The Formula for Freedom and Prosperity

It appears that economic freedom, which many regard as something intangible and indefinite, can be measured. Economic freedom has fairly clear manifestations and, according to Fraser Institute, Canada, which has announced Economic Freedom of the World 1997, can be expressed in numbers. The report is valuable in three respects. To begin with, it reveals a robust link between a country’s economic freedom and prosperity. Second, not only does the report measure economic freedom, but it also prompts paths to it. Finally, the study confirms an intuition we in the Baltics have had in the past few years, an intuition that Baltic economies are freer than those of other post-socialist countries. Estonia and Lithuania have outstripped such generally recognised reform leaders as the Czech Republic, Hungary, and Poland.
Freedom and Prosperity Go Hand in Hand
In weighing up reform options, some observe that economic freedom is an unfathomable, theoretical concept which does not necessarily bring practical benefits. It is not necessarily free markets, they argue, that lead to growth and prosperity. Active state involvement, prudent regulation and circumspect protectionism can provide an alternative path to well-being, they say. The report developed by Fraser Institute uncovers a strong connection between a nation’s freedom and wealth.
Unlike other ratings, an economic freedom index does not aim to assess a country’s economic growth or “openness” to foreign investment or capacity to repay creditors. The purpose of a freedom index is to measure freedom. To that end, the index under discussion utilises four central elements of freedom. These are the credibility of money as a store of value and medium of exchange, freedom to make economic choices such as what to produce and what to consume, freedom to keep the wealth produced, and freedom to foster economic relationships the world over. The four elements fall into seventeen components and their scores serve to derive summary ratings and thus the level of economic freedom.
Although the report disregards such indicators as GDP growth, the level of income, etc., it reveals a striking correlation between economic freedom and economic and income growth. The more freedom a country enjoys, the faster the growth of GNP and per-capita income. The countries graded are classified into five groups according to the degree of freedom. It appears that the average per-capita income is the highest-$14,829-in the highest rated countries. In the second highest ranking group it is $12,369, as compared to $6,385 in the third group, $3,057 in the fourth, and a mere $2,541 in the least free countries (1995 data).
GNP growth is also directly related to the level of freedom. In the top freest countries it averaged, in 1985 through 1995, 2.9%, as compared to 1.8%, 1.1% and 0.1% in the second, third and fourth groups. The growth of national product in the least free countries was negative, -1.9%.
The above data give much food for thought for both the public and policy makers. The data help the public discern which of the promises articulated by politicians strike the right note and may bring Lithuania closer to rapidly developing and prospering countries. They also assist policy makers in identifying reform options that will lead to prosperity not in word but in deed. The findings dispel the myths about “the Swedish model” or “the German model” and about the popular appeal of copying individual countries.
It should be borne in mind that, while there are as many models as there are countries and as many combinations of freedom and lack thereof as models, a correlation is only one. This is a simple and obvious link between freedom and prosperity. The more freedom, the more wealth. There are as many examples-good and bad-as there are countries. Those anxious to justify reform options by pointing to international experience (the favourite argument in Lithuania!) should eventually scrap the whole idea. One will always find a country that was first to liberate a certain area from state control and a country that was first to curb freedom in another. One need not know all combinations. Being aware of regularities is what really matters.
The Parameters of Freedom
Hong Kong-the country that was given the highest ratings for all “measurable” dimensions of economic freedom-ranks the freest country in the world. The colonial Hong Kong was in the lead in terms of economic liberation for the past few decades. The freedom has surpassed, over the full measure, the expectations of people who chose to rely on it. Per-capita income, which equalled $2,247 in 1960, peaked at $27,202 in 1996, beating the long unrivalled record of the US! Ever since that time the average per-capita income has been higher than in any other country of the world. In addition to that, people in Hong Kong retain a total of 82% of income generated, with the state redistributing a mere 18% of GDP. The rating of Hong Kong is somewhat tarnished by inflation, whose annual level is six to nine percent. Yet, in the strict sense of monetary “freedom”, Hong Kong is outperforming the countries with traditional central banks through a consistent conformity to a currency board model.
Hong Kong has a one point lead over Singapore. Public spending in Singapore has been steadily decreasing, reaching the level of 14% of GDP in 1996. In the past twenty years taxes have dropped almost by half. The currency is stable and freely convertible. Not surprisingly, per-capita income equalled $23,342 in 1996, falling behind only some of the “First World” countries. Hong Kong and Singapore are not the only leaders though. New Zealand, which as recently as a decade ago ranked sixtieth out of 107 countries covered by the report, appears today among the highest rated countries. This country presents an example of a masterly and innovative implementation of free market solutions in all economic policy areas.
Due to the liberalisation of the Asian countries, the United States has been forced to descend “the freedom pedestal”, dropping from the first to the fourth place. Moreover, the US is very likely to concede it in the near future to such “rising stars” as Malaysia, Tailed or Mauritius. This has already occurred to Canada, Holland, Germany, and other European countries. The position of these countries is somewhat retrieved by the stability of their currencies, but in terms of other dimensions-such as redistribution, taxes or government regulation-they are lagging behind the new leaders committed to radical reforms and rapidly boosting their competitiveness.
In the countries labelled as “Asian tigers” unemployment is virtually non-existent and the average income level is approaching, or in some cases even surpassing, those of industrial countries. Therefore, talks about widespread exploitation of “cheap labour force”-a factor that has ostensibly ensured the competitiveness of the “tigers”-is but a myth. Economic freedom is beneficial to all, for it provides the best opportunities for all people to work and to earn.
