The Rational of Private Bank Note Issuance The Enskilda Banks in the Economic and Financial Development of Nineteenth Century Sweden

Keywords: E40, G21, N13, N23

First established during the 1830's, the Enskilda banks were characterized by unlimited liability and the right to issue bank notes. In Swedish banking history, these banks have been considered to be primitive relics. This paper utilizes new data to revise this picture. Issuing notes based on an anchor provided by the National bank, the Enskilda banks made an important contribution to the development of liquid capital markets and for economic growth. The note issuance was also of importance to overcome shortages of liquidity due to both seasonal and regional variations in demand. In view of the crucial role of the Enskilda banks, the Banking Act of 1864, which permitted freer establishment and automatic prolongation of the charters for such banks, must be judged to have been an important institutional change.

Introduction

Wealthy countries have well developed financial sectors. Research shows that financial systems are important for economic growth and this was the case also for Sweden. 1 Thus, there should be a link between economic performance and the quality of the banking system. This question of the importance of the Swedish banking system has also been the matter of a debate among international scholars. In 1978 Lars G. Sandberg published his article, "Banking and Economic Growth in Sweden Before World War I". Sandberg argued that the explanation of Swedish economic success, to a considerable extent, could be found in the early development of a sophisticated banking system. More generally, the relatively high level of education that had been achieved despite low income levels, permitted the development of a banking system well suited to the demands of a growing, credit based, economy. Indeed, the relative sophistication of the banking system was a major pillar supporting Swedish industrialization. Sandberg divided the Swedish banking history into an early and a modern period. The latter began in 1864 when limited liability banking was introduced and the usury law was repealed. 2 Rejecting Sandberg's argument, Charles P. Kindleberger questioned whether the nineteenth century Swedish banking system truly could be considered "sophisticated".

Moreover, he expressed doubt as to the importance of the banking system in promoting Swedish economic growth at that time. Kindleberger's skepticism was largely based on the observation that the Swedish banks participated only modestly in the export activities that generally were taken to be the driving force behind Swedish industrialization. 3 Nonetheless, Douglas Fisher and Walter N. Thurman concluded that the decreasing velocity of circulation of means of payment from the 1870s was evidence of an increasingly sophisticated banking system and thus that the evidence supported Sandberg's point of view. 4 The nineteenth century Swedish commercial banking system, the so called Enskilda (literally meaning private) banks, started to establish in the 1830s. The Enskilda banks 1 For the case of Sweden see for instance Hansson and Jonung "Finance", Ögren "Financial Revolution". Sweden has also been included in several cross country studies such as Rousseau and Sylla "Financial Systems" and "Emerging Financial Markets" and Rousseau and Wachtel "Financial Intermediation" 2 Sandberg "Banking" pp. 656-657 3 Kindleberger "Sweden" pp. 918-920 4 Fisher and Thurman "Sweden's Financial Sophistication" pp. 625, 627-631 were characterized by unlimited owner liability and the right to issue bank notes. The banking history literature portrays Enskilda banks in two ways:

1) Traditionally as a primitive relics, outdated with the arrival of the "modern" limited liability banks of Credit Mobilier type in 1864. These limited liability banks were financed by substantial equity capital and deposits instead of note issuance. The division of the "modern" and the "early" period in banking is usually set in 1856 or 1864. The repeated arguments for Swedish financial backwardness before the 1870s are the absence of a limited liability banking system relying on deposits and of liquid capital markets. 5 2) As a case of free banking. This interpretation coincides with the boom in free banking literature in the 1980s. But, apart from the right to issue notes, the interpretation of the Enskilda banks as a case of free banking is not supported by empirics. Unlike the Enskilda bank notes that were inside money the National Bank notes were domestically high-powered money and thus functioned as base money; i.e. as reserves in the banking system. 6 The fact that the Enskilda banks did not constitute a free banking system does not, however, mean that these banks were not beneficial for the economic and financial development of Sweden. In fact the system where the National Bank issued base money and the Enskilda banks based on that issued notes was beneficial for the Swedish financial development and economic modernization. 7 At least during the first half of the nineteenth century, Sweden did indeed lack liquid capital markets. The most important capital markets were located in the two principal 5 An example of an anachronistic interpretation is the view of Brisman who wrote in the interwar period. A real and thus effective banking system required a central bank holding monopoly on note issuance, defending the fixed exchange rate by altering the discount rate, and commercial banks were to be non note issuing limited liability banks (see Brisman Sveriges Affärsbanker and "Den stora reformperioden"). Because of its emphasis on deposits, some scholars point to the establishment of Stockholms Enskilda Bank in 1856 as the birth of the "modern" banking system (see Nilsson Banker and Gasslander History) others to the entrance of limited liability banks (Fisher and Thurman "Sweden's Financial Sophistication" p. 625, Sandberg "Banking" pp. 657, 663). But in all respects the Stockholm Enskilda Bank was an anomaly among the Enskilda banks (see Ögren Empirical Studies and "Free or Central Banking?"). 6 A boom that followed on Lawrence H. White's book Free Banking in Britain from 1984. Lars Jonung argued the Enskilda banks to be a case of free banking without making a critical examination of the case, (Jonung "Economics"). This interpretation was quickly picked up by free banking theorists and presented as a successful case of free banking (see for instance Schuler "The world history". Regarding the history and working of the Enskilda bank system and its relation to the National Bank, see Ögren Empirical Studies and "Free or Central Banking?". 7 In Ögren's "Free or Central Banking?" it is shown that the complementary system of the National bank that was functioning as a rudimentary central bank and the private Enskilda banks utilizing National bank cities, Stockholm and Gothenburg. 8 As banks convert illiquid assets into liquid liabilities, they serve to channel capital to activities where demand for it is greatest. 9 Thus, a result of a successfully expanding banking system should be the creation of more liquid, and hence more efficient, capital markets. 10 The fact that these banks were unlimited liability note issuing private banks was not a matter of chance. All business was at the time run with unlimited liability. The right to issue notes was seen by contemporaneous actors as a necessary prerequisite for the operation of a bank. 11 Perhaps the members of Parliament at the outset of the nineteenth century knew what form of banking system that was feasible in the poor and largely unmonetized economy which was lacking high-powered money in the form of specie and at the same time aimed at not deteriorating the value of the currency by over issuance of National bank notes. 12 The question if the banking system was "modern" or not thus is an anachronistic question based on the view that a banking system has to operate with deposits or equity capital to finance its business. If the Swedish banking system was modern or sophisticated is really not the question. The question is if the Enskilda banks with their right to issue notes were beneficial for Swedish financial and economical development.

In order to analyze the development of the banking system over time I have collected a unique database on note issuing banks. It consists of balance sheet data at the end of each year from 1834 until 1900. I have also collected data on monthly basis from 1874 onwards. 13 This makes it possible to construct long term series on the banking system's notes as reserves promoted financial deepening in Sweden. Furthermore this system contributed to economic growth and modernization (Ögren "Financial Revolution"). 8 See Lobell Växelkurspolitik. 9 See Diamond and Dybvig "Bank Runs" and Diamond and Rajan "Liquidity Risk" 10 Diamond "Liquidity" pp. 949-950 11 See Ögren Empirical Studies Chapter 2. This chapter contains a study of the Parliamentary debate in Sweden concerning the nineteenth century banking system. 12 It is well known that coins and other forms of specie was an exception in transactions in Sweden. That private banks and even companies and merchants issued promissory notes that were used as means of payments was a Swedish reality long before the birth of the Enskilda banks (see Brisman Sveriges affärsbanker and Hallendorf "Bankens öden"). 13 These were published in Post & Inrikes Tidning [hereafter POIT] for the years 1834 -1870 and in Sammandrag af Bankernas Uppgifter [hereafter Sammandrag] for 1871-1906. The years 1835-1846 have been supplemented with data from Sveriges Riksbank "Statistiska tabeller" pp. 172-179. These balance sheets are the only sources that include detailed information of the Enskilda banks' assets and liabilities for the entire period. The accuracy and reliability of the figures reported by the banks might be questioned. When other sources differ from them, however, other sources than balance sheets are more favorable for the Enskilda banks in terms of the size of reserves (see Bankoutskottet Riksdagstryck 6:e portfolios (assets and liabilities) such as lending, note issuance, reserves and so on. The data with higher frequency makes it possible to study the flexibility of the banking system in altering these portfolios as supplier of credit and means of payments.

The structure of the paper follows three questions: 1) Did the importance of the Enskilda banks decrease with the introduction of limited liability banking? 2) Why was the possibility to issue notes such an advantage that it was worth carrying the extra risk of unlimited liability? 3) Did the Enskilda banks promote the development of the financial system and the economy as a whole?

The results show that the system of Enskilda banks was well designed, given the institutional setting of the nineteenth century. The Enskilda banks contributed substantially to the creation of liquid financial markets, and by extension also to economic growth. The Act of 1864, essentially permitting the free establishment of Enskilda banks and the automatic renewal of their charters, thus played an important role in the financial and economic development in nineteenth century Sweden.

The Success of the Enskilda banks

The form of unlimited liability provided the owners of the Enskilda banks with a higher degree of risk than was the case for the owners of the limited liability banks. Thus, if the agents were rational and limited liability banks truly were superior to Enskilda banks, the post 1863 period should have witnessed a decrease in Enskilda banks and an expansion of limited liability banking.

In this section I show that this was not the case. Instead the Enskilda banks continued to dominate as banking system until the right to issue notes was revoked in 1903 in accordance with the banking act of 1897.

