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KYKLOS, Vol. 65 August 2012 No.

3, 371407

Democracy, Economic Freedom and Growth in Transition Economies


Evgeni Peev and Dennis C. Mueller*

I. INTRODUCTION It has been roughly twenty years since communism collapsed in East Europe and the Soviet Union. Although former communist countries are still generally referred to as transition countries, enough time has elapsed since the end of communism to claim that the transition process is, or should be, largely completed, and to assess how well the countries have done achieving growth and transforming themselves into market economies. When communism collapsed, the expectation (hope) in the West was that the former communist countries would become both free market economies and democracies. In many cases this happened, but not in all. Indeed, several former members of the Soviet Union have either not adopted democratic institutions at all, or quickly reverted to some form of authoritarian rule after a brief interlude of democracy. In principle, a country might remain a dictatorship and still introduce economic reforms that create market and capitalist institutions. Indeed, since it faces no political opposition, a dictatorship might conceivably be able to implement market reforms faster than a democracy. Singapore illustrates that dictatorship and free market institutions can exist side-by-side. Singapore seems to be somewhat of an exception, however. We shall, therefore, examine the extent to which the introduction of democratic institutions has been accompanied by market reforms and has led to more rapid growth in transition countries. A large literature in political science links democracy to various socioeconomic variables like income and education. Kitschelt (1999) has argued that institutional choices in the early post-communist transition years were the result
* Evgeni Peev Department of Economics, University of Vienna, BWZ-Bruenner str. 72, A-1210 Vienna, Austria. E-mail: evgeni.peev@univie.ac.at Tel: +43-1-4277-37489 and fax: +43-1-4277-37498. Dennis C. Mueller Department of Economics, University of Vienna, Hohenstaufengasse 9, A-1010 Vienna, Austria. E-mail: dennis.mueller@univie.ac.at Tel: +43-1-4277-37408 and fax: +43-1-4277-37498. The authors would like to thank the editors of Kyklos, and the referees for helpful comments on the rst draft. We are grateful to participants at the DEMO workshop at Universitat Autnoma de Barcelona and EAIRE 36th Annual Conference in Ljubljana. We wish to thank the Austrian National Bank for nancial support under the Jubilumsfondsproject Nr. 12325 and the FWF project P 19522-G14.

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of deeper structural factors such as bureaucratic legacies and state-society relationships. An additional factor spurring the movement toward democracy for many transition countries was the lure of joining the European Union (Cameron, 2007). We identify the factors that led some former communist countries to democratize and others not to do so. When the transition process began, the state was the major economic actor in all transition countries. State-owned enterprises were dominant, and the allocation of resources was guided by state bureaucracies rather than market forces. Public sectors, measured by government outlays and taxes, were not unusually high, however. The transition process thus has at least two dimensions with respect to state activity: (1) privatization of state enterprises and the liberalization of economic activity, and (2) changes in government expenditures, transfers and taxes. We treat both dimensions separately and propose and test hypotheses about the relationship between democracy, economic liberalization and growth, and between democracy, the size of the state, and growth. A large literature has established a relationship between the quality of a countrys economic institutions and economic growth.1 Countries with low levels of corruption, strong property rights, independent judiciaries and other institutions that underpin market systems grow faster. Glaeser, La Porta, Lopezde-Silanes and Shleifer (2004) have criticized this interpretation of the evidence, however. They argue that economic and political institutions are endogenous, and that the key exogenous determinants of economic growth are a countrys stocks of human and social capital. The evidence that they present for this proposition is drawn from the growth experiences of developing countries since 1960, and the long-run growth histories of currently, highly developed countries. We reexamine the relationship between economic institutions and growth for a sample of transition countries. Transition countries represent a particularly good source of data for testing the importance of institutions for economic growth, because they all began the transition process as dictatorships with weak economic institutions. Moreover, in comparison with other developing countries, they all began the transition process with relatively large stocks of human capital. Thus, differences in this variable should not play a decisive role explaining differences in growth rates in the transition countries. In this article we test to see whether the former communist countries, which did liberalize their economies, were rewarded with faster growth. Most studies of the effects of economic liberalization on growth measure liberalization using a single index of economic freedom.2 Fidrmuc (2003), for example, measures economic liberalization in transition countries using an unweighted mean of eight EBRD indicators of progress in transition. This index
1. See, Johnson, Kaufmann, and Shleifer (1997), Metelska-Szaniawska (2009) for transition countries, and the survey by De Haan, Lundstrm and Sturm (2006). 2. There are few exceptions. See, Justesen (2008).

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mixes different aspects of reform such as large- and small-scale privatization, governance and enterprise restructuring, price liberalization, trade and foreignexchange liberalization, competition policy, and banking and securities markets reform.3 As Heckelman and Stroup (2005) show, however, these aggregations have several potential methodological problems. Therefore, in this article, we examine the link between separate measures of liberalization and growth in transition countries. Some other authors have tried to overcome the aggregation problem by dividing the aggregate indexes into subsets. Tommaso, Raiser and Weeks (2007), for example, subdivide them into one group of indexes measuring initial economic reforms, and another containing indicators of institutional reform. However, as the authors note, some aspects of reform (e.g. large-scale privatization) do not clearly fall into either subset. Other authors examine the link between economic reform and growth focusing on only a few dimensions of reform small-scale privatization, price and trade liberalization (Falcetti, Raiser and Sanfey, 2002); privatization (Godoy and Stiglitz, 2006). A rst contribution of the article is thus to identify which economic freedoms make the greatest contributions to growth. Several of the transition countries were hard hit by the global nancial crisis that occurred toward the end of the last decade. One of the interesting and, perhaps for some, surprising ndings of this article is that some of the factors associated with faster growth prior to the crisis were associated with greater declines in growth during the rst years of the crisis. A second contribution of the article is to examine the effects of economic freedoms, public expenditures and scal balance on growth in transition countries over the period 19942007, and following the nancial crisis (20082009). We wish to describe what has happened in the transition countries since the end of communism and why it has happened. Underlying the analysis is the basic premise that the shift to a market economy and the performance of the economy were related to the strength of the democratic institutions established. We shall see that this was largely the case with a few important exceptions. The plan of the paper is as follows. We begin by describing what has happened since the fall of communism (Section II). Which countries became democracies? Which liberalized their economies? Which grew the fastest? In Section III we set forward our main hypotheses and present some evidence regarding the adoption of democratic institutions and economic freedoms in the transition countries. The relationships between economic freedoms, the size of the state, and growth are examined in Section IV. Additional tests of the main hypotheses are presented in Section V. In Section VI, we analyze the experience of the transition countries during the rst years of the nancial crisis (2008 and 2009). Conclusions are drawn in the nal section.
3. Recently, EBRD constructed a ninth index measuring infrastructure reforms.

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II. WHAT HAS HAPPENED?

1. Initial conditions
Table A1 lists for 1990 and 1995 the GDP per capita (Gcap) and secondary (Sec) and tertiary (Ter) school enrollment percentages for each of the 24 transition countries upon which this study focuses (see Appendix). The year 1990 comes one year after the satellite communist countries in Europe abandoned communism, and one year before the Soviet Union did, and thus constitutes essentially the starting point of the transition process. Because of the massive upheavals through which the transition countries passed in the early years, the focus of this study is on the post-1995 period, and thus, 1995 will also be used as a starting point in our empirical work. The last column in Table A1 presents the scores given by Kitschelt (1999, Appendix) for the communist legacy (ComLeg) of each transition country. These scores represent Kitschelts evaluation of the communist bureaucracies whether they were professional or relied on patronage, or patrimonial. The higher the score, the better suited a countrys communist legacy was to the development of liberal economic and democratic institutions. Table A1 groups the transition countries into four sets: ve central and eastern European countries (CEE-5), ve southern and eastern European countries (SEE-5), the three Baltic States, and the remaining countries from the former Soviet Union (FSU).4 Each set of countries has elements of both geography and political history in common. The two richest transition countries in CEE in 1990 were Slovenia and the Czech Republic. The three Baltic countries also had relatively high incomes per capita in the early 1990s. Russia, Ukraine, Belarus, Turkmenistan and Kazakhstan had relatively high GDPs per capita at the start of the transition, but the remaining FSU countries were initially rather poor. All transition countries had close to 100 percent school enrollments for primary level students, so we focus on enrollments in secondary schools and universities as measures of differences in human capital. Here the FSU countries score rather well with the four lowest secondary school enrollments in 1990 in the ve SEE countries Bulgaria, Croatia, Albania and Macedonia. Both Russia and Belarus had over 50 percent enrollment levels at universities in 1990, the only transition countries to reach such high levels. On the other hand, secondary and tertiary enrollments tended to increase after the transition process began in the CEE and SEE countries, while they tended to fall in most of the FSU countries. Spagat (2003) establishes a link between the economic success of
4. Some SEE countries (Bosnia, Kosovo, Montenegro and Serbia) and FSU countries (Uzbekistan) are not included in our sample due to lack of data.

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transition countries and their ability to maintain or increase their levels of human capital. The communist legacy scores for the four country groups are quite homogenous within groups, and differ greatly across groups. The ve CEE countries receive scores of 2 or in the case of the Czech Republic 3, and the three Baltic States also get 2s. The ve SEE countries get 1s, on the other hand (1.5 for Croatia), while the FSU countries get either zeros (7) or ones (4). Thus, according to Kitschelt, the CEE and Baltic countries were much better positioned for a successful transition than were the SEE and FSU countries.

2. Democracy
Of course, initial conditions for all transition countries with respect to politics were essentially the same authoritarian. Over time, however, some became democracies while others remained or reverted back into dictatorship. To measure the strength of a countrys democratic institutions, we use Freedom Houses Index of Democracy. Freedom House has covered transition countries in two publications: Freedom in the World reporting annually two indicators (political rights and civil liberties scores) and Nations in Transit, a comprehensive survey of reforms in transition countries since 199495. While the former publication is useful for comparative studies between established democracies and post-communist countries, the latter presents a more comprehensive picture of post-communist transition focusing on seven dimensions of democratic institutions.5 We thus use this composite index of democracy in our study.6 The index runs from one to seven, with one signifying the strongest democratic institutions. The rst three columns of Table A2 present the values for 1999, 2007 and the average for the period 19992007 (see Appendix).7 The average for the CEE countries is around two. Thus, CEE countries score high in terms of both levels of income per capita, and the strength of their democratic institutions, which is consistent with the common nding in political science that democracy and income levels are positively associated.8 The numbers in Table A2 indicate that the ve CEE countries have successfully introduced democratic institutions, although they still do not match the scores of one obtained by Western European, EU countries. Somewhat troubling is the slight upward drift in the index in Poland and Hungary. Slovakias index, on the other hand, fell over the time period bringing it more in line with the other CEE
5. There is a very strong correlation between the average political rights and civil liberties score and the composite index of democracy (in 2007, for example, r = 0.98). 6. Brief descriptions of it and the other variables used in the study appear in the appendix. 7. The earliest year for which the democracy index is dened in its present form is 1999. Prior to 1999, it did not include the category of corruption. 8. See, for example, Lipset (1960) and Przeworski, Alvarez, Cheibub and Limongi (2000).

