A sharp drop in Nominal GDP will cause a drop in Economic Freedom

Last week I visited and gave two lectures at Southern Methodist University in Dallas. Among other things I had the great pleasure of spending time with Ryan Murphy who is a Research Assistant Professor at the O’Neil Center for Global Markets and Freedom at SMU and I had the opportunity to talk to Ryan about a new paper that has just been published.

The hypothesis in the paper Aggregate Demand Shortfalls and Economic Institutions essentially is that a sharp drop in aggregate demand over a period will cause a change in political climate and sentiment, which in turn will cause policy makers to implement policies, which undermines economic freedom.

This of course is very close to what I often have been arguing namely that a failure on part of central banks to keep nominal spending growth (aggregate demand) “on track” can cause an increase in populist sentiment, which in turns leds to bad policies, which likely will have negative supply side consequences.

Ryan has co-authored the paper with Taylor Leland Smith of Texas Tech University. Here is the abstract:

Political instability is often exacerbated in periods of aggregate demand shortfall, with both short and long-term implications for economic institutions. It has been conjectured that inadequate policy responses to recessions may be inimical to free economic institutions. This paper uses the Economic Freedom of the World index as its measure of economic institutions, and finds that the change in economic freedom in the following five, ten, and fifteen years is negatively impacted by an aggregate demand shortfall as measured by negative NGDP growth. The result is (largely) robust upon the exclusion of the monetary policy variables from Economic Freedom of the World, but is not robust if economic institutions are measured as trade openness

I think the paper is great and very innovative in its approach to analyzing the connection between monetary policy failure and Economic Freedom.

I have suggested to Ryan that he should expand the study to cover the 1930s as I think that he will be able to show that exactly the same kind of mechanisms where in place during that period. The only problem of course is that we don’t have an Index for Economic Freedom of World in the 1930s…

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