Bank Deposit Financing

The traditional argument for the superiority of the limited liability banks is that they, apart from the apparent advantage of limited liability, managed to pool resources by deposits instead of using something as backwards as the issuance of notes. If reliance on deposit financing is a measure of bank modernity, then the Enskilda banks pass the test. Indeed, Enskilda banks had accepted deposits right from their inception, although these were originally less import than notes. By 1867, deposits exceeded notes as a source of Enskilda bank financing. As demonstrated in Figure 1, until the turn of the twentieth century total Enskilda bank deposits considerably exceeded those of the limited liability banks. the only limited liability banks that can be considered to be commercial banks were established in Stockholm and Gothenburg, where capital markets already existed. The limited liability banks that appeared outside these two cities were small, so-called folkbanks. These were more akin to regional savings than to commercial banks.

14 Indeed, the last Enskilda bank was not established until 1893. It was located in Norrbotten, in the far north of Sweden where business still was suffering from a scarcity of capital. One piece of evidence used, first by Flux and later by Kindleberger, to argue that the Enskilda banks were not a successful form of banking is the small number of such banks established before the mid 1860's. This is taken as a sign that the demand for Enskilda bank credits was low. 15 The true reason for the small number of new banks, however, was institutional in nature. The crown and influential groups in the parliament (the nobility) that were granted the monopoly privileges of establishing such banks of course had more to gain from preventing a massive establishment of banks. Not surprisingly the extract of monopoly rents made large groups dislike Enskilda banks and these started to act to inhibit the establishment of such additional banks. Prior to 1864, the Enskilda banks were required to obtain royal charters that were limited to ten years duration. At the end of that time, the bank had to close its operations and reapply. This explains why the Banking Act of 1864, which granted liberalized the prolongation of charters and the freedom to establish Enskilda banks, was so important.

Many of the Enskilda banks that were established during the late 1860's were former so-called "filial banks". These were a form of limited liability bank operating on the 15 Flux Swedish Banking System, Kindleberger "Sweden" p. 920 basis of credits from the Riksbank. When this form of banking was ended all of these filial banks chose to convert into Enskilda, and not limited liability, banks. 16 It was only during the late 1890's, when a plethora of new banks were established, that the Enskilda banks ceased to be the primary form of bank. The reason behind this change, however, was institutional rather than strictly economic. The increase in the number of limited liability banks was also accelerated by legislation constraining savings bank behavior passed in 1892. Consequently a lot of savings banks were converted into folkbanks. 17

The previously anticipated act rescinding the Enskilda banks' right to issue notes was enacted by Parliament in 1897. The right to issue notes was to end in 1903 and no notes were to be left in circulation after 1906. As seen in figure 2 Enskilda banks started to decrease in numbers around 1902. Many of these would merge with existing limited liability banks or reform as limited liability banks when their charter's ended. But apparently this did not happen until the right to issue notes was taken away.

Bank assets

Also when comparing the size of the two banking systems, it is clear that the Enskilda banks constituted the dominant banking system until the end of the nineteenth century.

In fact the same pattern reemerges when looking at total assets as in the case of the number of banks. From the mid 1870s the commercial banking sector consisted to approximately seventy percent of Enskilda banks after the initial establishment of limited liability banks in the main cities of Gothenburg and Stockholm.

16 When Parliament initiated these banks, the hope was that they would facilitate the replacement of Enskilda bank with Riksbank notes. Instead, the filial banks became major distributors of Enskilda bank notes, see From the mid-1890s limited liability banking in shadow of the coming end of Enskilda bank note issuance closed in on the size of the Enskilda banks. In 1903 limited liability banks for the first time held more assets than did Enskilda banks. Thus when note issuance ended so did the dominance of the Enskilda banks.

Since the Enskilda banks imposed unlimited liability on their owners, the question becomes why would anyone accept a greater personal risk in order to run or even to found an already outdated bank? This might be a question of path dependence but more likely is that this organizational form of banks had something that made it worth carrying the extra risk. As seen in this paper this extra value was the right to issue notes.

Enskilda Banks and the importance of note issuance

There is no doubt that the Enskilda banks performed an important service before the 1870's by supplying good quality means of payment. As early as 1859, the volume of Enskilda bank notes in circulation exceeded that of Riksbank notes, a situation that continued throughout the rest of the nineteenth century. While the share of notes in total Enskilda bank liabilities decreased, the absolute volume of notes in circulation continued to increase and peaked in 1900 (Figure 4). Overall note issuance diminished in importance after it had become possible to establish limited liability banks. But, the Enskilda banks still continued to dominate as banking form until the banking law of 1897 deprived them of the right to issue notes from 1903. As seen in figure 1 the number of Enskilda banks declined drastically after the implementation of this ban.

The possibility to issue notes thus was viewed as such an advantage when running a bank that this banking form was kept also after the entrance of the limited liability bank in the middle of the 1860s. The question thus is what did the note issuance provide that made it worth carrying the extra risk of unlimited liability instead of limited liability?

Regional differences in liquidity

The major cities were reasonably well supplied with credit and means of payment, but peripheral areas still suffered from a shortage of capital after 1870. The reliance on deposits varied geographically. A bank situated in Gothenburg or Stockholm, cities with their own capital markets, had greater opportunities to attract deposits than did rural banks. Thus, after 1863, the motive for opening a note issuing bank might be expected to be the supplying of credit to an area where deposits alone would not do the trick. Figure 5 shows that there was a negative relationship between the use of notes or deposits. Notes could be substituted for deposits in an area were capital was not available to such an extent that it could fund the bank's business.

Similarly in figure 6 we see that there was a negative relationship between holding of deposits and distances to Stockholm and Gothenburg whereas there was a positive one between note issuance and distances to these cities. The regressions indicate a negative relationship between deposits as a percentage of total assets and a bank's distance from liquid capital markets. Another factor that might have been of importance for a bank's reliance on note issuance was how recent the bank was established. A newly established bank may have been more in need of utilizing the possibility to issue notes, but whether or not the bank was of recent origin (post 1864)

did not significantly affect its reliance on deposits. Source: Sammandrag af Bankernas Uppgifter 1871, 1881

In table 1 we see that the banks in the north were utilizing the possibility to issue notes more than those in other areas. Deposit financing differed more among banks in various regions than did note issuance, but the banks closest to Stockholm and Gothenburg had the most deposits. The relative importance of notes diminished for all banks as increased overall liquidity permitted an increase in deposits. In absolute amounts, however, notes outstanding continued to increase for all banks.

Thus the possibility to issue notes was of vital importance for banks located in areas more remotely from Stockholm. But in fact several Enskilda banks also were established in close proximity to Stockholm and Gothenburg. Of the fourteen Enskilda banks that were established post 1864 five were established close to these cities. Thus, although the right to raise funds through note issuance was most important in peripheral areas of Sweden, such as the northern parts, it was seen as important to some extent by banks in all regions.

Seasonal differences in liquidity

Since Enskilda banks were established also in areas where capital scarcity was not an acute problem, the question must be asked why the limited liability form of organization was not used?

The Enskilda banks did not exhaust their issuance quotas and thus (unlike the limited liability banks) could instantly relieve a temporary lack of liquidity by issuing notes. 19 In an agricultural economy as Sweden in the nineteenth century, demand for liquidity would be seasonally volatile. With the right to issue notes the Enskilda banks were well suited to face changing demand for liquidity by easily altering their portfolios. This fact explains the willingness of owners to accept the greater risks of unlimited liability.

A large part of the lending of the Enskilda banks was in the form of granted credita credit which the holder could utilize at will. This credit, as all lending from the Enskilda banks, was made in the banks' own notes. And collaterals held by the Enskilda banks for this form of credit was a legal basis for note issuance. The seasonal flexibility in note issuance is supported in a regression analysis on the basis of the Enskilda bank note issuance. 19 Ögren "Free or Central Banking?" The legal basis of the Enskilda banks note issuance was determined by adding: a) their holdings of principal securities that amounted to three quarters of the equity capital plus their cash holdings in legal tender plus their holdings of specie plus the (estimated) value of collaterals they held for granted credits (see Ögren "Free or Central Banking?"). The regression on seasonal determinants on Enskilda bank note issuance strongly supports that the Enskilda banks followed a seasonal pattern in their note issuance. The absolute most important peak every year was in the month of September when a lot of businesses conducted their annual clearing. Another important month was in March when payments for deliveries before the winter would be due. Notes would flow back to the Enskilda banks mainly in the months of January and July. All in all it seems as the dynamic over the year would allow the Enskilda banks to increase their note stock in circulation since the increases in note issuance were not fully met by decreases. Over time the Enskilda banks increased liquidity in the form of Enskilda bank notes in circulation. The question is if the development of the Enskilda banks contributed to the creation of liquid capital markets in Sweden?

Enskilda Banks and the Liquidity of the Swedish Capital Market

Banks make an important contribution to economic growth by converting illiquid assets into liquid liabilities. Doing so, however, exposes banks to the danger of runs, in turn forcing them to hold non-interest bearing liquid assets to be able to meet the demands of depositors and note holders. The more instantly redeemable liabilities a bank has, the more vulnerable it is to runs, and therefore the more liquid assets it needs to meet possible liquidity shocks. While more liquid assets reduces the likelihood of bank failure, however, it also impedes credit creation and, thus, economic growth. 20 In brief, the level of liquid reserves reflects a trade off between the risk of bank failure and the demand for credit.