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countries. The high democracy scores for the CEE countries are in line with Kitschelts predictions based on the communist legacy in these countries. The democracy scores for the FSU countries all fall between four and the maximum possible seven. Scores above six imply virtual dictatorships. By 1999, all FSU countries had settled down into some form of electoral authoritarianism or outright authoritarianism.9 This pattern is also consistent with Kitschelts predictions based on the communist legacy in these countries. Elections are typically held in FSU countries, but the results are foregone conclusions long before votes are counted, and presidents routinely are reelected with 80 percent or more of the votes cast. The atrophying of democracy in Russia is still visible during the rst years of the 21st century, as its democracy index rises by nearly one and a half points between 1999 and 2007, indicating a substantial weakening of the strength of its democratic institutions. Indeed, every FSU country had a higher Freedom House score (weaker democratic institutions) in 2007 than in 1999. In contrast, only three of the remaining 13 countries in Table A2 had higher democracy index scores in 2007 than in 1999. All of the transition countries either wrote new constitutions at some time after the collapse of communism, or radically modied earlier constitutions, perhaps dating back to before communism. When choosing political institutions, transition countries could select between a parliamentary system with weak or nonexistent president, a strong presidential system, or something in between. The last two columns of Table A2 report transition countries scores for system of government from the World Banks Database on Political Institutions (DPI). A score of zero implies a strong presidential system, two a pure parliamentary system, with scores between 0 and 2 representing mixed systems. In the far right column are the classications of Metelska-Szaniawska (2009) based on a careful reading of each countrys constitution. The two classications are in substantial agreement. The simple correlation between the DPI system score and the democracy score for 2007 is -0.68, and between the DPI and the mean democracy score -0.64. Thus, strong presidential systems are closely associated with authoritarianism, and parliamentary systems with strong democratic institutions. This need not be the case, of course. The United States is a strong democracy with a strong president. In the transition countries, however, it would appear that those countries that remained authoritarian simply institutionalized this choice by creating a presidential system. In addition, countries which started off in the direction of being strong democracies, like Russia and the Kyrgyz Republic, but instituted strong presidential systems, appear to have succumbed to the temptation afforded by a presidential system to become authoritarian.

9.

For discussions of these concepts and regimes, see Levitsky and Way (2002), Diamond (2002) and Schedler (2002).

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3. Economic freedom
Economic freedoms were, of course, severely restricted under communism and at the start of the transition process. As with democratic institutions, economic freedoms have strengthened at varying speeds or in some cases hardly at all, in the transition countries. In this study, we measure the strength of economic freedoms using indexes of Economic Freedom produced by the Heritage Foundation. Many studies use instead the index of economic freedom of the Fraser Institute. For our purposes, the Heritage Foundation indexes have some advantages over the Fraser index. The Heritage Foundation updates its data on an annual basis while the Fraser index presents data only for ve year periods. Because economic institutions were changing quite rapidly in transition countries over this time period, annual data are a great advantage. The Heritage Foundation has also maintained a consistent rating methodology over time. It covers all transition counties starting with 1994.10 Some studies have used EBRD indicators to measure institutional change in transition. EBRD has published annual ratings of transition countries measuring their progress in market reforms. However, the EBRD indicators are designed as benchmark indicators focusing on the distance to the post-communist transition goal (functioning market economy). Thus, in the late transition years they produce rather homogenous ratings for the most advanced transition economies (e.g., the Baltic States and CEE countries). They are more suitable for distinguishing between more advanced and less advanced transition countries rather than to study emerging market economies completing their transition from communism. As noted above, studies examining the relationship between economic freedom and growth typically use overall measures of economic freedom that aggregate various individual freedom indexes.11 However, Heckelman and Stroup (2000, 2005) point out that the weights on the elements aggregated into a single index often do not appropriately reect the magnitude and even the direction of each elements marginal effect on growth. We thus keep the individual economic freedoms measured by the Heritage Foundation separate. A couple of these, like government size, can only loosely be called economic freedoms, but others like the strength of property rights and freedom from corruption capture important dimensions of institutional quality. We focus on the seven components of the index that seem to measure institutional quality with respect to economic freedoms best. We believe that the size of the state is also potentially an important determinant of economic growth, but treat it as a separate variable rather than as a
10. 11. Although both the Heritage Foundation and Fraser indexes differ in their coverage some authors conclude that they produce similar ratings for the countries covered (De Haan and Sturm, 2000). For a survey see De Haan, Lundstrm and Sturm, 2006).

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component of economic freedom. Table A3 reports the rst values of the measures of economic freedom recorded by the Heritage Foundation for the year 1994 and the gures for 2007. Brief denitions of each economic freedom appear in the appendix. Since all countries in our study had communist governments until 1989 or 1991, one might expect that the measures of economic freedom would start low and rise through 2007. For many countries this was the case, but not for all. The indexes run from zero to one hundred, with 100 being the maximum possible economic freedom. The Heritage Foundation gave the Czech Republic the implausibly high score of 100 in 1994 for business freedom and only somewhat under 64 for this index in 2007. In general, the numbers in TableA3 reveal considerable variation both over time and across countries. The CEE and Baltic countries tend to have the highest levels of economic freedom of the different country groups. As with democracy, economic freedom seems to have declined in Russia over the time period for most measures of economic freedom.

4. Public sector size


As noted in the previous subsection, government size is treated as a separate factor affecting economic growth. Table A4 presents EBRD gures for general government expenditures in 1995 and 2007. Since in some sense, the state controlled the whole economy under communism, one might expect the size of the public sector to be close to one at the start of the period and decline over time. The EBRD counts as government expenditures only state outlays for traditional public goods and transfers like roads and unemployment compensation, however, with publicly owned enterprises not included. Thus, the state sectors in several FSU countries like Turkmenistan, Armenia and Kyrgyzstan were quite small in 1995, and became even smaller over time. On average, the CEE countries have the largest public sectors in 2007, the FSU countries the smallest. Although large public sectors may contribute to social welfare, and thus indicate that citizens in CEE countries are better off in some meaningful sense than citizens in the FSU countries, the negative incentive effects from high tax rates to nance large public sectors are expected to have negative effects on economic growth. Immediately following the collapse of communism all transition countries suffered steep declines in GDP. Government revenue sources collapsed while outlays for unemployment compensation and other welfare expenditures increased. Thus, in 1995 most transition countries were running budget decits. In several countries the decits exceeded 5 percent of GDP, and in Kyrgyzstan it was more than 17. Large budget decits raise borrowing costs and can drive out private investment. They also portend of large future interest payments and higher future taxes. We thus expect that scal balance government decit (negative) or surplus (positive) will be related to the growth rates in the transition countries. This variable may also proxy for the quality of a countrys

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governmental institutions. Transition countries that were able to bring their decits under control are likely to have had greater success in other areas of reform that contribute positively to growth. The last two columns of Table A4 report measures of economic growth ratios of GDP per capita in 2007 and 2004 to GDP per capita in 1995. The three Baltic countries have quite high growth rates since 1995, the ve SEE countries performed rather poorly. Some FSU countries had quite high growth rates since 1995 (Armenia, Belarus, Azerbaijan and Georgia), others quite low rates (Moldova, Tajikistan and Turkmenistan). The growth gures in Table A5 indicate considerable variation across the transition countries. The numbers in Tables A1-A4 lend themselves to different interpretations. Peter Murrell (2003) looking at roughly the rst decade of transition observed solid improvement in institutional quality across the transition countries and reached a rather optimistic conclusion about the success of the transition process. Given their state of economic development, transition countries looked about the same as developing countries in other parts of the world. Shleifer and Treisman (2005) reached a similar conclusion for Russia. Russia was just another developing country, no better, no worse. Gur Ofer (2003) looking at the same time period as Murrell was somewhat pessimistic, on the other hand. The tasks and challenges of the newly established governments in TEs (transition economies), especially during the transition years were much more difcult than those in DEs (developing economies), and. . .the preparation and tools available to TEs, especially the weaker ones. . .were on balance poorer. Indeed TEs suffered from a devastating combination of missing economic and political and social tools, destroyed under the old regime. . . (Ofer, 2003, p. 70). Both Murrell and Ofer agreed, however, that a great difference existed between the FSU countries and the rest of the transition countries. This difference is readily apparent in Tables A2 and A3. Moreover, the data in these tables indicate that some transition countries have succeeded in overcoming the disadvantages that they inherited from communism, and have developed rather good democratic and economic institutions. We now examine the interrelationships among these developments.

III. TESTING FOR RELATIONSHIPS AMONG DEMOCRACY, ECONOMIC FREEDOM AND GROWTH

1. The determinants of democracy


The political science literature has rmly established a positive relationship between income per capita in a country and the probability of its being a
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democracy.12 Education might be yet another determinant of democracy, although it is likely to be linked to income also. A look at the democracy scores in Table A2 and a map of Eurasia suggests a third determinant of democratization in the transition countries their distance from the European Union. We thus construct a third variable, Dist, the distance of a countrys capital city to Brussels using internet sources.13 An alternative interpretation of the data would be that it is not the pull of the European Union that made CEE and SEE countries choose democracy, but the inuence of Russia that led FSU countries to stick with authoritarian governments. It is the distance to Moscow and not to Brussels that is important. Since the two distance measures are highly correlated, one will work as well as the other, and we stick with Brussels as the attraction point. Our model of the determinants of democracy, thus, includes Dist, initial GDP per capita, Y90, and initial education measured as university enrollments, EdTer90, with the Freedom House index of democracy for the years 1999 to 2007, Demt, being the dependent variable.14 We use annual observations of the democracy index rather than an average or the end value, because there is so much variation over time, and a single number would conceal much of this variation. Since our initial conditions remain xed, while the democracy scores change over time, it is possible that the coefcients vary with time. Separate regressions using the annual democracy scores indicated a non-linear pattern for the coefcients on Dist, which we allowed for by interacting this variable with time, t, and t2. Non-linear patterns were also observed for the other two variables. The results are as follows (t-statistics below the coefcients).15

Dem t = 3.98 0.14 t Y90 + 0.012 t 2 Y90 + 0.018 t EdTer90


14.56 7.96 2.61 6.92 5.75 10.96 4.48

0.0015t 2 EdTer90 + 0.00033t Dist 0.00003t 2 Dist, N = 216, R 2 = 0.67.


Recalling that higher democracy scores mean weaker democracy, we expect negative coefcients on the initial income and education variables and a positive coefcient on distance. The interaction between education and time is signicant but with the wrong sign. Thus, with respect to the importance of human capital for economic growth, transition countries do not perform like other developing
12. See again, Lipset (1960) and Przeworski, Alvarez, Cheibub and Limongi (2000) and the references therein. 13. A distance variable was previously used by Fidrmuc (2003), but he did not provide precise estimates for a few countries, setting them at the same arbitrarily high value. 14. We also estimated the model with secondary school enrollments. It too picked up the wrong sign, so we report only the results for tertiary education. 15. When 1990 education gures were unavailable, 1995 gures were substituted to ensure that all countries are in the regression.