A Leap of “Baltic Tigers” in Europe
How come the Baltic states-first of all, Estonia and Lithuania-have finally lived up to the “tigers'” image, outshining such reform authorities as the Czech Republic or Poland? The reasons for their success, according to the authors of the report, are manifold. They attribute it, among other things, to the fact that the Baltics are friendly to foreign capital and allow unrestricted investment of home-grown capital abroad. All of the three nations have freely convertible currencies, which safeguards the most important of freedoms, especially for a small economy. A number of countries in Central and Eastern Europe continue to be plagued by directive exchange rates, which prevent them from removing exchange restrictions, inviting black market activity.
As compared to other post-socialist, and even West European, countries, the Baltics have relatively low marginal tax rates. It should be noted though that these levels exclude social security contributions and therefore fail to reflect the actual marginal tax burden. The levels of redistribution and subsidising are also relatively modest.
Lithuania and other Baltic countries recorded somewhat lower scores because of the methodology of assessing currency credibility. The report takes into account the inflation record during the past five years, making the countries that have achieved sound money fall back down the scale. On the other hand, it is obvious that rejecting harmful practices requires a lot of time, so following the line of reasoning of the report’s authors, it will not be until 1998 that the Baltics will do away with the most dreadful legacy of inflationary policies-a quick-fix attitude to problem solving.
Given Lithuanian decision-makers’ shilly-shallying between inflationary and anti-inflationary policies, the year 1998 will be decisive. Those of the Baltic states that will show commitment to stable monetary systems will be well equipped to make a ten-spot leap up the freedom scale, roughly up to Portugal’s or Austria’s level.
Commitment to steady privatisation will further enhance these prospects. If you look at the 1995 data, you will get an impression that the Lithuanian economy is dominated by state-owned enterprises. It seems to us though that the expansion of the private sector has been truly demonstrable. Close scrutiny of the methodology employed reveals that economies with more than 30% of GNP (excluding agriculture) being created by state enterprises receive the lowest ratings. It is a hardly disputable, albeit harsh, judgement. The control of 30% of an economy by state-operated entities inevitably cripples the workings of the market due to the public sector’s inefficiency and misleading signals.
For Lithuania there is much room for improvement as far as this freedom parameter is concerned. The ratings of ten, eight and even six set very explicit tasks for Lithuanian authorities, which are committed to steady, large-scale privatisation.
Lithuanian price controls, primarily in the energy sector, other state monopoly areas and agriculture, present another handicap. Whilst there is a ray of hope that monopoly price controls will be solved through privatisation, agricultural price controls are likely to be conserved for many years to come. The socialist bill in agriculture-both direct and indirect-will once again have to be paid by society.
Lithuania has the edge over other countries in transition by allowing its citizens to maintain bank accounts abroad and to own foreign currency bank accounts domestically. Restraints on international trade appear to be relatively low due to the peculiarities of the methodology employed. The report does not measure import/export duties but looks at their yield relative to the overall volume of international trade. All of the Baltic states received a high rating of nine. Bearing in mind the credibility of official statistics and people’s legendary abilities to benefit by “dodging” customs duties, we can frame a paradoxical hypothesis that Lithuania scored well, not because of favourable trade policies, but thanks to people’s relentless entrepreneurship, which, strange as it may seem, is only bolstered by custom duties.
The use of exchange restrictions, licences, and quotas can also be a drag on free trade. For this reason the report measures another interesting freedom parameter-economic “openness”. First, it estimates an expected size of the trade sector as a share of GDP on the basis of a country’s location, population, access to sea, and closeness of trading partners. Then it calculates import/export as a share of GDP and compares the figure with the projected indicator.
The expected size of the Lithuanian trade sector is 43.9% and the actual size is 63.1% (a score of 9). In Estonia the figures are 52.1% and 87% (a score of 10) and in Latvia they are 46.1% and 60.5% (a score of 7) respectively. The smaller the country, the larger the volume of free international trade, and vice versa, the larger the country, the more trade takes place domestically. In the US, for instance, the expected size of the trade sector is a mere 13.9%, and the actual size is still lower, 11.8%. Singapore (64.4% and 166%) and Hong Kong are unquestionable leaders in this respect.
Unlike other indices, the report in question discloses another significant correlation-the more economic freedom a country enjoys, the less corruption and tax evasion plagues it. The lowest level of tax evasion has been recorded in Singapore, New Zealand and Hong Kong (according to Davos World Economic Forum). Economic freedom translates into government non-involvement, therefore the freest countries are successfully removing the roots of corruption, while the countries that impose wide-ranging regulations are forced to combat corruption by resorting to perfunctory measures.
In the freest countries transparent and simple tax systems coupled with low government consumption expenditure discourage tax evasion, while in the lowest rated countries any measures undertaken to dishearten tax evasion fail to live up to expectations. They only reduce it to persistent, morbid forms.
In summary, the report indicates what criteria are needed to receive the highest ratings of economic freedom. The report makes it explicit that the degree of economic freedom determines the rate of economic growth and the level of incomes. It is also clear that GDP can increase by seven or eight percent each year and people’s incomes can double or triple over a several-year period. Countries that are game for rapid transformations are heading towards freedom and prosperity. They are playing a clear game with clear rules. Being a leader is more fun than being an outsider.