The trust engendered by a banking system, as well as its efficiency, might be measured in terms of the evolution of its liquid reserves. The level of the banks' liquid reserves is an indicator of the public's fear of bank failures. The less reserves the banks have to hold, the more efficient they can be in promoting financial development and economic growth.

The level of reserves is also related to the state of secondary asset markets. The more liquid these are, the more the banks can substitute interest bearing, for non-interest bearing, financial assets, thus further increasing capital market liquidity.

In order to allow holders of their notes to redeem these in legal tender, the Enskilda banks were forced to hold cash reserves. Assuming that the banks behaved efficiently, they would not hold excessive cash reserves. Thus, legal limitations on the right to issue notes only provided a framework for the banks' choices of reserves. Since the Enskilda banks issued less than their legally permissible quantity of notes, their effective issue was not limited by rules and regulations, rather it was limited by the public's demand that they hold sufficient legal tender. The Enskilda banks regularly published their balance sheets, providing a high level of transparency of their situation.

Unlike a free banking system, however, the Enskilda banks were operating with National Bank notes as reserves (instead of specie reserves). Specie became part of the reserves in 1878 when the banking law of 1874 was fully established but was never used for the redemption of Enskilda bank notes. Thus the Enskilda banks continued to use National Bank notes as reserves and held specie only to the extent the law required, despite the fact that National Bank notes no longer were legal basis for note issuance. 21 The liquid reserves of the banks thus are defined as all their holdings in legal tender, i.e.

National Bank notes and specie held at the bank, at its exchange agents or the National Bank.

Figure The contemporary Swedish debate on banking focused on the question of bank notes.

Critics argued that note issuance threatened both the prudence of the banks and, by extension, the fixed exchange rate, even though a run on deposits would be just as serious as one on notes. 22 Still, as shown in figure 7, liquid reserves were not as closely linked to demand deposits as to notes in circulation.

Assuming that the banks were efficient in their choice of liquid reserves, the reserves actually maintained must have been sufficient in the eyes of the public. Either the banks' customers did not consider demand deposits to be a source of bank vulnerability, or else the demand for liquid reserves declined over time while, co-incidentally, demand deposits also increased.

The former explanation seems unlikely in view of the fact that Stockholm Enskilda Bank experienced a run on deposits in December of 1878. 23 The latter explanation would imply a general, over all decrease in the demand for cash reserves. As shown in figure 8, the overall level of liquid reserves did indeed decline during the latter part of the period. The question thus becomes why liquid reserves were allowed to shrink to approximately three percent of total assets by the end of the period? 22 Ögren "Free or Central Banking?", "Lender" 23 Söderlund Skandinaviska banken The dramatic decline in cash reserves can be explained by increasing confidence in the banking system and/or increasing liquidity of the financial market might have made it possible for the banks to substitute interest bearing (e.g. bonds, bills of exchange or shares), for non-interest bearing, financial assets.

The latter explanation would signal that a secondary market had arisen that lowered the risk, the transaction costs and the time needed when selling financial assets as bonds or bills of exchange. Consequently the banks could take advantage of holding such interest bearing assets since these could be sold without too much hassle when the banks needed to stand prepared with liquid reserves instead. If this was the case this follows the predictions of how banks contribute to the development of the financial sector by replacing holdings in cash (legal tender) with financial instruments.

Thus the fall in Enskilda bank reserves indicates that these banks experienced an increased ability to exchange interest bearing financial assets for liquid reserves. This might well have been the result of increased liquidity on the growing secondary financial market. Such a process would be consistent with a model of banks and financial markets in transitional economies created by Douglas W. Diamond. Diamond argues that the banks play an active role in creating liquid secondary markets. As capital markets become increasingly liquid, banks can reduce their holdings of fully mature assets. That is, liquid capital markets allow banks to reduce their holdings of liquid assets, thus, in turn, further increasing capital market liquidity. 24 The hypothesis that Sweden benefited from increasingly liquid capital markets is further supported by the increasing ability of the National Debt Office to place bonds on the domestic market. In 1861, the Office issued bonds underwritten by Stockholm Enskilda Bank and the domestic banking firms of C.G. Cervin and Carnegie on the Swedish credit market. In order to generate domestic demand for these bonds, the bonds and their interest coupons were made acceptable for paying all kinds of taxes in Sweden. In addition they could be transferred to third parties at no cost. In effect, these bonds had been given legal tender status, clearly indicating that the secondary financial asset market suffered from a lack of liquidity. The coupon interest rate was a reasonable 4.5%, but in addition a commission (or capital discount) of 7% had to be paid to the underwriters of the loan. In view of the problems encountered in selling the bonds outside the major cities, a further 2% commission was added for such sales.

In 1865 another, supposedly temporary, loan to be administered by Skandinaviska Kreditaktiebolaget in Gothenburg bank was planned for the domestic credit market. Not only did it have to be denominated in Mark Hamburg Banko and Cologne Silver and payments had to be made in Hamburg and Copenhagen (not in Stockholm as demanded by the National Debt Office), the interest rate required was a generous 6%, with another 3.5% in total commissions.

Less than ten years later, in 1870 and 1872, two significantly larger bond loans were placed on the Swedish market. This time, no middle man was required and the interest rates were 5% and 4% respectively. In addition the commissions were lower. The second of these loans was designated to pay off the first, as well as two international bond loans dating from 1868 and 1869. Even if swings in the business cycle played some role, the domestic bond market seems to have become more liquid during these years. 25 To test whether financial instruments (bonds) were substituted for cash reserves and 2) If bonds are viewed as a substitute for liquid assets, then increased demand for credit ought to affect relative bond holdings negatively.

Since this model is intended to explain long term developments, the dependent variable, BONDS, is measured as the natural logarithm of bank holdings of bonds, exclusive of their security fund, in relation to total assets. As was the case with the previous model, the starting year is 1848. in commercial and savings banks) is used as a parameter to measure the growth of liquidity in Sweden. 26 The hypothesis is that growth in M3 ought to lead to increased Enskilda bank bond holdings. Since the natural logarithm of M3 is not stationary, it has to be implemented as first differences. GDP: Nominal GDP is utilized as a proxy for the public's demand for credit. 27 If bonds were considered to be a substitute for liquid reserves, then increased demand for credit (as measured by GDP growth) ought to be negatively related to bond holdings. As was the case with M3, the nominal GDP series has to be differenced to become stationary. According to the ADF-test, the lending series is actually more stationary in its original, than in its logarithmic, form. Thus the series LEND is defined simply as lending as a share of total assets, even though this series is only close to being stationary at the 5% significance level. It was expected that bond holdings would be positively related to bond holdings lagged 27 The series of GDP at current prices is from Krantz "Swedish Historical National Accounts" pp. 12-14.

one year, since the ability to substitute bonds for liquid reserves was increasing over time.

As was the case with the previous model, one question concerns the existence of a structural break point either in 1864 or in 1865. Dealing with Swedish monetization indicates that there was a structural break in the late 1860's which ought to have increased the ability to substitute bonds for liquid reserves. 28 , 1871-1900, SCB (1960) pp. 99, 102-103, Sveriges Riksbank (1931) pp. 172-185

The results of estimating the model seem to be consistent both with the hypothesis that interest bearing bonds increasingly become a reliable substitute for liquid reserves and the hypothesis that this was a consequence of the increased liquidity of the secondary financial markets.

Increases in domestic liquidity, as measured by the growth of M3, resulted in larger bond holdings. Since the growth of economy wide liquidity facilitated the conversion of bonds into liquid assets, this result is in accord with the hypothesis. Since both the dependent and the independent variable are natural logarithms, it is also possible to evaluate the size of the coefficients. A one percent change in economy wide liquidity resulted in a 1.38 percentage point increase in the share of bonds in total bank assets.

Increases in both lending and the demand for credit, the latter represented by annual changes in nominal GDP, resulted in decreased Enskilda bank bond holdings (although the GDP relationship was not significant at the 5% level). These results tend to support the hypothesis that bonds were held as substitutes for liquid reserves since both strictly cash reserves and bond holdings decreased when the demand for credit increased.

28 See also Ögren Empirical Studies

The percentage of bonds in total bank assets was positively related to bonds held the previous year. This is likely to be the result of an increasing ability over time to substitute interest bearing bonds for liquid reserves, as the liquidity of secondary asset markets improved. A discontinuity in the ability to hold financial assets in place of cash reserves indicates that the secondary markets for such assets had become sufficiently liquid to assure the holder that they could be sold with little risk of substantial loss.

It is also evident that the Banking Act of 1864 that resulted in an increased number The shift in monetization that occurred in the late 1860s and early 1870s is indicating that a structural change in the ability hold bonds occurred during these years when the establishment of new banks accelerated in response to the Banking Act of 1864. This supports the hypothesis that the right to freely open new banks facilitated the development of the Swedish credit market. Thus the 1860's, thanks to the evolution of the banking system, witnessed significant progress in the creation of the prerequisites needed for the development of an efficient over all capital market. The question is if the activity of the Enskilda banks also was related to economic growth?

Enskilda banks and Economic Growth

The Enskilda banks were crucial for the Swedish monetization. The symbiotic system with the National Bank issuing base money and the Enskilda banks providing liquidity (notes) based on these notes was of fundamental importance for replacing other, less efficient, means of payments such as private IOUs. 29 The idea that liquidity promotes growth is supported in theory. A well designed financial system leads to lower information and transaction costs and possibilities to better risk management. 30 The main instrument in order to avoid transaction costs is formal liquidity, i.e. means of payments directly possible to use for transactions as trusted by all parts. This is of especial importance in an illiquid emerging economy in the process of formalizing and integrating its domestic markets. The larger acknowledgement of the means of payments, the more it can be used in larger networks, including as became the case with the Enskilda bank notes, the entire Country (and some neighboring regions in Norway and Denmark).