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countries (see again, Glaeser, La Porta, Lopez-de-Silanes and Shleifer, 2004). (Educations perverse performance might be due to multicollinearity, however. The simple correlation between distance and tertiary enrollments is 0.23.) Initial income has the predicted negative sign and is statistically signicant. The signicant positive coefcient on t2Y90 indicates that the relationship between democracy and initial income grew stronger during the rst few years of transition, but then tapered off. The coefcient on distance is positive and signicant, and rises with time peaking in 2005, the year after the rst wave of post-communist countries entered the European Union. It then declines for the next two years, but remains positive. The steady increase until the rst wave of transition countries entered the EU reects the increasing separation of the transition countries as time elapsed. Thus, relatively rich post-communist countries lying close to the European Union were the ones that successfully adopted democratic institutions. Although distance and initial income are both signicant in the equation, the fact that initially poor Slovakia did successfully democratize, and relatively rich Russia and the Ukraine did not, suggests that proximity to the EU was a primary driving force behind democratization in the transition countries, and perhaps that proximity to Russia hindered democratization. As discussed above, Kitschelt (1999) attributes the institutional choices of transition countries to structural factors and bureaucratic legacies present before communisms demise. To test this hypothesis, we add the variable, ComLeg, to the above equation. Some problems in using and interpreting this variable should be noted, however. In addition to its somewhat subjective nature as a measure of preconditions in the transition countries, its use in a regression equation implies that the difference between the preconditions in Moldova and Georgia (scores of 0 and 1) has the same marginal impact on their democratic development as the difference between Hungary and the Czech Republic (scores of 2 and 3). In addition, as is readily apparent in the ComLeg scores reported in Table 1, there is a high correlation between our distance from Brussels variable and Kitschelts ComLeg scores. Thus, each is likely to detract from the explanatory power of the other. Once again we allow the effect of ComLeg on democracy to vary over time.

Dem t = 3.91 0.004 t Y90 + 0.014 t EdTer90 + 0.0011t 2 EdTer90


16.48 0.60 3.67 3.99 2.20 8.83 2.28

+ 0.00010 t Dist 7.9E 06 t 2 Dist 0.49t ComLeg + 0.042 t 2 ComLeg, N = 216, R 2 = 0.79
6.30

The two coefcients on the ComLeg terms are highly signicant and imply that the relationship between a favorable communist legacy and the subsequent adoption of democratic institutions strengthened over time, peaking as with the distance variable in 2005.
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EVGENI PEEV/DENNIS C. MUELLER Table 1.


Part A. Economic Freedoms, Government Expenditures and Growth
The table presents estimates of the equation: Gct = aGEct + bEFct + cGDPct-1 + dINVct + eGPOct + et. (1) GE GDP INV GPO Business Trade Monetary Investment Finance Prop. Rights Corruption Constant Observations R-squared -13.49 (1.99)* 322 0.08 -17.55 (2.57)** 322 0.12 -7.07 (1.10) 322 0.16 -13.48 (1.99)* 322 0.09 -11.95 (1.78)* 322 0.09 -13.37 (1.97)* 322 0.08 -0.164 (3.56)** 2.13 (2.42)** 0.173 (2.15)* -41.165 (0.60) 0.014 (0.42) (2) -0.147 (3.32)** 1.648 (1.97)* 0.162 (2.10)* -28.78 (0.44) 0.126 (2.90)** 0.108 (4.06)** 0.029 (1.18) 0.029 (1.41) -0.005 (0.25) 0.118 (2.76)** -5.519 (0.80) 322 0.11 (3) -0.122 (2.83)** 0.647 (0.77) 0.148 (1.94)* -63.01 (0.97) (4) -0.172 (3.75)** 2.08 (2.45)** 0.177 (2.28)* -28.44 (0.42) (5) -0.170 (3.78)** 1.90 (2.22)* 0.176 (2.25)* -32.23 (0.48) (6) -0.158 (3.38)** 2.206 (2.53)** 0.178 (2.26)* -45.37 (0.65) (7) -0.22 (4.46)** 1.158 (1.35) 0.165 (2.12)* -19.90 (0.30)

Robust t statistics in parentheses * signicant at 5%; ** signicant at 1% using a one-tail test. Notes: Dependent variable (G) is the annual growth rate of real per capita GDP in 2005 US dollars. GE is total government expenditures as percentage to GDP. EF denotes economic freedoms: Business, Trade, Monetary, Investment, Finance, Property Rights, Corruption (see Appendix, for denitions). GDP is logarithm of annual real GDP per capita lagged one year. INV is investment as percentage to GDP. GPO is growth in population. Subscript c stands for country and t for year. Sources: Penn-World Table Version 6.3; EBRD; Heritage Foundation.

Thus, the different legacies from the communist era had a more pronounced effect on the adoption of democratic institutions with the passage of time, as some moved toward becoming full-edged democracies and EU membership, and others remained behind. By 2004 the implied coefcient on ComLeg is around 0.9, which implies a difference in the democracy index for the Czech Republic with ComLeg = 3, and Armenia (ComLeg = 0) of about 3, which is what we observe. With ComLeg added, initial income becomes insignicant (also true with an interaction term with t2). A bad bureaucratic legacy from communism might have caused lower initial incomes in several FSU countries explaining why Y90 loses explanatory power when ComLeg enters the equation. The coefcients on distance retain their signs and remain signicant, although with smaller values. Thus, both

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DEMOCRACY, ECONOMIC FREEDOM AND GROWTH IN TRANSITION ECONOMIES Table 1.


Part B. Economic Freedoms, Fiscal Balance and Growth
The table presents estimates of the equation: Gct = aFBct + bEFct + cGDPct-1 + dINVct + eGPOct + et. (1) FB GDP INV GPO Business Trade Monetary Investment Finance Prop. Rights Corruption Constant Observations R-squared 7.50 (1.23) 322 0.14 1.97 (0.32) 322 0.18 10.70 (1.82)* 322 0.22 8.906 (1.51) 322 0.15 10.09 (1.66)* 322 0.15 7.45 (1.20) 322 0.14 0.669 (5.98)** -0.576 (0.76) 0.10 (1.27) -13.76 (0.21) 0.029 (0.86) (2) 0.631 (6.15)** -0.746 (1.01) 0.097 (1.30) -6.545 (0.10) 0.126 (3.07)** 0.107 (4.33)** 0.047 (1.87)* 0.037 (1.81)* 0.003 (0.16) 0.073 (2.06)** 14.37 (2.14)* 322 0.15 (3) 0.598 (5.95)** -1.46 (2.01)* 0.084 (1.13) -43.295 (0.68) (4) 0.709 (6.05)** -0.799 (1.13) 0.106 (1.39) -7.01 (0.10) (5) 0.683 (6.01)** -0.892 (1.22) 0.107 (1.40) -3.922 (0.06) (6) 0.656 (5.67)** -0.408 (0.54) 0.111 (1.45) -18.61 (0.28) (7) 0.683 (6.17)** -1.40 (1.71)* 0.104 (1.36) -1.52 (0.02)

Robust t statistics in parentheses * signicant at 5%; ** signicant at 1% Notes: FB is general government balance as percentage to GDP. For the other variables, see Table 7A. Notes.

history in the form of a countrys communist legacy, and the future in the form of expectations (hopes) of entering the European Union help explain the adoption of democratic institutions in the former communist countries.

2. Democracy, economic freedom and the size of public sector


Several scholars have argued that economic liberalism fosters political liberalism. Freedom of choice and action in the market induces people to want and get freedom of choice in the political arena.16 North, Wallis and Weingast (2006) have put forward the parallel thesis that the economic and political systems of a country must be in balance free entry into a competitive political system must be matched with free entry into a competitive economic system. Closed economies are paired with closed political systems. Throughout history most countries
16. Friedman (1962), Bobbio (1990), and Diamond 1995).

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have been authoritarian regimes of one sort or another in which economic freedoms were highly constrained. Free entry into the political process did not exist, nor was it possible to enter into economic activity freely. Most countries, which combine competitive political systems with competitive market economies, are fairly new on the worlds stage. All of the countries examined in this study were dictatorships with closed economies until 1989 or 1991. In the early transition years, rapid democratization took place in some, and political liberalization often preceded economic reforms.17 Some transition countries have thus become reasonably free and competitive democracies. Others, however, have remained or quickly reverted back to authoritarianism. Some authors have found a high correlation between political freedom and economic liberalization.18 The North et al. thesis would lead us to expect greater economic freedoms in the former communist countries, which have become reasonably strong democracies, and this is what we observe. The ve CEE and three Baltic countries have the highest democracy scores (Table A2) and relatively high economic freedom scores (Table A3) compared to the SEE and FSU countries. This association is also apparent when one examines the simple correlations between the various measures of economic freedom and the democracy index (see Table A5). They all fall in the range -0.42 to -0.76. As noted above, the Heritage Foundation also treats the size of the public sector and scal balances as measures of economic freedom. We do not adopt this interpretation, but believe that these variables will be associated with economic growth. Table A5 also includes the correlations between democracy, the economic freedoms and the two measures of public sector size. The correlations between democracy, the economic freedoms and the measures of public sector size are for the period 1998 - 2007. Democracy and government expenditures are highly correlated (r = -0.55). Citizens in the more democratic transition countries appear to want larger public sectors and are able to get their governments to supply them. In doing so, governments in the more democratic countries also tend to run bigger government decits (smaller surpluses, r = 0.21). The correlations between the democracy scores and government spending are open to an alternative interpretation, however. We have seen in Table A2 that strong democratic institutions are correlated with the existence of parliamentary forms of government, while weak democracy is associated with strong presidential systems in the transition countries. Persson and Tabellini (2000, 2003) have developed a model, which predicts large public sectors in multiparty parliamentary systems, because of the need to form broad coalitions of interests in these systems. They predict and nd smaller public sectors in countries with presidential systems than in multiparty parliamentary systems. The correlation between
17. 18. See, Fidrmuc (2003). See, de Melo, Denizer and Gelb (1996), Dethier et al. (1999), and Fish (2003).

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democracy and state spending in the transition countries might be due to the fact that the countries with strong democratic institutions overwhelmingly have multiparty parliamentary systems. The Persson and Tabellini model, however, assumes that political competition also exists in presidential systems. This is not the case for the transition countries. Thus, whether the correlations in Table A5 corroborate Persson and Tabellini cannot really be determined. In the transition countries authoritarianism and presidential systems are too closely entwined. Government expenditures are also highly correlated with a few of the indexes of economic freedoms. In particular, large public sectors are strongly correlated with low levels of corruption (r = 0.58), strong property rights enforcement (r = 0.47), and nancial markets liberalization (r = 0.35).

3. The determinants of growth in transition countries


Several studies have established a link between economic freedoms of various sorts and economic growth.19 Thus, the rst causal chain that we identify posits that strong democratic institutions determine strong economic freedoms, which in turn lead to more rapid economic growth. Alternatively, one might think of democracy and economic freedoms being jointly determined by the initial conditions identied above including legacy from communism. We depict it as a single causal change, however.

Democracy Economic Freedom Economic Growth


Most studies that look at the relationship between economic freedoms and growth, measure growth over a span of years and use one or more of the following three measures of economic freedoms: initial values, an average over the time period, or the change in economic freedoms over the time period. Some studies include both the initial values and the change in the measure. Thus, if EF0 is the value of a measure of economic freedom at the beginning of the time period, EFn is its value at the end of the period, and G is the growth rate, they estimate an equation looking like G = aEF0 + b(EFn EF0) + m. But this is equivalent to estimating a model that includes just the initial and ending values of EF, G = (a - b)EF0 + b EFn + m.20 Such a model will suffer from endogeneity problems, if a countrys economic growth has a feedback effect on its economic institutions and economic freedoms. Because we have so few time series observations, measuring growth over a span of years would effectively limit us to a single cross-section regression with at most 24 observations (one per country). Moreover, using an average of an EF
19. 20. See, for example, Knack (1996), Knack and Kiefer (1995), De Haan and Sturm (2000), Heckelman (2000), Heckelman and Stroup (2000), and for a survey De Haan, Lundstm and Sturm (2006). See discussion in De Haan, Lundstm and Sturm (2006).

