Institutions, economic freedom, and cross-country differences in performance.

• Author: Gwartney, James
• Position: 2008 Presidential Address - Column

1. Introduction

   I have spent most of my research time during the past two decades working on the Economic Freedom of the World (EFW) project. The purpose of this project was straightforward: the development of a comprehensive measure that would reflect the consistency of the institutions and policies of a large set of countries with economic freedom. In this article, I will briefly review the history of this project, outline the measure, and consider 10 things we have learned as the result of this tool and the research that has utilized it.

2. History of the EFW Project

   The project was the result of a series of six Liberty Fund conferences during the 1986-1994 time period that were hosted by Michael Walker, the president of the Canadian Fraser Institute, and Milton and Rose Friedman. After participating in a 1984 Mont Pelerin Society (MPS) session on George Orwell's Classic novel 1984, Walker was convinced that it was important to differentiate between economic freedom and other factors such as political freedom, democracy, and civil liberties. In Walker's judgment, failure to correctly differentiate among these terms was a source of confusion that needed to be corrected. Over lunch following the MPS session, Walker convinced Milton and Rose Friedman to join him in hosting a series of conferences designed to clearly define and measure economic freedom. Neil McLeod, who was the president of the Liberty Fund Foundation at that time, was at the same luncheon table, and he agreed to arrange for the necessary financing.

   The participation of the Friedmans in this project was of crucial importance. This made it possible for the small Liberty Fund conferences, typically involving about 15 participants, to attract some of the world's best minds, including Gary Becket, Peter Bauer, Douglass North, William Niskanen, Alvin Rabushka, and Gordon Tullock, in addition to the Friedmans. I remember reading a letter in 1989 inviting me to this conference that would focus on how to measure economic freedom. My initial reaction was that this was a hair-brained idea. How could anyone measure something as complex and multidimensional as economic freedom? But then I noted the invitation was from Milton Friedman, so I immediately fired back my acceptance. Obviously, the measurement of economic freedom was, and continues to be, a complex task, but there are historic parallels. In the 1920s, the architects of national income accounting faced a similar problem. National income was also highly complex and multidimensional. The initial measurement efforts were imperfect, and debate continues with regard to precisely how various items should be handled.

   Measuring instruments are designed to help us better understand the real world. As Lord Kelvin stated 125 years ago:

   In physical science the first essential step in the direction of learning any subject is to find principles of numerical reckoning and practical methods for measuring some quality connected with it. I often say that when you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot measure it, when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind; it may be the beginning of knowledge, but you have scarcely in your thoughts advanced to the state of Science, whatever the matter may be. (Physics Letters A, vol. 1, "Electrical Units of Measurement," 1883-05-03) Reflecting the views of its founder, Michael Walker, the Fraser Institute's motto was, "If it matters, measure it." This motto was an underlying inspiration for the development of the EFW measure.

   From the very beginning, transparency and objectivity were central elements of the EFW project. Milton Friedman constantly reminded participants that we were developing a scientific instrument. It was vitally important that the derivation of each component was carefully specified, and the methods used to assign component values for each country clearly outlined. This means that the measure can be duplicated by others and, given the specifications of the index, it will not make any difference whether the data are assembled and the index derived by a libertarian or a socialist. Of course, the libertarian and socialist are likely to disagree about whether the high or low ratings are most desirable, but the calculation of the index should not be influenced by their very different subjective views.

   All of the data incorporated into the EFW index are from external sources such as the Worm Development Indicators, the Doing Business rankings, and The Global Competitiveness Report. Thus, we are merely secondhand dealers. We simply transform the foundational data for each of the components to a 0-10 scale and combine them in a sensible manner to derive both area and summary ratings for each of the 141 countries now included in the index.

3. Overview of the EFW Index

   The EFW index is designed to measure the consistency of a nation's institutions and policies with economic freedom. Conceptually, economic freedom is present when economic activity is coordinated by personal choice, voluntary exchange, open markets, and clearly defined and enforced property rights. The EFW measure might be thought of as an effort to identify how closely the institutions and policies of a country correspond with a limited government ideal, where the government protects property rights and arranges for the provision of a limited set of "public goods," such as national defense and access to money of sound value, but little beyond these core functions. To a large degree, a country's EFW summary rating is a measure of how closely its institutions and policies compare with the idealized structure implied by standard textbook analysis of microeconomics.

   Currently, the index incorporates 42 different variables that are organized into five areas: (1) size of government; (2) legal structure and protection of property rights; (3) access to sound money; (4) international exchange; and (5) regulation of capital, labor, and business. The components in areas 1, 3, and 4 are objective measures such as government consumption as a share of total consumption, standard deviation of the inflation rate, mean tariff rate, and revenues from trade taxes as a share of the trade sector. The structure of the components in these three areas has changed only slightly over time, and the data for the variables are generally quite complete back to 1980.

   Variations in institutions and policies are much more difficult to measure in legal structure and regulation (areas 2 and 5). As a result, the components in these two areas rely heavily on survey data, expert evaluations, and generic case studies undertaken by the World Bank's Doing Business project.

   The EFW measure is available at five-year intervals during the time period 1970-1995 and annually since 2000. These data are continuously available for approximately 100 countries since 1980. Missing data and structural changes reduce the comparability across time periods. However, a chain-link measure has been developed for both area and summary ratings in order to minimize this problem and increase the reliability of the ratings across time. The data are updated each year, and the annual Economic Freedom of the Worm report is now co-published by a network of institutes in 75 countries.

   As with any multidimensional measure, there is an issue with regard to how the various components should be aggregated. Theory provides direction regarding elements that should be included in the five areas and the summary index, but it does not indicate how the various components should be weighted when deriving area or summary ratings. It would be nice if the components of economic freedom were independent of each other and a statistical tool such as regression analysis could be used to derive an appropriate weight for each component. However, the components are often interrelated, and even if they were independent, the number of observations would limit the use of statistical techniques to derive weights.

   Even more important, there is reason to believe that the components of economic freedom work together like a team. Put another way, they may be linked like the wheels, motor, transmission, driveshaft, and frame of a car. Which of these components is most important for the operation of the car? The question cannot be easily answered because all of the parts work together. If any of these key parts break down, the car is immobile. Institutional quality may be much the same. If any of the key parts are absent, the overall effectiveness is undermined. Just as there is a bundle of interrelated parts underlying the operation of an automobile, there is reason to believe that there is a bundle of interrelated components underlying the operation of economic freedom.

   As the result of these two considerations, we organize the elements of the index in a manner that seems sensible to us, but we make no attempt to weight the components in any special way when deriving either area or summary ratings. Of course, the component and area ratings are available to researchers, and if they believe that an alternative weighting procedure is more appropriate for their purposes, we encourage them to employ it. Over the past several years, we have investigated several alternative methods of weighting components, including principle component analysis and a survey of economists. In most cases, the summary index is not very sensitive to substantial variations in the weights. Thus, while this issue is an interesting one, variations in component weights exert only a small impact on the pattern of the area and summary ratings.

4. Growth Theories and the EFW Measure

   During the past two decades, there has been a surge of interest concerning the importance of institutions as a source of economic growth. Building on the work of the 1993 Nobel laureate Douglass North, new institutional...