Prior research has shown that the Swedish system consisting of the National Bank issuing base money and the Enskilda banks issuing notes based on National bank notes, granger-caused both general economic growth and growth in the increasingly important industrial sector for the period of the silver and the gold standard from 1834 until 1913. 31 Cointegration analysis can be used for detecting relationships between unstationary variables (i.e. containing unit roots). The basic assumption in the cointegration analysis is that even though there are trends in the data series, there may be a stable relationship between the series. If there exists a linear combination of the two non stationary variables that is stationary the time series are cointegrated. This linear combination shows a long-run equilibrium relationship between the variables. This equilibrium is an 29 Ögren "Free or Central Banking?" The Swedish system seems in many ways to be similar to that of the USA in its early years when the two Banks of the United States issued convertible base-money used by US state banks as reserves (see Officer "U.S. Specie Standard"). 30 Levine "Financial Development" 31 Ögren "Financial Revolution" econometric equilibrium, i.e. means that the variables do not diverge randomly from each other over time.

As seen in figures 14 to 16 there might be a case of cointegration between the Enskilda bank variables such as notes issued by the Enskilda banks (EBNOTES), Enskilda bank lending (EBLEND), Enskilda bank assets (EBASSETS) and general growth in the economy (GDP) and/or growth in the industrial sector (INDUSTRY). It may not be visible in the figures but pair wise cointegration tests shows the existence of cointegration vectors between the different measures of the Enskilda banks and economic growth for the period 1834 and 1900. Any particular causality in the internal relationship between the growth variables and the system of Enskilda banks is not detectable. But since the cointegration tests without exception showed a mutual relationship in long term growth and the measures of the Enskilda bank system it is quite clear that the system of Enskilda banks was of main importance for economic growth. Table 4 below summarizes these results. To conclude, the statistical tests shows that growth in the lending of Enskilda banks as well as in the banking system was related to growth not only in GDP but also in the industrial sector. Most important; the amount of supplied Enskilda notes held by the public was related to the size of GDP and the industrial sector as well. In addition to this a prior study has shown that the amount of Riksbank plus Enskilda bank notes that circulated positively influenced economic growth. 32 Again this underlines the importance of creating means of payments with the qualities that makes them accepted for transactions outside small regional networks.

Conclusions

To paraphrase Mark Twain; the rumors concerning the end of the Enskilda banks in response to the introduction of limited liability banking during the 1860's are exaggerated. The Enskilda banks continued to dominate Swedish banking until the dawn of the twentieth century. Given the commercial banking system's contribution to financial development and economic growth, the Enskilda banks was a successful response on how to develop a banking system in a poor and illiquid economy as the nineteenth century Swedish. The aspect of the Enskilda banks used to brand them as backward, the issuance of notes, in fact was the source of their success.

The ability to issue notes gave the Enskilda banks a degree of flexibility that made it possible for them to operate in areas of capital scarcity. Another important part of the success of the Enskilda banks were their ability to adjust to the changing seasonal demand for means of payments; i.e. notes. The use of deposit financing developed not so much because of the repeal of the usury law in 1863, but because of the provision of sufficient means of payment. The circulation of money, usable for deposits, was largely a result of the note issuance activities of the Enskilda banks.

As deposits increasingly become a viable alternative means of financing banking activity, the Enskilda banks came largely to rely on them. By the late 1860's, note issuance had become secondary to deposits. Indeed, throughout the nineteenth century, the Enskilda banks held more deposits than did the limited liability banks. One of the advantages of the Enskilda banks versus their limited liability competitors was their greater ability to liquify fixed assets, even when they lacked sufficient deposits to operate their business. This advantage was maintained throughout the nineteenth century and made the Enskilda banks' mode of operation superior in most parts of Sweden.

The latter section in this chapter examined the interaction between the Enskilda banks and the emergence of liquid capital markets. The level of liquid reserves maintained by the Enskilda banks declined rapidly during the period 1834-1900. Three 32 Ögren "Financial Revolution" explanatory hypotheses were discussed: 1) Increasing confidence in the banking system resulted in a decreased demand for liquid reserves, 2) Increasing demand for credit by the public resulted in a decreased demand for liquid reserves and 3) Increasing liquidity of capital markets allowed the Enskilda banks to substitute income generating assets, such as bonds and shares, for non-interest bearing cash reserves.

All three hypotheses seem to have some validity, even if the confidence effect is difficult to measure. Liquid reserves definitely decreased as demand for credit rose, and bond holdings were strongly negatively related to totally liquid reserves. As Enskilda bank bond holding increased in tandem with the economy's overall liquidity, growing capital markets made it possible to substitute interest bearing assets for liquid reserves.

Thus, as the liquidity of capital markets increased as a result of banking activities, the banks needed less liquid reserves, thereby further increasing the liquidity of the markets.

The years 1864 and 1865 witnessed a leap upward in the bond holdings of the Enskilda banks, implying a breakthrough for Swedish capital markets. The conclusion is that the Banking Act of 1864, by removing virtually all legal barriers to the establishment of new banks, at the time was of greater importance for the development and integration of the Swedish credit market than was the introduction of limited liability banking.

There is no doubt that the Enskilda banks were related to economic growth both overall and in the up and coming industrial sector. Issuance of notes as well as lending and total assets were all cointegrated with GDP and the industrial sector. It is however not clear how this link was and/or how the causality was between these measures of the Enskilda banks and the measures of economic growth.

In all respects the importance of the Enskilda banks in the financial and economic development of Sweden in the nineteenth century should not be underestimated. These banks were a rational response to the difficulties of funding banking business in an illiquid economy. And they stayed as long as the right to issue notes lingered. As soon as this right was taken away, however, they chose to reorganize as limited liability banks. Thus, the right to issue notes was the key to why these banks were as successful in promoting financial and economic development as they were.

Figure

  Figure1: Total Deposits in Enskilda and limited liabilityBanks, 1834 -1900 (1,000,000's SEK)

Figure 5 :

 5 Figure 5: A Cross Sectional study of the relationship between Deposits and Notes (in percent of total liabilities) for all Enskilda banks in 1871 (Logarithmic values).

Figure 6 :

 6 Figure 6: Cross Sectional studies of the relationship between Deposits and Distance to Stockholm times Gothenburg (left) and between Notes and Distance to Stockholm times Gothenburg (in percent of total liabilities) for all Enskilda banks in 1871 (Logarithmic values).

  as a result of increased overall liquidity I estimate a model determining the variables affecting Enskilda bank holdings of bonds relative to total assets. The two hypothesis are: 1) Increasing over all liquidity made bonds a better substitute for liquid assets, and 25 Riksgäldskontoret Lånekontrakt Tryckta 1858 -1872. Riksarkivet RGK No 9060 [hereafter RGKLKT]. Administering the 1861 loan were the Banking firms Carnegie o Co., C.G. Cervin and Stockholm Enskilda Bank. Administering the 1865 loan was Skandinaviska Kreditaktiebolaget in Gothenburg.A Professor from the Royal Institute of Technology had to help the national Debt Office with calculating the actual cost of the loan. In the case of the loans 1870 and 1872 commission was probably paid to local tax governors administering the handling of these bonds (see alsoÖgren "Lender"). 20

Figure 9 :

 9 Figure9: Bond Holdings as Percent of TotalAssets and in Natural Logarithm Form, 1834 -1900

Figure 10 :26

 10 Figure10: Money Supply M3 as a NaturalLogarithm and Annual Changes Therein, 1834 -1900

Figure 11 :

 11 Figure11: Nominal GDP as a NaturalLogarithm and Annual Changes Therein, 1834 - 1900

Figure 12 :

 12 Figure 12: Enskilda Bank Lending as Percentage of Total Assets and as a NaturalLogarithm, 1834 -1900

Figure 14 :Figure 15 :Figure 16 :

 141516 Figure14: Per Capita Enskilda Bank Notes and GDP (to the left) and Per Capita Enskilda BankNotes and INDUSTRY in stable prices, 1834 -1900. Logarithmic values.

  Figure 4: Per Capita Total Liquidity (LIQ M0) (amount of Enskilda bank and National Bank notes Held by the Public), Enskilda Bank notes (EBNOTES) in Stable Prices (Left Y axis = SEK). Enskilda Bank notes in percentage of Total Enskilda Bank Liabilities (EBnotes/EBLiabilities)(Right Y axis),1834 -1900.

	25																								70%
														LIQ M0
														EBNOTES									60%
	20													EBNotes/EBLiabilities
																									50%
	15																								40%
	10																								30%
																									20%
	5
																									10%
	0	1834	1837	1840	1843	1846	1849	1852	1855	1858	1861	1864	1867	1870	1873	1876	1879	1882	1885	1888	1891	1894	1897	1900	0%

18 18 See Ögren Empirical Studies and "Free or Central Banking?" Sources: Post & Inrikes Tidning 1835-1871, Sammandrag af Bankernas Uppgifter, 1871-1900

Table 1 :

 1 Issued Notes, Deposits and Bond Holdings, as Percentages of Total Assets in 1871 and 1881 for Enskilda Banks Established Between 1865 and 1871, Arranged by Note Issuance in 1871.