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measure over the sample years would disguise the considerable variation in economic freedoms that took place in many of the transition countries during the years of our study. On average, the standard deviation of the total index of economic freedom in transition countries is 9.45 (mean score 56.87), much larger than the standard deviation of the same index in EU-15 countries, 5.62 with mean of 66.87. We have thus chosen to use annual rates of growth in income per capita on the left-hand-side of the equation and annual measures of economic freedoms and the other variables. This choice of annual data nds further support in recent work by Mollick and Cabral (2011) who show that averaging annual data over ve-year time spans mutes the effects of variables with considerable variation within the time span.21 Thus, our specication allows us to capture the effects of changes in economic freedoms over time. According to De Haan and Sturm (2000), the change in an EF variable on the right-hand-side of a growth equation is the most robust specication of such a model.22 Our use of panel data effectively allows us to capture the effects of both levels of EF through the cross-section variation in the data, and changes in EF through the time-series variation. Our specication does not, however, address a question that concerned several earlier studies of growth in the transition countries namely whether rapid institutional reforms at the start of the transition process produced higher levels of growth than gradual reforms.23 We leave out the initial years, when rapid liberalization was occurring in some transition countries, and thus hope to be estimating the long-run relationship between institutional quality and growth. A large literature has explored the relationship between the size of the public sector and economic growth. It is well-established that the size of the state sector in developed and developing countries, at least after some point, is negatively related to economic growth.24 Much of this literature uses US data on local and state expenditures, but a fair number of studies have also used cross-national data. As yet, however, relatively little work in this area has focused on transition countries. For example, in a comprehensive survey of studies of economic growth in transition, Campos and Coricelli (2002) report only a few, which look at the effects of the size of the state on growth.25 In the broader literature, some studies have reported a negative, insignicant link,26 while others nd a non-linear relationship, still others nd no relationship
21. Eberhardt and Teal (2009) also present evidence of the superiority of annual data in growth equations. 22. See again De Haan, Lundstm and Sturm (2006). 23. See de Melo, Denzier and Gelb (1996), Heybey and Murrell (1999), and Godoy and Stiglitz (2006). Heybey and Murrell present a nice review of the literature. 24. See, Barro (1991) and the survey of the literature in Mueller (2003, pp. 54854). 25. See e.g. Chu Ke-young and Gerd Schwartz (1994), Kornai (1995), Coricelli (1997), and Dabrowski (1997). 26. See, Beck and Laeven (2005).

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between the size of the public sector and economic growth, and a few have even found a positive relationship large public sectors foster growth. However, the most typical nding has been that a large public sector is associated with slower economic growth.27 This nding adds another dimension to the above link between democracy and economic growth. A dictatorship might, of course, have either a very large or a small public sector. Dictators often live very lavishly at the publics expense. But a few palaces and Mercedes are unlikely to make as big of a dent in the public budget as a generous transfer system. Citizens may also demand more spending on roads, schools and other public goods than a dictator would choose to spend. We thus expect a negative relationship between authoritarianism and the size of the public sector, or stated differently, a positive relationship between the strength of democratic institutions and the size of the public sector. Combining this hypothesis with the prediction that large public sectors lead to slow economic growth due to the negative incentive effects of high taxes leads to the following causal chain.

Democracy Large Public Sector Slow Economic Growth


Many types of government expenditures are popular with voters education, police protection, highways. Taxes are never popular. Thus, elected politicians are more likely to introduce higher spending than higher taxes. Dictatorships might also be less prone to run decits because bond markets are unwilling to buy their debt out of fear that the dictatorship will fail to honor its obligations. These considerations lead to the expectation of bigger budget decits (smaller surpluses) in countries with strong democratic institutions. Budget decits lead to higher taxes to service the debt, which in turn have the usual disincentive effects of all taxes. As noted earlier, all transition countries had decits at the beginning of the period under investigation, so that the size of decits (surpluses) later in the period measures the success of countries in removing decits and thus might be regarded as a measure of the quality of governmental reforms. We, thus, expect budget decits to have a negative association with economic growth.

Democracy Large Budget Deficits Slow Economic Growth


We test these hypotheses by regressing country growth rates on various measures of public sector size and economic freedoms. In doing so, we treat democracy as a latent variable explaining both public sector size and economic freedoms. In the regressions to explain economic growth, we also include standard control variables from the growth literature total capital investment as a
27. See, Pushak et al (2007).

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share of GDP, and the growth in population.28 We also attempt to control for the frequently observed catch-up phenomenon. Since we use annual growth rates as the dependent variable, however, we do not use the income per capita for each country at the start of the time period to test the catch-up hypothesis. Instead, we us the lagged, annual deviations in each countrys GDP per capita from the sample mean to test the catch-up hypothesis. This formulation allows us to take into account that some countries are catching up at different rates than others. Conspicuous in their absence from out growth equations are measures of human capital. We have seen for the transition countries, however, that school enrollments were relatively high in all of the countries, and that the shift to democracy was not associated with initial levels of school enrollment, or even perversely related. School enrolments in 1990 also do not explain subsequent growth rates in transition countries. Indeed, their coefcients are typically negative and often statistically signicant, when added to the growth equations. This is not surprising when one examines the school enrollment rates and growth gures in Tables A1 and A4. Estonia had a high growth rate, but not particularly high school enrollments. Russia and the Ukraine had high university enrollments, but only middling growth performance. Therefore, we do not report results including initial school enrollments in the growth equations. IV. RESULTS FOR GROWTH EQUATIONS Table 1 presents regression results testing the second parts of the three causal chains described above. The dependent variable in all cases is the annual growth in GDP per capita of country c in year t, Gct. The data span the period 1994 to 2007. Part A of Table 1 presents results including the size of the public sector, while Part B substitutes government scal balance for government size. Most coefcients on the economic freedom measures have the expected positive signs, with three of the seven (trade freedom, monetary freedom and freedom from corruption) being signicant at the one percent level. When all seven economic freedom indexes are included in the same equation, there is obviously considerable multicollinearity.29 The government size variable is negative in all eight equations in Part A, and is signicant at the one percent level in all equations. Larger public sectors in the transition countries are associated with slower economic growth. The coefcients on the two of the control variables (investment and population growth) have the correct signs in the seven equations with a majority of them being
28. See discussion in Temple (2000). 29. See, Heckelman and Stroup (2005) for discussion on the aggregation procedures producing a single index value.

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statistically signicant.30 The coefcients on deviations from the mean lagged GDP per capita are all negative, as predicted under the catch-up hypothesis, with all but two being signicant at the ten percent level or better. Part B of Table 1 substitutes the government surplus for the size of government. All seven economic freedom indexes have the predicted positive signs, with ve of the seven signicant at ve per cent level, one-tailed test. The budget surplus always has the predicted positive coefcient and is highly signicant in all equations. In addition to capturing the drag on economic growth from running decits, the government surplus is presumed to measure the competence of governments. Well-managed public sectors exhibit budget surpluses (small decits) and high economic growth. Inclusion of the government balance detracts from the explanatory power of investment. Perhaps this is because large budget decits reduce investment by raising country interest rates. Both the lagged deviations in GDP per capita and population growth are generally statistically insignicant with population growth having the predicted negative coefcients, and lagged deviations in GDP per capita having the wrong, positive coefcients. Although the control variables do not perform very well when scal balance is included in the model, its performance and that of the economic freedom variables do generally support the main hypotheses put forward in this article. Although we interpret government surpluses as proxies for the quality of political governance, it is possible that causality is running in the opposite direction rapid growth raises tax revenue and reduces decits (increases surpluses). We attempted to test for this possibility by estimating a two equation, three-stage-least-squares model with growth and budget surpluses as endogenous variables. Growth was never signicant in the budget surplus equation, but most of the other variables we tried were also insignicant. We simply could not come up with a decent model to explain government surpluses. The proper interpretation of the coefcient on budget surpluses in Table 1B and subsequent tables must thus be left to the reader. V. ADDITIONAL TESTS

1. Results with country xed effects


Growth equations are vulnerable to several econometric problems.31 In crossnational regressions, for example, an omitted variable might be relevant for a subset of countries, but perhaps not all. For example, several transition countries have large ethnic minorities. Their presence might lead to political discord,
30. Some studies focusing on the transition years before 2000, do not nd signicant negative effects of government size and signicant positive effects of investment on growth (see e.g. Campos, 2001; Fidrmuc, 2003). 31. See, Temple (2000).

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which adversely affects economic growth. To control for such possibilities, we re-estimate our models after including country xed-effects. Country xed-effect dummies also control for preconditions peculiar to each country, which might affect the speed and extent of adoption of reforms that inuence growth. Although these results can simply be viewed as a robustness check, they provide some additional insight into what has been going on in the transition countries. Table 2 presents the results. The coefcients on the country dummies represent differences from the sample mean. Regressing annual growth rates on the full set of country dummy variables for the transition countries, yields an adjusted R2 of essentially zero. When they are added to the various equations whose estimates are reported in Part A of Table 2, however, they produce signicant increases in explanatory power. With government size in the regressions, the coefcients on trade freedom, monetary freedom and freedom from corruption are statistically signicant and of the correct sign. When government size is replaced by scal balance, again only trade and monetary freedom, and freedom from corruption have the predicted positive coefcients and are statistically signicant (Table 2B). The coefcients on both government size and the decit increase in size and signicance once country xed-effects are controlled for. A ten percentage point increase in the size of the public sector is now expected to reduce a countrys annual growth by two percentage points. A reduction of the budget decit by one percent of GDP increases a countrys growth rate by slightly more than 0.8 percentage point. The control variables perform less consistently with country xed-effects. The lagged GDP per capita and population growth are never negative and signicant as predicted, and even have a positive and signicant coefcient in some equations. Investment has a positive and signicant coefcient in a few equations when government size is included (Table 2A). The coefcients on the country dummies contain some interesting insights as to the reasons why transition countries exhibit different growth rates. We saw in Table A4 that Estonia had one of the highest average growth rates among the transition countries. Yet its dummy variable is generally insignicant. Estonias rapid growth appears to be well explained by the economic freedom, government size, and scal balance variables, along with the control variables. In contrast, Turkmenistan had quite low growth over the sample period, and its coefcient is negative and usually highly signicant. Although Turkmenistan failed to liberalize its economy as much as the central European countries did, this alone does not explain its poor growth performance. We conclude that there are some important country differences in growth performance that cannot be accounted for by the other variables in the model. Among the economic freedom variables, only trade freedom, monetary freedom and freedom from corruption appear to be robust to all specications and thus are

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DEMOCRACY, ECONOMIC FREEDOM AND GROWTH IN TRANSITION ECONOMIES Table 2.


