The Road to Prosperity

Why do some countries prosper while others do not? This is the question that The Fraser Institute’s “Economic Freedom of the World. 2000 Annual Report” tries to answer. The index was compiled by independent institutes from 53 countries, including the Lithuanian Free Market Institute, under the leadership of Canada’s Fraser Institute and Nobel Laureate in Economics, Milton Friedman. The main finding of the index is that countries with the most economic freedom perform better in terms of growth and prosperity than those with less economic freedom.
Measuring Freedom
One may wonder whether it is really possible to measure economic freedom. As the prominent American economists Steve Hanke and Stephen Walters noted in their paper “Economic Freedom, Prosperity, and Equality: A Survey,” economic liberty, unlike a country’s Gross Domestic Product or a candidate’s votes totals, cannot simply be counted. Indeed, freedom is a quality rather than a quantity, therefore a certain amount of subjectivity and imprecision is inevitable in any attempts to measure economic freedom.
Seeking to determine the level of economic freedom in acountry, it is necessary to answer a range of questions: what economic liberty is; what its crucial elements are; how to quantify these elements; and how to attach weights to these factors in deriving category ratings. It should be noted that many important components of economic freedom might not be readily discernible or quantifiable. Also, attaching weights to each element involves some degree of subjectivity and may bring distortion into the final ratings.
Before discussing the elements of economic freedom, it is important to distinguish economic liberty from political or civil liberty. Political liberty means that citizens are free to participate in the political process under equal conditions, that there is meaningful competition in the political arena, and that elections are free and fair. Civil liberty is present when citizens have access to fair trials and rights to free assembly, convictions, expression, and practice of religion. While such political and civil liberties may go hand in hand with economic freedom, it should be recognised that a country may be “free” or “democratic” in a civil or political sense, but lack economic freedom, and vice versa. In evaluating economic growth and well-being, the focus is on economic freedom not because other liberties are inessential, but simply because there is no conclusive evidence that they are preconditions for economic growth.*
So far, no single definition of economic freedom has been devised; however, there is wide agreement on its key elements: secure property rights, freedom to engage in voluntary transactions, domestically and internationally; freedom from governmental control of transactions between individuals; freedom from governmental expropriation of property by confiscatory taxation or unanticipated inflation.*
The seven major categories of variables included in The Fraser Institute’ index are: (1) size of government (general government consumption expenditures as a percent of total consumption and transfers and subsidies as a percent of GDP); (2) the structure of the economy and use of markets (government enterprises and investment as a share of the economy, price controls, top marginal tax rate, conscription); (3) monetary policy and price stability; (4) freedom to use alternative currencies (freedom to own foreign currency bank accounts domestically and abroad, difference between the official exchange rate and the black market rate); (5) legal structure and security of private ownership; (6) freedom of trade with foreigners (tariffs and non-tariff regulatory trade barriers); and (7) freedom of exchange in capital and financial markets.
Data on twenty-three variables was gathered from 123 countries in the most recent year. These variables attempt to quantify the restrictions on economic freedom imposed by governments in a variety of areas. A score from 0 to 10 (0 being least free, 10 representing freest) was assigned for each variable for each country. Principal component analysis (an advanced statistical technique) was used to attach weights to the component data which was ultimately combined to create a summary rating.
Freedom leaders and outsiders
It is delightful that over the past year more countries have expanded economic freedom than restricted it. However, countries that curtail economic liberties still outnumber those in which economic freedom is expanding.
As the survey results show, Hong Kong remains the freest economy in the world. Despite the resumption of sovereignty over Hong Kong by China on July 1, 1997, the region continues to enjoy free trade, strong protection of property rights and a top marginal income tax rate of 17 percent. True, the Asian financial crisis has taken its toll on Hong Kong: In 1998 gross domestic product shrank by 3 percent, the rate of unemployment rose from 3 to 6 percent, and property values decreased by one-third. The economic downfall forced the government to resort to interventionist measures. The two most controversial moves were the suspensions of public land sales for a year and the purchase of more than HK$100 billion worth of shares of Hong Kong blue chip companies.
According to the report, Hong Kong shares the top position with Singapore as the freest jurisdictions in the world. Although both countries have the same rating of 9.4, there are marked differences in two areas. Hong Kong’s government consumption constitutes 12.4 percent of total consumption, while in Singapore it amounts to 18.8 percent. However, Hong Kong scored much lower in evaluating risk of contract repudiation by the government, rule of law, and the judiciary.
