The benefits of economic freedom: a survey.

• Author: Berggren, Niclas

The absence of economic growth implies the continued existence of poverty and hardship. The International Monetary Fund (IMF 2001) and others now perceive the prospects for global economic growth to be relatively weak.

Neoclassical economic theory explains economic growth as a function of changes in four factors--capital, labor, human capital, and technology (Romer 1990)--but the question remains: Which economic policies are most favorable to growth? A new line of research on economic freedom answers as Adam Smith did long ago. "Economic freedom" means the degree to which a market economy is in place, where the central components are voluntary exchange, free competition, and protection of persons and property (Gwartney and Lawson 2002, 5). The goal is to characterize the institutional structure and central parts of economic policy.

Economic freedom may constitute an explanatory factor for growth and the distribution of income. In econometric analysis, economic freedom is thus an independent variable. However, economic freedom may also be affected by other variables and thereby constitute a dependent variable, possibly influenced by factors such as political freedom, wealth, or democracy. (1)

The most ambitious attempt to quantify economic freedom is the Economic Freedom Index (EFI) reported annually in Economic Freedom of the World (Gwartney and Lawson 2002). (2) Since 1996, data updated yearly have been published, and the data now cover the years 1970, 1975, 1980, 1985, 1990, 1995, and 2000. These data have begun to be used in scholarly research, which has contributed to increasing our knowledge of the importance of economic freedom.

Another such index is published by the Heritage Foundation in cooperation with the Wall Street Journal (O'Driscoll, Holmes, and O'Grady 2002). (3) This index and the EFI are similar in their overall implications, but because the EFI has been used more extensively in academic contexts (in part because the other index goes back only to 1995 and uses more subjective variables), (4) it is the focus of this article, which surveys the recent literature in the field.

The Concept of Economic Freedom

Economic freedom is a composite that attempts to characterize the degree to which an economy is a market economy--that is, the degree to which it entails the possibility of entering into voluntary contracts within the framework of a stable and predictable rule of law that upholds contracts and protects private property, with a limited degree of interventionism in the form of government ownership, regulations, and taxes. (5) Economic freedom is distinct from political freedom (participation in the political process on equal conditions, actual competition for political power, and free and fair elections) and from civil freedom (protection against unreasonable visitations, access to fair trials, freedom of assembly, freedom of religion, and freedom of speech).

The EFI is a means of measuring the degree of economic freedom by including thirty-seven components divided into five groups in an index for the years 1970 (54 countries), 1975 (83 countries), 1980 (105 countries), 1985 (111 countries), 1990 (113 countries), 1995 (123 countries), and 2000 (123 countries). The five groups are (1) size of government: expenditures, taxes, and enterprises; (2) legal structure and security of property rights; (3) access to sound money; (4) freedom to exchange with foreigners; and (5) regulation of credit, labor, and business. (6) Each component is measured from 0 ("no economic freedom") to 10 ("full economic freedom"). The index is calculated using arithmetic averages. It should be noted that the components of the EFI, as well as weighting schemes, have changed in the various editions that have been published. Hence, when comparing studies, one needs to be careful to clarify which editions one uses.

Table 1 presents the EFI values in 2000 for a number of countries, as well as the percentage change of the index since 1970. In absolute numbers, two small Asian countries along with the United States and the United Kingdom rank at the top. At the bottom, one finds the Democratic Republic of Congo; many other African nations rank low as well. In relative change, of the countries listed here the United Kingdom and Sweden stand at the top, whereas the countries with low initial scores have declined in economic freedom. More detailed data for the United States are presented in table 2. The U.S. scores are high across the board. Improvements have been made in all areas during the period studied, especially with regard to the size of government. The index enables researchers to carry out statistical analyses of the importance of economic freedom. Examining the construction of the index, one finds that it builds in large part on data published in secondary sources, which therefore can easily be verified. Furthermore, it is easy to assign new weights to the components of the index should one so desire.

As with respect to any composite index, however, one may wonder what is really measured when a great number of separate variables are combined. Different variables in an index surely have different effects on certain dependent variables. Another serious concern is the selection of variables for the index. Some might be regarded as doubtful, and some missing variables might be important. Again, however, one can recalculate and reweight to one's choosing. Also, one can incorporate additional variables. Yet another problem is that some variables of the EFI build on survey data, which can be uncertain and arbitrary. This quality is not necessarily a reason to exclude them because they may be better than no data at all. In the final section, I note some of the avenues for further research that these and related questions suggest might be worthwhile.

The Importance of Economic Freedom

Economic Growth

That economic freedom is an important factor accounting for economic growth is probable on purely theoretical grounds. The incentives that economic actors (entrepreneurs, innovators, financiers, industrialists, and others) face are determined in large part by the institutions in place, which, as Douglass C. North (1990) points out, can be inefficient or efficient. To the extent that the institutions stimulate actions that contribute to the production of more valuable output, they contribute to economic growth. (7) Institutions that guarantee economic freedom plausibly have the capacity to provide the growth-enhancing kind of incentives, for several reasons: they promote a high return on productive efforts through low taxation, an independent legal system, and the protection of private property; they enable talent to be allocated to where it generates the highest value (as argued in Murphy, Schleifer, and Vishny 1991); they foster a dynamic, experimentally organized economy in which a large amount of business trial and error can take place (Johansson 2001, chap. 2) and in which competition between different actors occurs because regulations and government enterprises are few; they facilitate predictable and rational decision making through a low and stable inflation rate; and they promote the flow of trade and capital investment to where preference satisfaction and returns are the highest.

Although certain types of institutional change can be expected to have distinctly positive growth effects by introducing the kind of incentives just mentioned, institutions per se, in place over time, can exert an influence not only on the level of wealth but also on growth rates, all else being equal. In any given period, established institutions set the economic incentives and influence what economic actors do. Very high and stable economic freedom, we presume, allows a dynamic economy to function and grow, even though an increase in economic freedom from a low level might exert a much more distinct influence on the growth rate for a certain period. Furthermore, sustained high growth rates imply ultimately great wealth, and so in the long term the economic freedom that increases growth can also be expected to increase accumulated wealth.

If we have theoretical reasons to expect a positive relationship between economic freedom and economic growth, does empirical evidence confirm this effect? Jagdish Bhagwati thinks it does:

it is not difficult to assert that economic freedom is likely to have a favorable effect on economic prosperity, for the simple reason that the last fifty years of international experience more or less confirms the fact that wherever governments used markets more and engaged in more open policies in foreign trade and investment, indeed in more economic freedom of different kinds, their countries have tended to prosper. By contrast, those countries that turned inward and had extensive regulations of all kinds on domestic economic decision-making in production, investment and innovation, are the countries that have really not done too well. (1994, 4) (8) A simple mapping by Gwartney and Lawson (2002) to a large extent supports this position, as is clear from figure 1. (9) As the figure shows, the one-fifth of countries that have had the highest economic freedom have grown considerably faster than other countries, whereas the one-fifth of countries with the lowest economic freedom bare, in fact, had negative growth. A number of econometric studies corroborate this conclusion, with varying strengths and in different forms. The results should be interpreted with the usual care.

Gwartney, Lawson, and Holcombe (1999), like de Haan and Sturm (2000, 2001) and Adkins, Moomaw, and Savvides (2002), find that the level of economic freedom at the beginning of the growth period studied does not contribute significantly to explaining growth, but that positive changes in economic freedom do so. The latter result is also obtained by Dawson (1998), Pitlik (2002), and Weede and Kampf (2002). Others, however, have found that the...