Part A. Economic Freedoms, Government Expenditures and Growth (Fixed Effects)
(1) GE GDP INV GPO Albania Belarus Armenia Azerbaijan Georgia Croatia Slovak Rep. Poland Lithuania Latvia Estonia Kazakhstan Kyrgyz Rep. Macedonia Romania Turkmenistan Tajikistan Moldova Bulgaria Czech Rep. Russ. Fed. Hungary Slovenia Ukraine Business Trade Monetary Investment Finance Prop.Rights Corruption Constant Obs R-squared -17.91 (1.00) 322 0.19 -6.27 (0.35) 322 0.22 35.73 (1.84)* 322 0.20 -17.62 (0.99) 322 0.19 -20.57 (1.16) 322 0.19 -0.236 (2.92)** 3.27 (1.63) 0.143 (1.69)* 369.44 (3.10)** 0.397 (0.15) 3.75 (1.51) 5.54 (2.51)** -1.68 (0.59) 4.84 (1.93)* 1.84 (0.79) 0.262 (0.11) 1.42 (0.66) -0.072 (0.04) 4.82 (2.18)* 3.98 (1.55) -2.57 (1.15) -6.98 (2.34)** -3.49 (1.33) -0.87 (0.49) -11.76 (3.93)** -8.34 (1.96)* 0.66 (0.25) 3.84 (1.82)* -2.14 (0.82) 1.62 (0.62) -0.68 (0.36) -1.01 (0.36) 3.34 (1.58) -0.019 (0.35) (2) -0.189 (2.33)** 0.519 (0.24) 0.153 (1.85)* 381.20 (3.26)** -0.509 (0.19) 5.62 (2.31)* 3.92 (1.75)* -2.02 (0.74) 4.44 (1.79)* 2.28 (1.02) -0.0005 (0.01) 1.66 (0.79) -0.73 (0.40) 4.11 (1.96)* 3.00 (1.34) -0.489 (0.21) -8.64 (2.91)** -3.26 (1.27) -1.05 (0.60) -8.85 (3.30)** -11.11 (2.61)** -2.48 (0.89) 4.61 (2.21)* -1.49 (0.61) 2.14 (0.84) 2.04 (0.97) 1.12 (0.40) 3.22 (1.59) 0.137 (2.98)** (3) -0.124 (1.57) -4.54 (1.92)* 0.136 (1.70)* 338.65 (3.00)** -6.28 (2.25)* 12.28 (4.51)** 1.68 (0.76) -4.67 (1.74)* 2.13 (0.87) 1.51 (0.70) 1.13 (0.51) 2.18 (1.07) 1.08 (0.61) 3.78 (1.86)* 5.30 (2.44)** 0.84 (0.38) -11.64 (3.96)** -7.99 (3.06)** 1.39 (0.77) -5.83 (2.03)* -12.79 (3.13)** -5.40 (1.99)* 4.61 (2.29)* 0.35 (0.15) 3.04 (1.23) 3.31 (1.68) 3.57 (1.31) 2.67 (1.36) (4) -0.241 (2.99)** 3.25 (1.62) 0.142 (1.69)* 370.39 (3.11)** 0.69 (0.26) 3.55 (1.40) 5.56 (2.52)** -2.13 (0.69) 4.76 (1.89)* 2.01 (0.89) 0.44 (0.19) 1.59 (0.79) 0.031 (0.02) 4.99 (2.21)* 4.39 (1.55) -3.04 (1.22) -7.02 (2.36)** -3.45 (1.32) -0.73 (0.41) -12.16 (3.80)** -8.73 (1.98)* 0.41 (0.16) 4.13 (1.90)* -2.01 (0.77) 1.93 (0.70) -0.718 (0.37) -1.17 (0.43) 3.31 (1.58) (5) -0.247 (3.02)** 3.62 (1.75)* 0.142 (1.69)* 377.10 (3.14)** 0.45 (0.17) 3.47 (1.37) 5.99 (2.56)** -1.96 (0.68) 4.73 (1.88)* 2.11 (0.93) 0.37 (0.16) 1.43 (0.67) -0.15 (0.08) 5.02 (2.25)* 4.13 (1.69)* -2.96 (1.26) -6.79 (2.31)* -3.03 (1.13) -0.89 (0.50) -12.77 (3.56)** -8.55 (2.01)* 0.91 (0.34) 4.13 (1.92)* -1.81 (0.68) 1.78 (0.68) -0.86 (0.44) -1.38 (0.51) 3.38 (1.64) (6) -0.223 (2.78)** 2.27 (1.10) 0.145 (1.74)* 393.85 (3.31)** -1.54 (0.54) 3.10 (1.28) 5.94 (2.69)** -3.69 (1.23) 3.43 (1.31) 0.79 (0.34) 1.37 (0.57) 3.73 (1.50) 0.85 (0.40) 5.85 (2.64)** 7.65 (2.41)** -3.48 (1.53) -9.40 (2.89)** -5.13 (1.86)* -2.35 (1.20) -13.86 (4.46)** -11.22 (2.49)** 0.48 (0.19) 4.06 (1.93)* 1.44 (0.44) 5.08 (1.57) -0.70 (0.37) 0.69 (0.24) 2.20 (1.02) (7) -0.282 (3.53)** 2.13 (1.07) 0.111 (1.34) 372.92 (3.21)** 2.18 (0.83) 5.91 (2.44)** 4.51 (2.06)* -0.156 (0.06) 6.44 (2.57)** 1.61 (0.72) -0.67 (0.30) -0.57 (0.26) -1.45 (0.78) 4.13 (1.98)* -0.83 (0.33) -0.25 (0.11) -6.91 (2.39)** -3.01 (1.18) -0.62 (0.36) -8.11 (2.77)** -6.75 (1.64) 0.84 (0.33) 3.33 (1.61) -3.65 (1.45) -0.61 (0.24) 1.11 (0.57) -3.63 (1.32) 4.81 (2.34)**

0.168 (5.60)**

-0.021 (0.49)

-0.022 (0.61)

-0.118 (1.83)* -5.65 (0.30) 322 0.20

0.192 (3.53)** -12.78 (0.74) 322 0.23

Absolute value of t statistics in parentheses * signicant at 5%; ** signicant at 1% Notes: See Table 7A. Notes.

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EVGENI PEEV/DENNIS C. MUELLER Table 2.


Part B. Economic Freedoms, Fiscal Balance and Growth (Fixed Effects)
(1) FB GDP INV GPO Albania Belarus Armenia Azerbaijan Georgia Croatia Slovak Rep. Poland Lithuania Latvia Estonia Kazakhstan Kyrgyz Rep. Macedonia Romania Turkmenistan Tajikistan Moldova Bulgaria Czech Rep. Russ. Fed. Hungary Slovenia Ukraine Business Trade Monetary Investment Finance Prop.Rights Corruption Constant Obs R-squared 3.665 (0.21) 322 0.28 14.95 (0.87) 322 0.30 42.42 (2.27)* 322 0.33 3.12 (0.18) 322 0.28 3.12 (0.18) 322 0.28 0.879 (6.77)** 0.32 (0.17) 0.044 (0.54) 220.71 (1.92)* 4.47 (1.81)* 1.06 (0.49) 7.79 (4.18)** 0.28 (0.11) 6.40 (3.15)** 0.86 (0.45) 0.22 (0.11) 0.82 (0.43) 0.032 (0.02) 2.84 (1.35) 0.76 (0.31) -1.05 (0.57) -2.42 (0.85) -5.26 (2.13)* -0.87 (0.52) -7.39 (2.82)** -5.35 (1.37) -2.46 (0.99) -0.96 (0.47) -1.06 (0.44) 2.13 (0.95) -3.25 (1.78)* -1.79 (0.71) 0.33 (0.17) -0.002 (0.03) (2) 0.828 (6.43)** -1.98 (0.95) 0.066 (0.84) 240.73 (2.13)* 3.24 (1.31) 3.02 (1.38) 5.89 (3.01)** -0.69 (0.29) 5.49 (2.70)** 1.59 (0.85) 0.48 (0.25) 1.43 (0.77) -0.436 (0.25) 2.49 (1.25) 0.40 (0.19) 0.22 (0.12) -4.40 (1.55) -4.97 (2.05)* -1.13 (0.69) -5.79 (2.37)** -8.53 (2.17)* -4.99 (1.90)* 0.04 (0.02) -0.08 (0.04) 3.16 (1.45) -0.663 (0.33) 0.62 (0.24) 0.40 (0.21) 0.119 (2.78)** (3) 0.684 (5.13)** -5.10 (2.25)* 0.067 (0.88) 229.79 (2.07)* -1.79 (0.64) 8.48 (3.20)** 3.91 (1.94)* -3.03 (1.24) 3.41 (1.63) 1.23 (0.68) 1.43 (0.75) 1.94 (1.06) 0.95 (0.55) 2.58 (1.32) 2.68 (1.24) 0.72 (0.39) -7.28 (2.48)** -8.29 (3.33)** 0.80 (0.47) -4.50 (1.85)* -10.04 (2.60)** -6.40 (2.47)** 0.77 (0.38) 1.06 (0.47) 3.75 (1.75)* 0.469 (0.24) 2.40 (0.94) 0.55 (0.30) (4) 0.889 (6.83)** 0.325 (0.17) 0.039 (0.50) 211.56 (1.84)* 4.17 (1.65)* 1.59 (0.70) 7.70 (4.12)** 1.02 (0.38) 6.38 (3.14)** 0.95 (0.51) -0.029 (0.01) 0.589 (0.31) -0.36 (0.19) 2.36 (1.09) -0.26 (0.10) -0.48 (0.24) -2.15 (0.76) -5.19 (2.11)* -0.97 (0.58) -6.57 (2.38)** -4.63 (1.16) -2.19 (0.87) -1.30 (0.61) -1.48 (0.62) 1.69 (0.74) -3.17 (1.73)* -1.83 (0.76) 0.31 (0.16) (5) 0.88 (6.81)** 0.408 (0.20) 0.044 (0.55) 223.25 (1.93)* 4.50 (1.82)* 0.949 (0.42) 7.93 (3.86)** 0.217 (0.09) 6.42 (3.16)** 0.87 (0.46) 0.227 (0.12) 0.812 (0.43) 0.048 (0.03) 2.91 (1.38) 0.857 (0.37) -1.12 (0.59) -2.39 (0.86) -5.18 (2.06)* -0.878 (0.52) -7.64 (2.52)** -5.40 (1.40) -2.42 (0.96) -0.912 (0.43) -0.968 (0.40) 2.16 (0.98) -3.31 (1.77)* -1.87 (0.76) 0.314 (0.16) (6) 0.855 (6.52)** -0.155 (0.08) 0.05 (0.63) 240.26 (2.08)* 3.27 (1.21) 0.711 (0.33) 7.94 (4.26)** -0.998 (0.37) 5.57 (2.56)** 0.255 (0.13) 0.898 (0.44) 2.16 (0.96) 0.634 (0.34) 3.56 (1.67)* 3.06 (0.99) -1.65 (0.86) -3.97 (1.26) -6.16 (2.37)** -1.71 (0.92) -8.84 (3.18)** -7.15 (1.71)* -2.48 (1.00) -0.722 (0.35) 1.02 (0.34) 4.12 (1.43) -3.20 (1.75)* -0.708 (0.27) -0.272 (0.13) (7) 0.856 (6.68)** -0.309 (0.16) 0.019 (0.24) 233.33 (2.06)* 5.91 (2.37)** 2.13 (1.01) 7.49 (4.06)** 1.73 (0.71) 8.18 (3.87)** 0.076 (0.04) -0.940 (0.47) -0.958 (0.49) 0.773 (0.44) 2.53 (1.26) -2.33 (0.96) 1.03 (0.52) -2.37 (0.86) -5.02 (2.06)* -0.63 (0.38) -4.52 (1.73)* -3.89 (1.02) -2.27 (0.92) -1.31 (0.64) -2.50 (1.06) -0.023 (0.01) -2.03 (1.09) -3.95 (1.55) 1.22 (0.63)

0.129 (4.35)**

0.024 (0.59)

-0.005 (0.15)

-0.065 (1.06) 10.44 (0.58) 322 0.29

0.138 (2.68)** 5.33 (0.32) 322 0.30

Absolute value of t statistics in parentheses * signicant at 5%; ** signicant at 1% Notes: See Table 7B. Notes.