Hong Kong and Singapore are followed by New Zealand, the United States, and the United Kingdom. In recent years, no other country has moved to the top ranks of the index as rapidly as New Zealand, which as recently as 1985 ranked 32nd. This country has created a well-functioning legal system with secure property rights and reduced government transfers and subsidies from 27.5 percent in 1990 to 12.4 percent in 1997. Consistent privatisation coupled with extensive business liberalisation have been the key to New Zealand’s outstanding success. The United States has maintained its remarkably stable economic freedom rating over the last three decades; however, the greatest threats to economic freedom in this country are in areas that are not captured well in the index. These refer to the regulation of the labour market, health-care regulation, and the burdensome social security system.
Other countries ranking near the top of the list include Ireland (6th), Canada (7th), Australia (7th), Netherlands (9th), Luxembourg (9th), and Switzerland (9th). Other countries one would expect to find at the top because of their track record of prosperity, like Germany, France of Sweden, are near the bottom of the industrialised European nations in terms of economic liberty. These countries are paying a price for tremendous government expenditures, the expanding welfare state, high income tax rates, and a mass of economic regulations. In Germany, government consumption hovers around 26 percent of total consumption; the transfer sector constitutes over 20 percent of GDP; and the top marginal tax rate is 61.7 percent. In France, the figures are 24.2 percent, 28.8 percent and 48 percent accordingly. The Swedish welfare state consumes over one third of the total consumption of the nation and redistributes another third, the top marginal income tax rate being 57 percent. It should be noted that the labour and housing markets, which are not included in the index, represent some of the biggest challenges to many Western countries. Wage and working time regulations plague the labour markets along with rigid laws governing hiring and firing decisions. The housing sector suffers from numerous controls and subsidies as well as poor competition. Were these to be featured in the index, the freedom scores of many developed nations would certainly drop.
Economic freedom leads to greater prosperity
One of the most compelling results of the study is the relationship between economic freedom and prosperity. Countries that score in the top quintile of the “most economically free” countries had an average per capita GDP of US$18,108 and an average growth rate of 2.27 percent. As freedom declined, so did the average per capita GDP, as well as the average growth rate. The bottom 20 percent of economically free countries had an average per capita GDP of US$1,669 and an average growth rate of -1.32%. Also, life expectancy in the top quintile is a full twenty years longer than that found in the bottom quintile.
Lithuania Enjoys Less Freedom than the Other Baltic States
Although the level of economic freedom in Lithuania has increased in the past two years, the pace of its growth has been slower than in the other Baltic States, Latvia and Estonia. From 1995 until 1997 Lithuania’s rating of economic freedom rose from 5.7 to 6.6 and moved the country from 77th to 62nd place. Latvia has improved its score from 5.7 to 6.7, moving up from 77th to 60th place. Estonia has shown the best performance of the three Baltic States, with a score of 6.8 for 1997 (6.4 in 1995), and ranked 57. In two years’ time it has improved its ranking by 10 positions.
The report indicates that market reforms have allowed Lithuania to improve its rating. However, Lithuania has scored less in both ratings and rankings than the other Baltic countries due to high government consumption, slower restructuring of the economy, and heavier restrictions on international trade. Lithuania’s rating was further worsened by its 33 percent income tax rate, as compared with 26 percent in Estonia and 25 percent in Latvia. One of the biggest concerns remains price control in the energy, transportation, and agriculture sectors. The three Baltic States ranked low in the monetary policy and price stability category. This is due to the methodology that looks at changes in the rate of inflation during the last five years. So even though Lithuania has pursued a strict, rule-bound monetary policy and has performed remarkably well since 1994, the index does not reflect directly the government’s non-intervention in the monetary system. On the other hand, we must recognise that doing away with the legacy of inflationary policies and proving commitment to a stable and credible monetary system does take time.
In recent years the Baltic States have made headway in facilitating exchange in capital and financial markets and have managed to reduce state interventions. In Lithuania, interest rates have dropped markedly and effective rates have become positive. In Latvia, there has been a marked increase in the amount of credits extended to the private sector; and Estonia has reported a growing amount of deposits held in privately owned banks. It should be noted that both in assessing all the categories of variables and in comparing the three Baltic States, Estonia scored highest for freedom related to international trade.
Prosperity is No Accident
The Economic Freedom of the World demonstrates conclusively that countries fostering and expanding economic liberties differ from those in which economic freedom is curtailed. And these differences are essential. The report not only shows the consistent, positive relationship between economic freedom and prosperity but also indicates how to bridge the gap from poverty to prosperity. Clearly, on this path to well-being, government is prescribed an important but limited role of establishing rules of just conduct, protecting the life and property of the citizens, and preserving the social order. And the formula for success is in people’s freedom to pursue individual goals and to choose the means by which these goals are achieved – without coercive government interference.
* Hanke and Walkers, Economic Freedom, Prosperity, and Equality: A Survey, 1997.