	Bank	Notes-	Notes-	Deposits-	Deposits-	Bonds-	Bonds-	Region
		1871	1881	1871	1881	1871	1881
	HernösandsEB	42%	24%	24%	44%	1%	5% North
	SundsvEB	38%	18%	31%	51%	0%	3% North
	WesterbEB	35%	20%	21%	46%	0%	4% North
	GeflebLEB	32%	17%	39%	57%	3%	5% North
	SkarabLEB	31%	13%	44%	56%	0%	3% West
	ChristianstEB	30%	19%	38%	48%	2%	7% West
	CalmarEB	29%	13%	26%	50%	5%	13% South
	Ebi Christineh	28%	15%	23%	37%	0%	5% West
	UplandsEB	27%	13%	52%	63%	18%	21% East
	EB I Wernersb	26%	16%	37%	41%	3%	4% West
	GotlEB	25%	13%	24%	49%	0%	4% South
	SödermanlEB	23%	17%	44%	55%	8%	10% East
	BohusLEB	21%	16%	23%	47%	0%	5% West
	BoråsEB	16%	10%	41%	57%	1%	4% West
	All Enskilda banks	27%	16%	39%	53%	7%	9%

Table 2 :

 2 OLS-Regression on the Seasonal Determinants of Enskilda Bank NoteIssuance, 1878 -1900, Monthly Data (276 observations).

	Dependent Variable: DLOG(NOTES)
	Included observations: 275 after adjusting endpoints
	Variable	Coefficient	Std. Error	t-Statistic	Prob.
	C	-0.01	0.00	-2.12	0.03
	DLOG(LIQRES)	0.05	0.02	2.39	0.02
	JANUARY	-0.05	0.01	-7.00	0.00
	FEBRUARY	0.04	0.01	5.37	0.00
	MARCH	0.07	0.01	9.86	0.00
	APRIL	-0.02	0.01	-2.61	0.01
	MAY	-0.02	0.01	-2.95	0.00
	JUNE	0.04	0.01	5.00	0.00
	JULY	-0.06	0.01	-8.04	0.00
	AUGUST	0.03	0.01	4.77	0.00
	SEPTEMBER	0.13	0.01	17.44	0.00
	NOVEMBER	-0.03	0.01	-3.84	0.00
	R-squared	0.78 Adjusted R-squared	0.77

  7: Note Issuance, Demand Deposits and Liquid Reserves of the Enskilda banks,1834 -1900 (1,000's SEK).

	120 000
	100 000			Notes
				Liquid Reserves
	80 000			Demand Deposits
	60 000
	40 000
	20 000
	0
	1834	1838	1842	1846	1850	1854	1858	1862	1866	1870	1874	1878	1882	1886	1890	1894	1898
	Sources: Post & Inrikes Tidning 1835-1871, Sammandrag af Bankernas Uppgifter 1871-1900

  Figure 8: Liquid Reserves of the Enskilda Banks as a Percentage of TotalAssets, 1834 -1900.

	35%
	30%
	25%
	20%
	15%
	10%
	5%
	0%
	1834	1838	1842	1846	1850	1854	1858	1862	1866	1870	1874	1878	1882	1886	1890	1894	1898
	Sources: Post & Inrikes Tidning 1835-1871, Sammandrag af Bankernas Uppgifter 1871-1900

Table 3 :

 3 OLS-Regression Results of the Determinants of Enskilda Bank Bond Holdings

	Dependent Variable: LOG(BONDS)
	Sample: 1848 1900
	Included observations: 53
	Variable	Coefficient Std. Error		t-Statistic Prob.
	C	-2.07	0.43	-4.77	0.00
	DLOG(M3)	1.43	0.41	3.51	0.00
	DLOG(GDP)	-1.14	0.55	-2.09	0.04
	LOG(LEND)	-0.82	0.25	-3.37	0.00
	LOG(BONDS(-1))	0.57	0.09	6.67	0.00
	R-squared	0.82 Adjusted R-squared			0.81
	Sources: Krantz, O. (1997) pp. 12-14, Post & Inrikes Tidning 1849 -1871, Sammandrag af Bankernas
	Uppgifter

  of Enskilda banks (from 12 in 1864 to 26 in 1867) was essential for the financial development. Monetization indeed shifted upwards during the years 1868 and 1872 and accelerated thereafter (see figure13 below). The biggest part of this monetization was by far deposits in the Enskilda banks but also Enskilda bank notes expanded.Figure 13: Broad Money Supply inSweden, 1834 -1913 (Per Capita and in Stable prices). Semi-logarithmic Scale with Growth rates for Sub periods. The Broad Money Supply is defined as Liquidity held by the Public plus their Deposits in Commercial and Savings Banks.

	10000
													Average annual growth
													1873 -1913 = 4.6%
	1000
		Average annual growth
			1834 -1867 = 1.7%
	100
	1834	1838	1842	1846	1850	1854	1858	1862	1866	1870	1874	1878	1882	1886	1890	1894	1898	1902	1906	1910
	Sources: Ögren, A. (2003)

Table 4 :

 4 Result of Johansen's Cointegration pair wise test of linear deterministic trend in the series of EBNOTES, EBLEND and EBASSETS with growth in the industrial sector (INDUSTRY) and overall economic growth (GDP) in par capita and stable prices, 1834 -1900 logarithmic values. The table shows number of cointegration vectors and their significance levels.

		Log(EBNOTES) Log(EBLEND) Log(EBASSETS)
	Log(GDP)	1**	1**	1**
	Log(INDUSTRY) 1**	1**	1**
	* 5% and ** 1% significance level

See Diamond and Dybvig "Bank Runs", Daimond and Rajan "Liquidity Risk". Diamond and Rajan also discuss the benefits of banking fragility for economic growth (Daimond and Rajan "Liquidity Risk" pp. 287-288).

Ögren "Free or Central Banking?"

 Diamond suggests that the model is particularly suitable for a developing economy, which Sweden at the time most certainly was.


Rami Abdelkafi
email: abdelkafirami@yahoo.fr.

Hatem Derbel
email: derbelhatem@yahoo.fr

THE EFFECTS OF ECONOMIC FREEDOM COMPONENTS ON ECONOMIC GROWTH: AN ANALYSIS WITH A THRESHOLD MODEL

Keywords: Size of the government, economic freedom, economic growth, threshold model J.E.L classification: C13, C21, H10, H11, H50, O10

 method to demonstrate the presence of threshold variables rejecting the linearity of the relation between variables on the entire sample. The GDP per capita and the initial enrollment rate in secondary school divide the sample in two groups of countries characterized by different relations. One of our principal results is that the reduction of the size of the government is not effective in countries having an initial GDP per capita and an enrollment rate in 1990 higher than the thresholds values. This enables us to put into perspective the need for a reduction of the size of the government and to insist on the effectiveness of economic policies in developing countries.

I. INTRODUCTION

In spite of the abundance of theoretical and empirical works, economic theory still until now unable to give a complete and exact specification of all variables having a significant impact on economic growth. Indeed, several models seem to be logical but give very different results that make very difficult to decide what lessons we can draw for economic policies.

But, although different in their conclusions and in the importance that each one gives to growth factors, these works agree on the fact that economic environment can determine the effectiveness of the various factors and their influence on economic growth.

Recently, the concept of economic freedom was advanced by several authors as a necessary condition and an effective mean to promote economic growth. Boockmann and Dreher (2001), for example, note that liberalization and privatization are the main objectives of the programs and policies of the IMF and the World Bank. So, based on liberal ideas, the economic freedom tries to reduce to the minimum the role assigned to the government and to amplify that of the market and the private sector. On the basis of these ideas, some studies try to empirically confirm the positive correlation between economic freedom and growth. So using an index of economic freedom (hereafter EFI), these studies try to show a positive relationship between this index and some development measures of which the most significant still the GDP per capita. In the context of developing countries, the investigation into the causes of failure, often evoked, of economic policies concern two types of different but dependent questions. The first one is related to the theoretical justification of these policies and the active role of governments in the economy. The second is related to the effectiveness of any intervention, even socially justified, of the government and it is generally considered that this effectiveness depends on political, institutional, geographical and economic factors.

Based on some empirical results showing, at the same time, the effectiveness of economic freedom and the inefficiency of public interventions in some countries, several economists present the total liberalization of the economy as a priority and a standard action that all countries must apply independently of their context and without any conditions. The aim of this paper is double. First, it is to show that the use of an aggregate index can mask the complexity of the link between economic freedom and growth as well as the importance of its various components. Second, it is to show that the link between economic freedom and growth could depend on the development level of countries. The remainder of the paper is organized as follows: section 2 discusses the method used in our estimations and justifies the choice of the explanatory variables. Section 3 tries to give a brief idea about the concept of economic freedom and its various components. Section 4 is devoted to the empirical study in which we try to analyze the link between economic freedom and growth.

The conclusion is presented in section 5.

II. ECONOMIC GROWTH FACTORS: MULTIPLE EXPLANATIONS BUT WEAK RELATIONS

Economic literature remains until now unable to provide an exact specification of the link between economic growth and its determinants. The multiplicity of these determinants has amplified the difficulties to analyze their nature and their importance in the development process. Thus two problems have taken more importance in recent studies on economic growth. The first one is a continuity of old efforts trying to widen the field of analysis and to integrate more explanatory factors of economic growth. The second, on the other hand, tries to reduce this field by insisting on the robustness of links that some empirical works propose.