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possible candidates for explaining growth. With country effects accounted for, government size and scal balance continue to have highly signicant relationships to economic growth. The fact that the strength of democratic institutions is strongly associated with larger government sectors and bigger government decits indicates that the transition countries, which have developed relatively strong democratic institutions, have ceteris paribus paid a price for their large public sectors and budget decits in terms of slower growth.

2. Results after dropping investment


One obvious difculty in the growth equations is that investment might be endogenous with respect, say, to some of the economic freedom measures. One way to adjust for this would be to choose instruments to estimate investment. Obvious choices would be initial income and education levels, but these also affect the other variables in the model. We have chosen, therefore, to check for the possibility of investments being endogenous, by dropping it from the equations and seeing what this does to the other coefcients. This step can also be viewed as a check for the sensitivity of the estimates to the preferred specication. Table 3 presents the same regression results as Table 1, except for the omission of investment. All 14 coefcients on the economic freedom variables are now positive, with 9 being signicant at the ve percent level, one-tailed test. These results strongly suggest that economic freedoms lead to higher growth rates in large part by stimulating investment. Only business freedom and property rights freedom have in both the equations insignicant coefcients. The Heritage Foundations economic freedom indexes are a mixed bag in that some clearly measure the quality of an underlying institution or set of institutions (property rights and nancial freedom, freedom from corruption), while others measure macroeconomic policy outcomes (trade and monetary freedoms) or industrial policy with respect to FDI (investment freedom).32 The signicant coefcients that we observe on trade freedom, monetary freedom and freedom from corruption even with investment in the equation indicate that these measures of institutional quality have an independent effect on growth beyond any effect that they have on investment.

3. Combining the effects of economic freedoms


Having established that several measures of economic freedom appear to have positive impacts on economic growth in the transition countries, we shall now attempt to isolate any joint impacts that they might have.
32. See denitions in the Appendix, and discussion in Heckelman and Stroup (2005).

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Part A. Economic Freedoms, Size of Government and Growth
(1) GE GDP GPO Business Trade Monetary Investment Finance Prop. Rights Corruption Constant Observations R-squared -12.50 (1.78)* 328 0.05 -18.05 (2.68)** 328 0.11 -5.893 (0.88) 328 0.15 -12.29 (1.75)* 328 0.06 -10.32 (1.46) 328 0.06 -11.93 (1.69)* 328 0.05 -0.167 (3.41)** 2.29 (2.55)** -57.87 (0.79) 0.041 (1.19) (2) -0.148 (3.20)** 1.883 (2.17)* -35.82 (0.53) 0.159 (3.57)** 0.126 (4.74)** 0.034 (1.38) 0.043 (1.99)* 0.007 (0.36) 0.149 (3.42)** -2.33 (0.31) 328 0.10 (3) -0.125 (2.74)** 0.787 (0.89) -70.63 (1.07) (4) -0.173 (3.56)** 2.38 (2.76)** -45.73 (0.63) (5) -0.175 (3.76)** 2.12 (2.35)** -44.12 (0.62) (6) -0.163 (3.24)** 2.47 (2.81)** -61.67 (0.83) (7) -0.234 (4.64)** 1.17 (1.26) -29.77 (0.43)

Robust t statistics in parentheses * signicant at 5%; ** signicant at 1% Notes: See Table 7A. Notes.

One can envisage two, polar possibilities. (1) The effects of the individual measures of economic freedom are additive. Adding strong trade freedom to strong enforcement of property rights produces additional growth. (2) The effects of the individual economic freedoms are multiplicative. In the absence of strong enforcement of property rights the other economic freedoms have no impact on growth. We attempted to determine which of these possible relationships best describes the data by experimenting with various multiplicative and additive combinations of the variables. The additive formulations always exhibited higher explanatory power than the multiplicative formulations. Due to high correlations among the seven economic freedoms, little improvement in t was observed after two or three economic freedoms were included in the model. With government expenditures as the measure of government size, the best-t equation was (t-statistics under coefcients).

G ct = 11.31 0.19GE ct + 1.04 GDPct 1 + 0.15Inv t 15.20 PopGr + 0.10 Trade


1.59 4.08** 1.21 2.03* 0.23 2.41**

+ 0.08Corruption, N = 322, Adj. R 2 = 0.13


2.66**

With scal balance as the measure of government size, the best t equations included trade freedom and either nance freedom or freedom from corruption

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Part B. Economic Freedoms, Fiscal Balance and Growth
(1) FB GDP GPO Business Trade Monetary Investment Finance Prop. Rights Corruption Constant Observations R-squared 9.88 (1.57) 328 0.13 2.72 (0.44) 328 0.18 12.87 (2.13)* 328 0.22 11.41 (1.87)* 328 0.14 13.27 (2.07)* 328 0.14 10.44 (1.63) 328 0.12 0.708 (6.19)** -0.729 (0.97) -40.09 (0.56) 0.051 (1.51) (2) 0.660 (6.18)** -0.793 (1.13) -22.94 (0.35) 0.154 (3.65)** 0.122 (4.90)** 0.054 (2.18)* 0.051 (2.38)** 0.016 (0.75) 0.100 (2.75)** 19.07 (2.68)** 328 0.15 (3) 0.625 (6.00)** -1.593 (2.24)* -60.09 (0.93) (4) 0.75 (6.38)** -0.842 (1.24) -18.04 (0.25) (5) 0.729 (6.38)** -1.04 (1.39) -23.16 (0.34) (6) 0.701 (5.92)** -0.509 (0.69) -42.97 (0.59) (7) 0.725 (6.49)** -1.757 (2.03)* -18.43 (0.27)

Robust t statistics in parentheses * signicant at 5%; ** signicant at 1% Notes: See Table 7B. Notes.

(similar explanatory power). Thus, the economic freedoms that had the highest explanatory power when included individually retained their explanatory power when included additively.

4. The endogeneity of economic freedoms


Another possible econometric problem in the growth equations is that the economic freedoms are endogenous with respect to growth. We addressed this possibility by estimating a two equation model using three-stage least squares. The rst equation was the growth equation from Table 1 with the mean economic freedom score now treated as an endogenous variable. The second equation had mean economic freedom as the dependent variable and growth, initial GDP per capita, and either distance from Brussels or the democracy index as explanatory variables. The results for the growth equation were similar to those reported in Table 1. Both distance and the democracy index were highly signicant in explaining economic freedom. Initial GDP per capita did not have a signicant impact on the level of economic freedom nor, more importantly, did growth. The
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Part A. Government Expenditures and Growth
(1) GE GDP INV GPO GDP Growth Business Trade Monetary Investment Finance Prop. Rights Corruption Constant Observations R-squared 13.75 (0.65) 23 0.71 50.47 (1.77)* 23 0.79 31.41 (1.26) 23 0.67 41.58 (2.10)* 23 0.74 34.80 (1.68)* 23 0.75 -5.06 (0.40) 23 0.71 0.26 (2.90)** -2.00 (0.81) 0.13 (0.60) 457.09 (2.44)** -0.48 (1.34) -0.244 (-2.34)** (2) 0.287 (3.14)** -4.47 (1.40) 0.065 (0.41) 403.06 (3.14)** -0.17 (0.74) -0.429 (4.58)** -0.128 (1.91)* -0.148 (3.18)** -0.176 (2.95)** -0.17 (2.71)** -0.192 (2.41)** -4.41 (0.20) 23 0.69 (3) 0.244 (2.21)* -4.54 (1.63) 0.44 (0.16) 449.96 (2.17)* -0.537 (1.32) (4) 0.268 (3.17)** -5.80 (2.84)** 0.66 (0.32) 296.94 (1.59) -0.44 (1.41) (5) 0.286 (3.93)** -4.65 (2.25)* 0.046 (0.24) 320.06 (1.79)* -0.457 (1.61) (6) 0.316 (3.39)** -0.973 (0.60) 0.101 (0.48) 519.94 (3.37)** -0.553 (1.59) (7) 0.333 (3.65)** -1.16 (0.44) 0.101 (0.44) -19.90 (0.30) -0.560 (1.50)

Robust t statistics in parentheses * signicant at 5%; ** signicant at 1% using a one-tail test. Notes: The dependent variable is the difference between average real GDP growth in 20082009 and 19942007. GDP growth is the average growth rate over the period 19942007. GDP is the logarithm of real GDP per capita in 1990. The other independent variables are averages over the period 19942007. For the other variables denitions see Table 7A. Notes.

positive link between economic freedom and economic growth does not disappear, once we allow for the possible feedback effect of growth on economic freedom.33 VI. ECONOMIC GROWTH FOLLOWING THE FINANCIAL CRISIS Our estimates of the determinants of economic growth are based on data up to the start of the nancial crisis. In this section, we examine whether the variables, which explained economic growth prior to the crisis, also can explain the growth performance changes caused by the crisis. Table 4 reports the results for equations using the same explanatory variables as were used in Table 1. The dependent variable, however, is now the difference between a countrys growth rate after
33. These results are available on request.

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Part B. Economic Freedoms, Fiscal Balance and Growth
(1) FB GDP INV GPO GDP Growth Business Trade Monetary Investment Finance Prop. Rights Corruption Constant Observations R-squared 19.35 (0.80) 23 0.64 51.09 (2.02)* 23 0.70 39.88 (1.34) 23 0.60 43.24 (1.88)* 23 0.66 40.19 (1.58) 23 0.67 7.93 (0.37) 23 0.61 0.013 (0.04) -1.33 (0.43) 0.132 (0.45) 288.35 (1.74)* -0.930 (2.28)* -0.222 (1.64) (2) -0.046 (0.16) -3.32 (1.20) 0.092 (0.35) 222.92 (1.81)* -0.690 (1.87)* -0.39 (2.79)** -0.118 (1.41) -0.137 (2.03)* -0.153 (2.04)* -0.124 (1.32) -0.113 (1.08) 16.71 (0.75) 23 0.58 (3) 0.138 (0.43) -4.08 (1.28) 0.015 (0.05) 293.54 (1.74)* -0.940 (2.29)* (4) -0.038 (0.11) -4.64 (1.91)* 0.090 (0.31) 135.48 (0.74) -0.905 (2.24)* (5) 0.067 (0.20) -3.81 (1.55) 0.037 (0.13) 157.46 (0.91) -0.940 (2.65)** (6) 0.047 (0.15) -0.911 (0.36) 0.100 (0.33) 321.28 (2.35)** -1.05 (2.57)** (7) 0.201 (0.72) -1.88 (0.66) 0.055 (0.17) 293.21 (1.74)* -1.04 (2.41)**

Robust t statistics in parentheses * signicant at 5%; ** signicant at 1% Notes: FB is general government balance as percentage to GDP. For the other variables, see Table 10A. Notes.

