reported in Table 3. Robust standard errors. Significance: * p < 0.05, ** p < 0.01, *** p < 0.001.

Table 4 shows that in all models the estimated coefficient of economic freedom is substantially higher for high trust than for low trust countries. In the four models for the HDI and income (columns 1–4) the difference in the estimated coefficients of economic freedom between high trust and low trust countries is significant at p = 0.05; in the four models for education and life expectancy (columns 5–8) the difference is not significant. These results provide further support for hypothesis 1 that generalized trust positively moderates the influence of economic freedom on human development, while rejecting hypothesis 2, that trust weakens the relationship between economic freedom and human development, and hypothesis 3, that the relationship between economic freedom and human development is independent of trust.