In an article, considered as a reference for the majority of recent works on economic growth, [START_REF] Levine | A sensitivity analysis of cross-country growth regressions[END_REF] deal with the problem of the multitude of specifications used to study the effects on economic growth. These authors show that the majority of these specifications are not robust and that the relations demonstrated between economic growth and some other variables must be putted into perspectives1 . Temple (2000) notes that the estimated parameters are likely to be much correlated with studied variables so the specificities of countries and their development levels can influence the importance of integrated variables and by there the results obtained. But, a more optimistic view point can be found at Sala-i-Martin (1997) who considers that the impact of many variables on economic growth is certain. Thus, it is not the pessimistic vision drawing aside a great number of variables which must characterize the studies on economic growth2 . Generally, even the strictest view points agree on the need for integrating some variables having an unquestionable impact on economic growth. Thus, initial GDP, investment and several measurements of human capital are regarded as "standard variables" and always correlated with economic growth.

Recently, economists are more interested in integrating institutional factors in growth regressions. [START_REF] Hall | Why do some countries produce so much more output per worker than others ?[END_REF], for example, insist on the role of social infrastructure, which includes institutions and government policies, in economic growth. In particular, they show that the difference in the output by worker between countries is explained only partially by the difference in their physical capitals and their education levels. The same authors show that the difference in the stock of physical capital and in productivity can be explained by institutional factors and many other variables relating to economic policies. In this new wave of empirical works, the integration of an index of economic freedom in growth regressions comes to enrich the debate relating to the respective roles of the State and the market in the development process. Motivated, at the same time, by liberal ideas and by the significant progress realized in calculating some indexes of economic freedom, several studies try to advance the benefits of economic liberalism.

III. THE CONCEPT OF ECONOMIC FREEDOM

The index of economic freedom measures the degree according to which institutions and various policies of a country encourage freedom. It is based on the personal choices, the freedom to exchange, the freedom of competition and the safety of private properties.

According to the Fraser Institute report, the African countries, those of Latin America and the former communist countries are less classified in terms of economic freedom. The same report notes that countries with a high score in economic freedom rating have relatively higher growth rates and better social indicators such as life expectancy. Thus, it is considered that market creates an environment in which it would be very difficult for authorities to exert pressures on people. On the concept of economic freedom, the report notes that the key ingredients of economic freedom are personal choice, voluntary exchange coordinated by markets, freedom to enter and compete in markets, and protection of persons and their property from aggression by others. So this concept assigns to the government the role of establishing a legal structure which ensures the correct operation of free market. However, this government must be disengaged of any activity which is likely to compete with the private sector and the correct operation of competition. Thus, economic freedom will be reduced if public expenditures and regulation policies replace some private activities.

Entirely, the construction of the economic freedom index is based on 38 components and subcomponents which relate to five different fields.

The first one is relating to the size of the government in the economy. So it is considered that public expenditures as well as subsidies and transfers are variables which limit economic freedom. In the same way, it is a question of seeing up to what point the production is realized by private enterprises rather than by public ones. The second is relating to legal structure and safety of property rights. Generally, it consists to see up to what point laws in force in the economy respect freedom to exchange and if private agents have confidence in these laws so they protect their private interests. The third field concerns inflation stability and consistency of monetary policies. In particular, it consists in studying the inflation volatility and the possibilities offered to the private sector to have access to foreign currencies which are safer and more stable than its national currency. The fourth field is relating to free trade and the opening of the economy to outside. It is about the ability of the private agents to exchange with foreigners. The last field is interested in regulations which can exist in the credit market, the labor market and the goods market.

The economic freedom index has made it possible to several studies to test the link which can exist between economic freedom and some economic indicators of which the most popular remains always income par capita. For example, some studies are based on heterogeneous samples including developed and developing countries arrive at conclusions showing a positive correlation between economic freedom and growth (Shaefer, 2003;[START_REF] Gwartney | Economic Freedom of the World -2005 annual report[END_REF][START_REF] Gwartney | Economic freedom, institutional quality, and cross-country differences in income and growth[END_REF][START_REF] Cole | The contribution of economic freedom to world economic growth, 1980-99[END_REF][START_REF] Esposto | Economic freedom and the quality of life: an empirical analysis[END_REF]. Some other studies [START_REF] De Soysa | False Prophet, or Genuine Savior? Assessing the Effects of Economic Openness on Sustainable Development, 1980-1999[END_REF][START_REF] Stroup | Economic freedom and environmental quality[END_REF] go further and show a positive effect of economic freedom on environmental quality.

Our empirical work is motivated by the conviction that economic freedom effects on growth can be conditioned by differences in development levels. It is very clear that the construction of the economic freedom index integrates some variables having effects which remain until now a subject of debate in economic literature. In fact, if economists are almost unanimous on the importance of the respect of property rights and personal freedom, they remain divided on the role assigned to the public sector and the effects of free trade on economic development. Thus we try in our empirical part to decompose the effect of economic freedom on growth and to highlight the differences which should exist between countries regarding to their development levels.

IV. EMPIRICAL ANALYSIS OF THE ECONOMIC FREEDOM-GROWTH LINK 1. The estimated model

Our approach in this part is progressive and consists in two different stages. In the first, we introduce the aggregate EFI in a growth regression explaining the growth rate of GDP per capita (noted GDPG) according to other variables. In the second, we try to decompose the EFI by replacing it by its various components in the same regression. Thus, we introduce the variable expressing the size of the government (noted SG), the variable indicating the legal system quality (noted LS), the variable expressing free trade (noted FT), the variable expressing the inflation volatility and the consistency of monetary policies (noted SM) and the variable indicating the regulation on the various markets (noted REG).

According to liberal ideas, the coefficient of the EFI must be positive and significant implying a positive effect of economic freedom on growth. In the same way, the coefficients related to the various components of the index should be positive. Indeed, the higher is the score of a country in each one of these variables, the more liberal is this country. For example, a higher score of a country in the variable SG indicates a smaller weight of the government in the economy.

The relatively big size of our sample enables us to integrate a high number of variables without reducing in a considerable way the degree of freedom. However, integrating a bigger number of variables having a link with economic growth as well as the study of the robustness of this link exceeds the contours of our work and is likely to mask the importance of the various economic freedom components. For this reason, we integrate only variables of which effects on growth are confirmed and regarded as robust by the majority of former studies [START_REF] Levine | A sensitivity analysis of cross-country growth regressions[END_REF][START_REF] Sala-I-Martin | I just run two million regressions[END_REF]Temple, 2000). Therefore, in addition to variables relating to economic freedom, we introduce the logarithm of initial GDP per capita

(noted 0 t
LGDP ), the enrollment ratio in secondary school (noted SCO) 3 and the share of investment in GDP (noted INV). Entirely, we have the following regressions:

(2)

(1)

8 7 6 5 4 3 2 1 2 4 3 2 1 1 0 0 i i i i i i i i it i i i i i it i REG FT SM LS SG INV SCO LGDP c GDPG EFI INV SCO LGDP c GDPG                              

Estimation with the aggregate index of economic freedom

Our study covers the period ranging between 1972 and 2003. Thus GDPG represents the average rate of GDP per capita over this period 4 . The variable INV is the average over the same period of investment share in GDP. The data of these two variables are extracted from the Penn World Tables 6 5 . For the variable SCO, lack of data over the total period and for all countries of the sample led us to use the average over the period ranging between 1990 and 1996. Data for this variable is obtained from the WDI 2003 of the World Bank. Lastly, all data relating to economic freedom are extracted from the Fraser Institute database6 . For these variables, data are available in intervals of five years over the period ranging between 1970 and 2000. Moreover, data are available for all variables and for all countries only since 2000. However, we use the average of the variables over the period 1985-2000. This choice enables us to avoid the return effect which could exist between economic freedom and growth [START_REF] Heckelman | Which economic freedoms contribute to growth ?[END_REF]Chong and Calderón, 2000;[START_REF] Dawson | Causality in the freedom-growth relationship[END_REF]. Then by this way, 3 In the majority of empirical works, the variable SCO is regarded as a proxy for human capital. Other variables, such as the enrollnment ratio in the primary school and the literacy rate, can also be used. [START_REF] Barro | Economic growth in a cross section of countries[END_REF] notes that the calculation of the literacy rate suffers from several problems especially in developing countries. In addition, [START_REF] Levine | A sensitivity analysis of cross-country growth regressions[END_REF] note that many countries already reached the maximum level of the literacy rate and the ratio of primary school. Thus, these variables would be unable to express the differences in the human capital between countries. Lastly, in their estimates, Green et al. (2002) use several indicators of human capital and note that the results are always the same. 4 We have

         31 100 ) ( 1972 2003 GDP GDP Log GDPG
we can take account of the delay effect in the link between the two variables [START_REF] Carlsson | Economic freedom and growth : Decomposing the effects[END_REF].

At the beginning, our sample comprised 104 countries at various development levels7 .

Thus heterogeneity is likely to influence the quality of our results because of the existence of some outliers that deviate from the general tendency of the sample. These outliers can have a big weight in such a way that they strongly influence the results. Therefore, to be robust, these results shouldn't be extracted from a small number of observations characterized by a relation that is different from that expressed by the estimated model (Temple, 1999;2000). Outliers occur frequently because of the measurement errors, owing to the fact that some observations are extracted from a sub-sample characterized by a relation that differs from the general model, or because of the presence of some exceptional events (Bengtsson and al., 2005). In the presence of such outliers, the use of the Ordinary Least Squares (OLS) method is inadequate. In this case, the use of the LTS (Least Trimmed Squares) method is necessary to detect the presence of atypical values8 .

