Crisis events are windows of opportunity during which a country’s leaders may implement economic policy adjustments which change that country’s level of economic freedom and affect the local capital market. This paper aims to investigate the relationship between annual changes in an economic freedom index, six types of crises and equity market returns.
The author uses fixed-effects regressions on annual panel data for 69 countries during the period 2000-2010.
Banking, domestic debt and inflation crises decrease economic freedom, and an external debt crisis weakly relates to increases in economic freedom. Only banking crises relate to a change in economic freedom in the following year, suggesting that crisis-driven changes in economic freedom happen quickly. Gains in economic freedom are more likely to occur during periods of positive local and global equity returns. Preceding and contemporaneous to increases in economic freedom, a country’s equity market outperforms a global equity index, offering observers a leading indicator for economic policy change.
The author finds that crises coincide with decreases in economic freedom, while gains in economic freedom happen during periods of positive capital market sentiment. The absence of a relationship between one-year lagged crisis events and changes in economic freedom suggests prior research relating gains in economic freedom to a crisis occurring 5 or 10 years earlier is a relationship which is more complex, non-linear and specific to the selected data period or spurious. Furthermore, relative equity market returns are related to changes in economic freedom, suggesting that equity markets identify which countries have increased economic freedom, long before popular economic freedom indexes are published.
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