the crisis (20082009), and before (19942007). The differences in coefcients between Tables 1 and 4 are dramatic. Where trade and monetary freedoms were associated with faster growth prior to the crisis, those countries which liberalized most suffered the biggest declines in growth rates. Indeed, all measures of economic freedom pick up negative and signicant coefcients in Part A of Table 4, which includes the size of the public sector. Some studies of the size of government have found that open economies with high terms of trade risk have signicantly larger government consumption and social security expenditures (Rodrik, 1998). Alesina and Wacziarg (1998) claim, however, that the association between openness and government size is due to the fact that smaller countries have both bigger public sectors and are more open to trade. In a recent paper, Ram (2009) discusses both views and presents evidence of a direct link between openness and government size. Our research on transition countries suggests that large government expenditures might be a form of insurance against adverse external shocks. While government size was seen to be a drag on growth prior to the crisis, a large public sector tended to insulate
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transition countries from the adverse effects of the crisis. Economic liberalization and small public sectors led to more rapid growth in normal times, but free markets and economic integration in the global economy made transition countries more vulnerable to the global nancial crisis when it hit. The nancial crisis played havoc with many countries public nances and thus it is not surprising that this variable becomes insignicant after the crisis hits. VII. CONCLUSIONS The collapse of the communist regimes in East Europe and the Soviet Union led to the expectation for many in both the West and the East that democratic and free market, capitalist institutions would take root in these countries. In the rst few years after the fall of communism, economic reforms were introduced in all former communist countries, and political reforms to introduce democracy were instituted in many. One might well have concluded that all former communist countries were in transition toward liberal market economies, although at different speeds (Murrell, 2003). Given the well-established link between economic and political freedoms, one might also have optimistically expected that economic liberalization would eventually lead to democracy in all transition countries. Such optimism is no longer possible. Today none of the former Soviet Union countries has even moderately strong democratic institutions with the exception of the three Baltic States, Estonia, Latvia and Lithuania. The rose and orange revolutions in Georgia and Ukraine raised hopes that they too might someday join the Baltic countries in the (relatively) strong democratic category, but that day still seems a long way off. We believe that the development of strong democratic institutions and economic freedoms in the Baltic States despite their having been part of the Soviet Union illustrates the importance of proximity to the European Union and the attraction of membership in it for the transition process. Had the Baltic countries been buried in Central Asia, like the Kyrgyz Republic, their rst steps toward democracy, like the Kyrgyz Republics promising rst steps, might well have faltered, and they too would have authoritarian regimes with weak economic freedoms today. We cannot rule out the possibility, however, that the success of the Baltic States was due to more favorable preconditions in these countries than in the other FSU countries. We have seen that there is a positive correlation between the strength of a countrys democracy and the quality of its economic institutions. Economic freedoms are stronger and corruption is weaker in former communist countries with strong democratic institutions. This result could again merely reect the pull of membership in the European Union, which demands certain economic freedoms and frowns upon corruption, but we think it is also partly due to the effect of democracy on these institutional variables. Voters demand less corrup-

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tion and greater economic freedoms and politicians respond to these demands in countries with strong democratic institutions. This relationship can be easily seen even within the countries, which have joined the European Union. Among these, Bulgaria and Romania have the weakest democratic institutions, the weakest economic freedoms, and the most corruption. In contrast, the three Baltic countries score relatively high in both democracy and economic freedom. This link between democracy and economic freedoms leads to a link between democracy and economic growth, because economic liberalization produces more rapid economic growth. We presented evidence that most economic freedoms (but not all) produce more rapid growth. We identify trade freedom, monetary freedom and freedom from corruption as the most important indicators of economic freedom for growth in transition countries over the period 1994 2007. Low corruption and external liberalization have been identied as positive factors for economic growth in other studies (Mauro, 1995; Babecky and Campos, 2011).34 Our study corroborates these ndings. Economic freedoms lead to higher growth rates in large part by stimulating investment, although some economic freedoms (e.g., trade and monetary freedom, and freedom from corruption) matter more for economic growth than others. Democracy can have an adverse effect on economic growth, however, by producing larger public sectors and public decits, which lead to higher taxes and a greater scal drag on the economy. Evidence of this relationship was also presented. Democracy also seems to be associated with less labor market freedom, which probably would also lead to slower growth, although we did not have enough data to test for this relationship. Although the former communist countries, which have become most democratic, have experienced higher levels of growth, our results suggest that democracy also brings with it some institutional changes that retard growth.

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34. In a recent survey on transition countries, Babecky and Campos (2011) present evidence on the positive effects of external liberalization on economic growth. However, the authors do not examine separately the two components of external liberalization (trade and capital ows).

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Heybey, Berta and Peter Murrell (1999). The Relationship between Economic Growth and the Speed of Liberalization during Transition, Journal of Policy Reform. 3: 12137. Johnson, Simon, Daniel Kaufmann and Andrei Shleifer (1997). Politics and Entrepreneurship in Transition Economies, William Davidson Institute Working Papers Series 57. Justesen, Mogens K. (2008). The Effect of Economic Freedom on Growth Revised: New Evidence on Causality from a Panel of Countries 19701999, European Journal of Political Economy. 24: 642660. Kitschelt, Herbert (1999). Accounting for Outcomes of Post-Communist Regime Change. Causal Depth or Shallowness in Rival Explanations, paper presented at the Annual Meeting of the American Political Association, Atlanta, September 15. Knack, Stephen (1996). Institutions and the Convergence Hypothesis: the Cross-National Evidence, Public Choice. 87: 20728. Knack, Stephen and Philip Keefer (1995). Institutions and Economic Performance: Cross-Country Tests Using Alternative Institutional Measures, Economics and Politics. 7: 20728. Kornai, Janos (1995). The Postsocialist Transition and the State: Reections in the Light of Hungarian Fiscal Problems, in: Highways and Byways: Studies on Reform and Postcommunist Transition, Cambridge: MIT Press. Levitsky, Steve and Lucan A. Way (2002). The Rise of Competitive Authoritarianism, Journal of Democracy. 13: 5165. Lipset, Seymour Martin (1960). Political Man: The Social Bases of Politics, Doubleday. Mauro, Paolo (1995). Corruption and Growth, Quarterly Journal of Economics. 110: 681 712. Metelska-Szaniawska, Katarzyna (2009). Constitutions and Economic Reforms in Transition: an Empirical Study, Constitutional Political Economy. 20: 141. Mollick, Andre and Rene Cabral (2011). Government Size and Output Growth: the Effects of Averaging out, Kyklos. 64(1): 122137. Mueller, Dennis. C. (2003). Public Choice III, Cambridge: Cambridge University Press. Murrell, Peter (2003). The Relative Levels and the Character of Institutional Development in Transition Economies, in: Campos, Nauro F. and Jan Fidrmuc (eds.), Political Economy of Transition and Development. Dordrecht, Kluwer Academic Publishers: 4167. North, Douglass C., John Joseph Wallis and Barry R. Weingast (2006). A Conceptual Framework for Interpreting Recorded Human History, NBER Working Paper No. W12795. Ofer, G., 2003. Transition and developing economies: comparing the quality of governments, in: Campos, Nauro F. and Jan Fidrmuc (eds.), Political Economy of Transition and Development. Dordrecht, Kluwer Academic Publishers: 6995. Persson, Torsten and Guido Tabellini (2000). Political Economics: Explaining Economic Policy, Cambridge MA: MIT Press. Persson, Torsten and Guido Tabellini (2003). Economic Effects of Constitutions, Cambridge MA: MIT Press. Przeworski, Adam, Michael Alvarez, Jose Antonio Cheibub and Fernando Limongi (2000). Democracy and Development, Cambridge: Cambridge University Press. Pushak, Taras, Erwin R. Tiongson and Aristomene Varoudakis (2007). Public Finance, Governance, and Growth in Transition Economies: Empirical Evidence from 19922004, World Bank Working Papers Series 4255. Ram, Rati (2009). Openness, Country Size, and Government Size: Additional Evidence from a Large Cross-Country Panel, Journal of Public Economics. 93: 213218. Rodrik, Dani (1998). Why Do More Open Economies Have Bigger Governments? Journal of Political Economy. 106(5): 9971032. Schedler, Andreas (2002). The Menu of Manipulation, Journal of Democracy. 13: 3650.

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Shleifer, Andrei and Daniel Treisman (2005). A Normal Country: Russia after Communism, Journal of Economic Perspectives. 19: 15174. Spagat, Michael (2003). Human Capital, Growth and Inequality in Transition Economies, in: in: Campos, Nauro F. and Jan Fidrmuc (eds.), Political Economy of Transition and Development. Dordrecht, Kluwer Academic Publishers: 25976. Temple, Jonathan (2000). Growth Regressions and What the Textbooks Dont Tell You, Bulletin of Economic Research. 52: 181205. Tommaso, Maria Laura Di, Martin Raiser and Melvyn Weeks (2007). Home Grown or Imported? Initial Conditions, External Anchors and the Determinants of Institutional Reform in the Transition Economies, The Economic Journal. 117: 858881.

APPENDIX Freedom House measures progress and setbacks in democratization in 29 countries and administrative areas from Central Europe to the Eurasian region of the Former Soviet Union. It covers seven categories: electoral process; civil society; independent media; national democratic governance; local democratic governance; judicial framework and independence; and corruption. Freedom House has provided numerical ratings in the seven categories listed above and constructs total index of democracy. The ratings are based on a scale of 1 to 7, with 1 representing the highest and 7 the lowest level of democratic progress. Heritage Foundation measures several aspects of economic freedom in 183 countries. The indexes are based on a scale of 0 to 100, with 100 being the highest level of economic freedom. We now briey dene the seven indexes of economic freedom used in this study.35 Business freedom is the ability to create, operate, and close an enterprise quickly and easily. Trade freedom is a composite measure of the absence of tariff and non-tariff barriers that affect imports and exports of goods and services. Monetary freedom combines measures of price stability and price controls. Property rights freedom is an assessment of the ability of individuals to accumulate private property, secured by clear laws that are fully enforced by the state. Investment freedom is an assessment of the free ow of capital, especially foreign capital. Financial freedom is a measure of banking security as well as independence from government control. Freedom from corruption is based on quantitative data that assess the perception of corruption in the business environment.

35.

Full denitions are in Beach and Kane (2008).

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The other data were obtained from various sources: Penn-World Table Version 6.3 (real GDP per capita, population); EBRD (general government expenditures to GDP, scal balance to GDP, investment to GDP); World Bank (secondary and tertiary education); Internet (distance from Brussels to capitals of transition countries).

Table A1.
Initial Conditions Country CEE-5 Poland Slovenia Hungary Czech Republic Slovak Republic SEE-5 Bulgaria Romania Croatia Albania The Macedonia Baltic States Estonia Latvia Lithuania FSU Russian Federation Ukraine Turkmenistan Armenia Belarus Kazakhstan Azerbaijan Kyrgyz Republic Georgia Moldova Tajikistan Gcap 1990* 7195 15125 11441 15097 12086 6209 6922 10842 2805 7195 9612 5918 7536 13068 7732 10124 2833 9386 8421 4572 3494 3025 3090 2579 Gcap 1995 8308 15204 10491 14602 10004 6415 6187 7976 2543 5956 7706 6098 6898 7895 5723 7131 3311 8339 7152 2563 2586 2895 2546 1664 Sec 1990 81,5 91,1 78,6 91,2 75,2 92 69,2 37,5 55,7 98,5 91 91,7 93,3 92,8 95,3 97,5 87,5 100,1 94,9 80 102,1 Sec 1995 96,3 90,5 97,8 98,7 93,7 78 77,9 81,8 70,2 60,9 103,7 85 84,2 85,7 92,6 115,3 80,2 93,4 84,4 76,8 78,8 75,6 80,9 80,6 Ter 1990 22,1 24,6 14,4 16,7 31,7 9,6 21,9 15,4 16,8 26,8 25,5 34 53,3 48,1 22,1 51,3 41,6 23,9 14,9 37 35,9 22,8 ComLeg 1990 2 2 2 3 2 1 1 1,5 1 1 2 2 2 1 1 0 0 1 0 0 0 1 0 0

Notes: Gcap is real GDP per capita. Sec is secondary school enrollment percentage. Ter is tertiary school enrollment percentage. ComLeg is the score for the communist legacies (Kitschelt, 1999). *For the Baltic and FSU countries (except Estonia and the Russian Federation) the initial real GDP per capita is for 1993. Sources: Penn-World Table Version 6.3; World Bank.