By applying the LTS method in our regressions they showed the presence of three outliers which are China, the Democratic Republic of Congo and Zambia9 . This led us to use the FWLS (Final Weighed Least Squares) which consists in assigning the value 0 to outliers and the value 1 to the other observations. Table 1 gives a comparison of the results obtained with the OLS method and those obtained with the FWLS method. This table shows that the results obtained with the two methods are very close. In both cases, all the coefficients are significant and have the awaited signs. The EFI is characterized by a positive and statistically significant coefficient. Therefore, like the majority of empirical works, our results show that the use of an aggregate index of economic freedom results in a positive effect of the latter on economic growth.

A decomposition of the EFI

The use of an aggregate index of economic freedom can mask the true characteristics of the link that can exist between freedom and growth [START_REF] Carlsson | Economic freedom and growth : Decomposing the effects[END_REF]Bengtsson and al., 2005;[START_REF] Heckelman | Which economic freedoms contribute to growth ?[END_REF]. First, it is completely reasonable to think that some components of the index can have a positive effect on economic growth, while other components exert a rather negative effect. Second, the importance of these effects can be different between countries.

Our objective in this part is to analyze the effect of the various components of the EFI on economic growth. Thus we try to test the relation (2) described previously. The countries which are outliers were withdrawn from the sample, so the number of countries is reduced to 101 only. Then, we applied the same step as previously to detect outliers in this model. The application of the LTS method showed that Botswana is an outlier 10 . Thus, on the whole, the number of countries included in the estimation of relation ( 2) is equal to 100. The results of the estimation are given in table 2.

According to the results presented in table 2, the detection of outliers is very important. Indeed, the coefficient of SG, insignificant in the sample including Botswana, becomes significant and positive in the sample without this country. This result means that reducing the size of the government in the economy would result in a positive effect on growth. Values of the variance inflation show the absence of multicollinearity problems in our estimations.

Up to now, our results agree with those of liberal economists considering the reduction of the size of the government in the economy as a necessary and efficient mean to stimulate economic activity. But, although our study takes account of the existence of outliers, it is important to note that conclusions, up to now drawn concerning the importance of economic freedom and the role of the government, are based on a strong assumption considering that the estimated model is linear on the entire sample and that all countries obey to the same specification. Such an assumption can be checked within a Solow growth model. On the other hand, according to new economic growth theories, it is essential to test the validity of this assumption and to see whether the relation between variables can change according to the characteristics of countries [START_REF] Durlauf | Multiple regimes and cross-country growth behavior[END_REF]. 10 The residual of the estimation by LTS relating to this country is equal to 3.1764.

The detection of threshold variables

A routine practice in econometric analysis consists in testing the stability of estimated parameters on the whole of the sample or the period. However, in these practices, it is necessary to choose the threshold variable a priori. By using the GDP and the literacy rate to differentiate countries, Durlauf and Johnson, 1995 reject the assumption of a homogenous and linear specification on the entire sample. Based on this study, [START_REF] Hansen | Sample splitting and threshold estimation[END_REF] proposes a test that makes it possible to determine the variable of transition between various regimes endogenously. The test can be used both in the case of time series and cross-section data11 . Moreover, the variable for which one can test the presence of a threshold can belong to explanatory variables of the regression or to be an external variable to this regression.

The model proposed by [START_REF] Hansen | Sample splitting and threshold estimation[END_REF] can be presented as follows:

(ii) (i) ' 2 ' 1           i i i i i i i i q e x Y q e x Y
Thus it is a question of testing the assumption 2 1 0 :

  

H

where i q is the threshold variable that divides the sample into two groups; i Y is the dependent variable; i x is the independent variable; i e is the error term and  is the threshold value. Assume that

) ( i I is a dummy variable with       i i q I ) (
and that  . is an indicator function. Thus we have I = 1 if

  i q and I = 0 otherwise. If we ) ( ) (   i i i I x x 
, relations ) i ( and ) ii ( can be written as follows: [START_REF] Durlauf | Multiple regimes and cross-country growth behavior[END_REF] we focuse our attention on the initial GDP per capita and the initial schooling rate as possible threshold variables. Thus by using the Hansen test, we test the presence of a threshold on initial GDP per capita ( 72GDP ) and initial enrollment rate.

i i n i i e x x Y      ) (   where 2    and 1    n ) iii ( Like
However, as noted previously, the enrollment rate in 1972 is not available for all countries.

For this reason, we use the value of 1990 for this variable (noted 90 SCO ).

Table3 contains the results of the test using 1000 replications. This table shows that the null assumption of stability of coefficients on the entire sample is rejected for the two variables 72 GDP and 90 SCO characterized by very small p-values. So, each one of these two variables divides our sample in two different groups according to the relationship between variables. For the variable 72 GDP , the optimal threshold value is equal to 2080.46 implying that this variable divides our sample in two groups of countries according to their initial GDP per capita. The first group (noted G1) comprises 66 countries having an initial GDP lower than 2080.46 whereas the second (noted G2) comprises the 34 remaining countries. For the variable 90 SCO , the optimal threshold value is equal to 81.456 what divides our sample in two groups according to this variable. A group (noted G3) comprising 73 countries having an rate in 1990 lower than 81.456 and another group (noted G4) comprising the remaining countries 12 .

Table 4 gives the results of the estimations of relation ( 2) for the two groups G1 and G2.

These results show that our sample is characterized by two different regimes. In G1, comprising countries with an initial GDP per capita lower than 2080.46; we can see that 72

LGDP , INV and SCO are characterized by significant coefficients and with the awaited signs. In the group G2 of countries having an initial GDP higher than 2080.46, only the variable 72

LGDP is characterized by a significant coefficient and with the awaited sign. The variable SCO has a negative and significant coefficient. This result can be explained by the heterogeneity of this group and by the presence of some countries which have a high GDP per capita and a small enrollment rate like Kuwait and UEA, or by the fact that the majority of countries in this group have reached the maximum level of enrollment. About the components of economic freedom, we can notice that they do not exert the same effect in the two groups of countries. In fact, we can see that in G1 only the variables SG, LS and SM are significant. So a reduction in the size of the government, an improvement in the quality of the legal system and a consistent monetary policy exert a positive effect on 12 The appendix B presents the whole of the groups of countries determined by the test of rupture. We have tried to test the presence of a threshold of second level, but for all the groups, the assumption of homogeneity of the coefficients is accepted. P-values for the variable 72 GDP relating to the groups G1, G2, G3 and G4 are respectively 0.267, 0.527, 0.351, 0.673. For the variable 90 SCO , they are equal to 0.187, 0.565, 0.332 and 0.698, respectively. economic growth in this group. However, for G2, significant variables are SG, FT and REG. But what is interesting is that the sign of the variable SG is changed and become negative. This result means that for these countries a reduction in the size of the government results in a negative effect on economic growth.

Table 5 presents the results of the estimation of relation (2) on the groups G3 and G4.

By comparing the two groups G1 and G3 13 , we observe that, except Romania, all countries of the group G1 are also in the group G3. Table 5 shows that the variable 90 SCO divides our sample in two regimes characterizing the link between economic growth and the explanatory variables. We can note that in group G3 the variable FT has a significant and negative coefficient which implies that free trade exerts a negative effect on economic growth for countries in this group 14 . But, in the same manner like in the preceding case, we can notice that the variable SG has a significant coefficient which is positive in G3 and negative in G4.

Therefore, for countries having an enrollment rate in 1990 bigger than 81.456, a reduction in the size of the government results in a negative effect on economic growth.

V. DISCUSSION OF THE RESULTS

Our results show that the link between economic freedom and economic growth is not linear on the totality of the sample. By using threshold variables, our sample has been divided in two types of regimes characterizing the impact of economic freedom on growth. For countries with an initial GDP lower than 2080.46 and/or an enrollment rate in 1990 lower than 81.456, the reduction in the size of the government, the improvement of quality of the legal system and the effectiveness of the monetary policy are the components which exert positive effects on economic growth. For countries with an enrollment rate higher than 81.456, there is especially free trade and the absence of regulation on markets which exert positive effects on economic growth.

An important result of our work is that the reduction of the size of the government is effective only in countries with an enrollment rate in 1990 lower than 81.456. However, in the 13 See appendix B. 14 This result agrees with that of [START_REF] Carlsson | Economic freedom and growth : Decomposing the effects[END_REF] who find a negative effect of free trade on economic growth, but this result is criticized by [START_REF] Bengtsson | Trust and growth in the 1990s -A robust analysis[END_REF] other countries, reducing the size of the government would result in a negative effect on growth. This leads us to put into perspectives the assumption of the necessity to reduce the size of the government in developing countries. Our results show that the problem of these countries remains that of the effectiveness of their economic policies. They show the importance of education, the importance of an effective legal system, the necessity of a consistent monetary policy and a good operation of markets in developing countries.

