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Note: this article is an excerpt from a full report published on Medium, visible here. If you like this article, or to understand the context of the model, I suggest consulting the complete text!
Incentives are the primordial determinant in nearly every metric essential to the performance of economic systems. Free market systems are defined by the invisible hand theorem and the incentive of self-interest. Command systems, on the other hand, attempt to incentivize action and innovation based upon social prestige and moral requisites. Across this spectrum, government and government regulation form the basis of country-wide incentive systems.
The regulatory quality variable indexes the ability of a given government to formulate and implement the policies and regulations that promote private sector development. Regulatory quality was shown to strongly infer a similar degree of economic complexity and economic freedom. This alludes to regulatory quality as heralding a central position in the index; this is most clear in its .84 correlation with the raw index, versus .35 for growth and .48 for equity. The question must then come to the question of whether regulatory quality creates a better overall system, or whether a better overall system brings about better regulatory quality.
I will make the case for the former. Regulatory decisions exist within a vast spectrum. These decisions can especially vary in authoritarian countries, whereas the decision-making process is private and discretionary, but even in democracies: just think of the United States, where the president may sign impactful executive orders nearly at his sole discretion (incentive to stay in office aside). So, it must be assumed that any number of improbable events can happen as a result of regulatory power being in the hands of a relatively small group of leaders. For this reason, testing the impact of regulatory quality should be fairly easy — one must only look at history.
The same cannot be said as to the question of whether a better overall system brings about strong regulatory quality. To reach a strong score on the raw index, a country must have a variety of strong systems in place. The input required to create these systems is extremely limited and quite standardized across…