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EVGENI PEEV/DENNIS C. MUELLER Table A2.


Democracy and Political Systems Democracy Index Country CEE-5 Poland Slovenia Hungary Czech Republic Slovak Republic SEE Bulgaria Romania Croatia Albania Macedonia Baltic States Estonia Latvia Lithuania FSU Russia Ukraine Turkmenistan Armenia Belarus Kazakhstan Azerbaijan Kyrgyz Republic Georgia Moldova Tajikistan 1999 1,58 1,88 1,88 2,08 2,71 3,58 3,54 4,46 4,75 3,83 2,25 2,29 2,29 4,58 4,63 6,75 4,79 6,25 5,5 5,58 5,08 4,17 4,25 5,75 2007 2,39 1,86 2,14 2,14 2,29 2,86 3,36 3,64 3,82 3,86 1,93 2,07 2,25 5,96 4,25 6,93 5,21 6,71 6,39 6 5,93 4,79 5 6,07 Average 19992007 1,91 1,80 2,03 2,26 2,21 3,20 3,51 3,78 4,13 4,00 2,01 2,17 2,21 5,32 4,56 6,88 5,01 6,53 6,12 5,74 5,57 4,67 4,74 5,78 DPI 1,75 1,79 1,96 2,33 2,08 3,38 3,63 3,79 4,17 4,29 2 2,25 2,13 4,96 4,71 6,83 4,92 6,46 6,17 5,46 5,67 4,83 4,71 5,63 Political Systems Political System Parliamentary (rationalized) Parliamentary (rationalized) Pure parliamentary Pure parliamentary Pure parliamentary Parliamentary Semi-Presidential Semi-Presidential (parlia. with strong president) Parliamentary Parliamentary Parliamentary Parliamentary (rationalized) Parliamentary-Presidential Presidential-Parliamentary Presidential-Parliamentary Authoritarian Presidential Presidential Authoritarian Presidential Close to Presidential Presidential Presidential-Parliamentary Presidential Parliamentary

Notes: The democracy ratings are based on a scale of 1 to 7, with 1 representing the highest level of democratic progress and 7 the lowest.The Democracy Score is an average of ratings for Electoral Process (EP); Civil Society (CS); Independent Media (IM); National Democratic Governance (NGOV); Local Democratic Governance (LGOV); Judicial Framework and Independence (JFI); and Corruption (CO). Source: Freedom House. DPI System Score: Direct Presidential = 0; Strong President Elected by the Assembly = 1; Parliamentary = 2. Source: Database on Political Institutions (DPI), see Beck et al. (2001). Political system classication is from Metelska-Szaniawska (2009).

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Table A3.
Economic Freedom
Trade 2007 86 86 86 86 86 86 70 70 50 70 . 65,00 90 50 50 63,33 90 70 70 76,67 70 50 30 50,00 . 50,00 50 50 50 50 50 30 50 50 . 45,00 80 70 80 76,67 70 50 50 56,67 48,71 60,49 64,21 69,25 63,33 61,198 82,26 79,54 77,2 80,28 76,89 79,23 70 30 70 70 70 62 60 60 80 70 70 68 50 70 50 90 50 62 60 50 70 80 80 68 50 30 70 70 70 58 50 50 70 70 50 58 1994 2007 1994 2007 1994 2007 1994 2007 1994 50 30 50 50 50 46 30 10 30 10 . 20,00 90 55 50 65,00 50 50 30 43,33 Monetary Investment Finance Property Rights Corruption 2007 37 64 52 48 47 49,6

Business

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1994

2007

1994

70 70 85 100 85 82

54,05 73,04 73,94 63,87 69,30 66,84

57 59 61 76 75 65,6

55 55 55 70

. 58,75 86 86 86 86,00 24,29 . . . 41,05 . 46,27 . 37,20 40,73 44,2 82,2 79,2 85 52,2 86,2 78,4 81,4 71 79,2 77,8 74,25 79,68 64,45 69,88 66,43 84,59 66,21 71,87 76,47 75,64 71,37 67,63 65,85 70,94 74,47 70 50 30 30 50 30 10 50 50 30 30 39,09 50 30 30 10 70 20 30 30 50 70 30 30 36,36 51,54 17,33 41,14 12,88 23,78 82,03 73,83 78,51 78,12

67,53 74,07 58,10 55,59 65,09 64,08

72,4 79 69 59 . 69,85

86 86 87,6 75,8 83,4 83,76

26,29 11,87 61,75 22,1 . 30,50

73,7 72,48 78,81 80,83 85,48 78,26

60 60 50 70 50 58,00

60 50 60 70 60 60,00

30 30 30 30 30 30,00

40 31 34 26 27 31,60 67 47 48 54,00

DEMOCRACY, ECONOMIC FREEDOM AND GROWTH IN TRANSITION ECONOMIES

CEE-5 Poland Slovenia Hungary Czech Republic Slovak Republic Average SEE-5 Bulgaria Romania Croatia Albania The Macedonia Average Baltic States Estonia Latvia Lithuania Average FSU Russian Federat. Ukraine Turkmenistan Armenia Belarus Kazakhstan Azerbaijan Kyrgyz Republic Georgia Moldova Tajikistan Average Total average 50 50 10 50 50 30 30 50 30 10 30 35,45 42,8 40 50 10 70 10 60 30 50 60 50 40 42,73 54,62 50 30 30 50 50 30 30 30 30 50 30 37,27 43,6 30 30 10 35 20 30 30 30 35 50 30 30,00 38,65

85 70 70 75,00

84,47 74,33 83,22 80,67

77 55 65 65,67

85 55 55 55 70 55 40 55 55 70 55 59,09 64

52,83 44,35 30,00 81,28 58,64 56,53 61,60 60,40 85,01 68,46 43,40 58,41 63,96

52 55 40 69 60 61 55 65 69 17,6 68,4 55,64 61,43

10 10 10 50 10 10 10 30 10 10 10 15,45 25,2

25 28 22 29 21 26 24 22 28 32 22 25,36 34,5

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EVGENI PEEV/DENNIS C. MUELLER Table A4.


Public Sector Size and Economic Growth Country Government Expenditure 1995 50,15 41,59 52,63 40,49 54,09 41,31 34,74 48,93 33,44 38,95 39,43 37,48 34,68 43,35 42,53 20,14 28,85 42,47 20,82 21,13 33,19 12,33 46,19 24,41 Government Expenditure 2007 42,1 42,3 49 42,6 34,4 37,2 34,5 42,8 29,1 33,1 34,8 35,9 34,8 34,4 43,8 13,4 22,4 49 23 27,4 28 20 41,5 28,6 Fiscal Balance 1995 -3,1 0,04 -6,72 -1,06 0,4 -5,63 -2,5 -0,71 -10,06 -1,05 -1,19 -3,57 -4,22 -6,61 -4,71 0,38 -8,97 -2,7 -3,35 -3,13 -17,3 -5,27 -6,74 -6,07 Fiscal Balance 2007 -1,9 0,5 -4,9 -0,6 -1,9 3,5 -3,1 -2,5 -3,5 0,6 2,6 -0,4 -1 6 -2 4 -2,3 0,4 4,7 2,4 -0,3 -4,2 -0,3 -6,2 Gcap 2007/95 Gcap 2004/95

CEE-5 Poland Slovenia Hungary Czech Republic Slovak Republic SEE-5 Bulgaria Romania Croatia Albania The Macedonia Baltic States Estonia Latvia Lithuania FSU Russian Federation Ukraine Turkmenistan Armenia Belarus Kazakhstan Azerbaijan Kyrgyz Republic Georgia Moldova Tajikistan

1,74 1,72 1,63 1,50 1,73 1,50 1,50 1,73 1,86 1,16 2,45 2,44 2,11 1,70 1,72 1,60 2,88 2,70 2,10 4,01 1,38 3,07 1,37 1,70

1,47 1,45 1,48 1,25 1,39 1,25 1,27 1,46 1,58 1,06 1,85 1,79 1,68 1,38 1,44 1,27 2,03 1,99 1,66 1,82 1,46 2,02 1,22 1,50

Notes: Government expenditures are general government expenditures as percentage to GDP. Fiscal balance is general government balance as percentage to GDP. Gcap is real GDP per capita. Source: EBRD.

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DEMOCRACY, ECONOMIC FREEDOM AND GROWTH IN TRANSITION ECONOMIES Table A5.


Correlations Between Democracy and Economic Freedom Demo Demo Business Trade Monetary Investment Finance Property Rights Corruption Gov. Expenditure Fiscal Balance Business Trade Monetary Investment Finance Property Rights

1.0000 -0.7051* 1.0000 -0.4237* 0.3033* -0.4577* 0.2670* -0.7811* 0.6712* -0.7178* 0.5762* -0.7602* 0.6371* -0.7554* 0.5622* -0.5546* 0.3327* 0.2154* -0.0106

1.0000 0.5436* 0.3253* 0.4491* 0.2475* 0.3917* 0.0688 0.1298

1.0000 0.3008* 0.4993* 0.1794* 0.3820* 0.0560 0.1977

1.0000 0.7126* 1.0000 0.6871* 0.6311* 0.6049* 0.6020* 0.3328* 0.3548* -0.1471* -0.0282

1.0000 0.7053* 0.4661* -0.0921 Fiscal Balance

Corruption Property Rights Corruption Gov. Expenditure Fiscal Balance 1.0000 0.5812* 0.0984

Gov. Expenditure

1.0000 -0.3034*

1.0000

* signicant at 1% Notes: Demo is the Freedom House total democracy score. The economic freedom indexes of the Heritage Foundation are: Business, Trade, Monetary, Investment, Finance, Property Rights, Corruption. See Appendix, for denitions of these variables. Government expenditures are general government expenditures as percentage to GDP. Fiscal balance is general government balance as percentage to GDP. Sources: Freedom House; Heritage Foundation; EBRD.

SUMMARY
This article examines the interrelationships between democracy, economic freedoms, and economic growth. We study 24 post-communist economies over the period 19902007, and nd that strong democratic institutions are associated with greater economic freedoms and larger public sectors and public decits. Stronger economic freedoms lead to more rapid growth, but large public sectors and public decits have adverse effects on growth. We identify trade freedom, monetary freedom and freedom from corruption as the most important indicators of economic freedom for growth in transition countries over the period 1994 2007. Some of the factors associated with faster growth prior to the crisis were associated with greater declines in growth during the rst years of the nancial crisis (20082009).

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