No one can deny the importance and the need for democracy, of the freedom of expression and any act aiming at improving the components of a descent life in the development process. Many policies are necessary for developing countries to meet the claims of their populations. However, an abrupt disengagement of the State in these countries would be a too premature and too risky stage. Such as it is envisaged by its defenders, the concept of economic freedom does not pour in the interests of developing countries. On the contrary, it shows increasingly tended relations between the North and the South, and the number of countries which refuse this form of freedom does not cease increasing. For example, the brain drain that certain authors evoke shows well that in certain cases this freedom can lead to an impoverishment of poor countries. Nduru (2006), for example, insists on the effects of such a phenomenon on African countries. He notes the lack in medical staff in these countries and the departure of several medical professions towards developed countries. What France calls "selected immigration" proves that the relationship with the South is far from being those of mutual interests. Certain authors go further and consider that the assistances granted to poor countries were translated by many harmful effects. Rahnema (2003), for example, notes that what one continues to call assistance is only an expenditure intended to reinforce the generating structures of misery. On the other hand, the victims of the globalized world are never help and seek always to find alternatives conform to their needs.

Developing countries need a reorganization of their development policies. The liberalization of their markets requires policies that support the private sector. The solutions for the problems of unemployment, of professional insertion and of educational system effectiveness etc. are far from being spontaneous and automatic. The numerical fracture that has emerged these last years shows well that these economies are badly prepared to follow the world train of technology. The recent works on the productivity paradox and the role that must be accomplished by, at the same time, the production and the use of new communication and information technologies makes increasingly urgent the effective intervention of the State in the economy. The free trade, for example, does not make it possible to benefit automatically from technological trainings. In fact, some countries are very far from the world technological threshold and such a situation leaves them trapped in very low development levels (Stokke, 2005).

We live in a world where the speed of technological progress has attained one of its higher levels. Competitiveness of countries depends on their capacity of adaptation and continuation of progress. In such a world, the role of the State is increasingly significant.

Lonely, the market is unable to establish, in other countries, the fascination for technology characterizing the Finnish people during the nineties. The market remains, in addition, impotent and nonselective in front of the waves of the very varied and sometimes strange ideas and cultures transferred by the current world of information.

VI. CONCLUSION

Independently of development levels, economic freedom is advanced by liberal economists as a priority action for development. Using an aggregate index, some studies show a positive correlation between economic freedom and growth. Our framework shows that the use of such an index can mask the true relationship between economic growth and the components of this index. Thus, our results show that the importance of the various components varies according to the development level of countries. In fact, our empirical study detects the presence of thresholds relating to the variables initial GDP per capita and initial enrollment rate in secondary school. So it rejects the assumption of a linear relation between economic growth and the explanatory variables. In addition, we show that reducing the size of the government is not always effective. Indeed, the coefficient attached to this variable is positive and significant in the whole of countries having an initial GDP and an enrollment rate that are relatively small, but this coefficient is negative and significant for the other countries. These results enable us to conclude that the positive effect of economic freedom proved by the majority of empirical studies on economic growth does not imply necessarily the need for a total disengagement of the government in the economy.

Such it is defined by its inventors; economic freedom neglects the specificity of developing countries and considers that liberalism would unconditionally offer to these countries the same opportunities as those of developed countries. In rich countries, the effective policies have been a prerequisite for a progressive liberalization of their economies.

In developing countries, to be entitled to an effective intervention of the government should constitute the first component of economic freedom.

Tables

Table1 -Estimation results for the aggregate index (regression (1))

Estimated

Table2 -Estimation results for the decomposed index (regression (2))

Estimated

significantly different from zero at 1% significance level, ** significantly different from zero at 5% significance level The values in parentheses represent the standard errors corrected of heteroscedasticity by White, 1980 method.

			by OLS	Estimated by FWLS
	Constant	7.88179 *	(1.51475)	6.9324 *	(1.2111)
	72 LGDP	-1.48352 *	(0.28423)	-1.1728 * (0.2244)
	INV	0.067114 *	(0.02002)	0.0613 *	(0.0163)
	SCO	0.02896 *	(0.00733)	0.0227 *	(0.0060)
	EFI	0.88493 *	(0.16928)	0.7593 *	(0.1454)
	R	2		0.52		0.48
	Number of observations 104

*

significantly different from zero at 1% significance level, ** significantly different from zero at 5% significance level The values in parentheses represent the standard errors corrected of heteroscedasticity by the White method. The values between hooks represent the variance inflation.

			by OLS	Estimated by FWLS
	Constant	7.00534 *	(1.23520)	6.5642 *	(1.1661)
	72 LGDP	-1.18053 * (0.23668) [4.43256] -1.0701 *	(0.2176) [4.56583]
	INV	0.07156 *	(0.01929) [2.53923] 0.0653 *	(0.0186) [2.56553]
	SCO	0.02287 *	(0.00708) [5.29028] 0.0230 *	(0.0070) [5.28890]
	SG	0.18230	(0.11007) [1.91049] 0.2255 **	(0.1028) [1.94844]
	LS	0.20111	(0.13312) [4.55584] 0.2001	(0.1298) [4.54561]
	SM	0.18589 ** (0.07653) [2.07468] 0.1992 **	(0.0760) [2.08400]
	FT	-0.08469	(0.12724) [3.14750] -0.1061	(0.1282) [3.14207]
	REG	0.26107	(0.18051) [2.85484] 0.1773	(0.1698) [2.94086]
	R	2		0.49		0.49
	Number of observations 101

*

Table 3 : Test of rupture for the relation (2)

 3 Value of the LM test Bootstrap P-value

	72 GDP	33.352457	0.000
	90 SCO	30.717982	0.000

Estimation results for the decomposed index for the groups G1 and G2

			Group G1 (	72 GDP 2080.46)	Group G2 (	72 GDP > 2080.46)
	Constant	4.905408 *		(1.280899)	19.268150 *	(1.526964)
	72 LGDP	-1.256161 *	(0.266056)	-2.173485 *	(0.192461)
	INV	0.075858 *		(0.023933)	0.025665	(0.016154)
	SCO	0.034603 *		(0.007975)	-0.014443 **	(0.005601)
	SG	0.301022 **	(0.124136)	-0.211079 **	(0.070851)
	LS	0.736462 *		(0.129282)	0.004389	(0.142678)
	SM	0.252999 *		(0.074059) 0.122379	(0.101573)
	FT	-0.284675	(0.159627)	0.282353 **	(0.077299)
	REG	0.197125	(0.166293)	0.555123 *	(0.122099)
	R	2		0.64		0.83
	Number of observations		66		34

* significantly

different from zero at 1% significance level, ** significantly different from zero at 5% significance level. The values in parentheses represent the standard errors corrected of heteroscedasticity by the White method. Table5 -Estimation results for the decomposed index for the groups G3 and G4

			Group G3 (	90 SCO		81.456)	Group G4 (	90 SCO > 81.456)
	Constant	4.696338 * (1.047296)	21.480645 * (3.376891)
	72 LGDP	-1.048613 * (0.207635)	-2.516273 * (0.417978)
	INV	0.059790 ** (0.021825)	0.049544 ** (0.020619)
	SCO	0.028784 * (0.006998)	-0.017096 ** (0.008091)
	SG	0.235108 ** (0.104452)	-0.228158 ** (0.078815)
	LS	0.555754 * (0.119825)	-0.105620	(0.213680)
	SM	0.280231 * (0.073556)	0.080382	(0.114586)
	FT	-0.297426 ** (0.136664)	0.328616 ** (0.166305)
	REG	0.265341	(0.173378)	0.765233 *	(0.229881)
	R	2		0.66			0.77
	Number of observations		73			27

* significantly

different from zero at 1% significance level, ** significantly different from zero at 5% significance level. The values in parentheses represent the standard errors corrected of heteroscedasticity by the White method.

[START_REF] Levine | A sensitivity analysis of cross-country growth regressions[END_REF] use the EBA (Extreme Bounds Analysis) method, due to[START_REF] Leamer | Sensitivity analyses would help[END_REF] which consists in studying the sensitivity of the coefficients of studied variables to modifications in the specification of the estimated model.

Indeed, using a more flexible version of the EBA, the author notes (p.182): « My claim in this paper is that, if one is interested in knowing the coefficient of a particular variable in a growth regression, the picture emerging from the empirical growth literature is not the pessimistic « nothing is robust » obtained with the extreme bound analysis. Instead, a substantial number of variables can be found to be strongly related to growth. »

http://pwt.econ.upenn.edu/

The data are downloadable at http://www.freetheworld.org/download.html.

The list of countries is given in appendix A.

Compared to other standard procedures (as the Mahalanobis distance, for example), this method has the capacity to treat models with more than one explanatory variable. In the same way, this method can detect the aberrant values at the same time in the explained variables and the explanatory variables[START_REF] Rousseeuw | Least median of squares regression[END_REF][START_REF] Rousseeuw | Unmasking multivariate outliers and leverage points[END_REF].

The residuals relating to these countries are 3.8677 for China, -3.2846 for the Democratic Republic of Congo and -3.2519 for Zambia. In our case, the LTS method consists in minimizing the sum of the 79 smallest residuals. For more details on the method, see[START_REF] Rousseeuw | Least median of squares regression[END_REF][START_REF] Rousseeuw | Unmasking multivariate outliers and leverage points[END_REF] Bengtsson and[START_REF] Sturm | Determinants of long-term growth : new results applying robust estimation and extreme bounds[END_REF][START_REF] Sturm | Determinants of long-term growth : new results applying robust estimation and extreme bounds[END_REF]

For an application of this test to time series, see for example BenSalem and Perraudin, 2001 and[START_REF] Chen | Government size and economic growth in Taiwan: A threshold regression approach[END_REF][START_REF] Chen | Government size and economic growth in Taiwan: A threshold regression approach[END_REF]

List of countries of the initial sample

Algeria