Introduction to the Economic Freedom of the World Index

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Introduction to the Economic Freedom of the World
Index
Auburn University College of Business November 9,
2007

• Robert Lawson
• George H. Moor Professor
• Capital University

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I want to talk about

• The methodology of the Economic Freedom of the
  World (EFW) Index.
• The impact of the EFW index.
• Media
• Academic Journals
• The EFW index as a research tool.
• Growth, Equality, Peace, Finance, Political
  Freedom

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• Liberal markets
• Sep 11th 2007From Economist.com
• HONG KONG keeps its top position in the Economic
  Freedom Index compiled by the Fraser Institute, a
  Canadian think-tank. The index ranks the policies
  of 141 countries according to how much they
  encourage free trade, both internally and with
  other territories. Countries with fewer taxes,
  strong property rights, low regulation and sound
  money score best. Britain and America tie with
  Canada for fifth place in the list. Germany is
  ranked 18thon a par with El Salvador but above
  Japan. Most of the low-ranking countries are
  African, except Myanmar and Venezuela, which are
  both in the bottom ten.

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Measuring Economic Freedom

• Economic freedom is complex and multidimensional,
  but it can be measured
• Personal choices v. Centralized choices
• Freedom to trade, domestically and abroad.
• Freedom to enter and compete in markets.
• Security of Property/Rule of Law
• No country perfectly conforms to the free-market
  idealall economies are mixed economies.
• Rothbard ? Friedman ? Keynes ? Marx
• Institutional Quality or Social Capital
• Barro, Hall and Jones.

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Why measure economic freedom?

• We want to measure EF for the same reason we want
  to measure GDP Freedom is a good. People
  appear to want more of it, ceteris paribus.
• EF may correlate positively (cause?) some
  desirable social goals (e.g., growth) but EF may
  require the sacrifice of some desirable social
  goals (e.g., equality)
• Having the index will help us evaluate these
  issues.
• The index is designed to measure EF. It does
  not, and cannot, determine the optimal level of
  freedom. This is a value judgment.

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Methodology

• We collect data on 141 countries using 42
  different components (grouped into five broad
  areas).
• 0-10 ratings are constructed to measure the
  degree to which the country conforms to the
  free-market ideal.
• Third-Party data from World Bank, IMF, Global
  Competitiveness Report, IMD, etc.
• Objective data
• Survey data
• Case study data
• Transparency is a highly valued part of the
  project.
• Economic Freedom Network of institutes in 72
  countries helps with some, but very little, data
  collection.

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Member Institutes of Economic Freedom of the
World Network
Albanian Center for Economic Research,
Albania Fundación Libertad, Argentina Institute
of Public Affairs, Australia TIGRA,
Austria Center for Economic and Political
Research, Azerbaijan The Nassau Institute,
Bahamas Making Our Economy Right (MOER),
Bangladesh Scientific Research Mises Center,
Belarus Centre for the New Europe,
Belgium Fundacion Libertad y Democracia (FULIDE),
Bolivia Instituto Liberal do Rio de Janeiro,
Brazil Institute for Market Economics,
Bulgaria Cambodia Institute of Development Study,
Cambodia The Fraser Institute, Canada Instituto
Libertad y Desarrollo, Chile ILP- Instituto
Libertad y Progreso, Colombia Instituto para la
Libertad y el Análisis de Políticas, Costa
Rica The Institute of Economics,
Croatia Liberální Institut, Czech Republic Center
for Politiske Studier (CEPOS), Denmark Fundación
Economía y Desarrollo Inc., Dominican
Republic Instituto Ecuatoriano de Economía
Política, Ecuador International University
Concordia Audentes, Audentes University,
Estonia Association pour la Liberté Economique et
le Progrès Social (ALEPS), France
Society for Disseminating Economic KnowledgeNew
Economic School Georgia, Georgia Liberales
Institut, Germany The Institute of Economic
Affairs, Ghana Centro de Investigaciones
Económicas Nacionales, Guatemala Institut de
Recherche pour la Liberte Economique et la
Prosperite (IRLEP), Haiti Hong Kong Centre for
Economic Research, Hong Kong Szazadveg
Foundation, Hungary Centre for Social and
Economic Research, Iceland Centre for Civil
Society, India The Institute for Development of
Economics and Finance, Indonesia Open Republic
Institute, Ireland Institute for Advanced
Strategic and Political Studies, Israel Centro
Einaudi, Italy Bureau d'Analyse d'Ingenierie et
de Logiciels (BAILO), Ivory Coast African
Research Center for Public Policy and Market
Process, Kenya Center for Free Enterprise,
Korea Economic Policy Institute-Bishkek
Consensus, Kyrgyz Republic Lithuanian Free Market
Institute, Lithuania D'Letzeburger Land,
Luxembourg Centro de Investigación para el
Desarrollo A.C., Mexico Open Society Forum,
Mongolia The Center for Entrepreneurship and
Economic Development, Montenegro The New Zealand
Business Roundtable, New Zealand Institute of
Public Policy Analysis, Nigeria Civita Center
for Business and Society Incorporated, Norway
Alternate Solutions Institute, Pakistan Fundación
Libertad, Panama Centro de Investigación y
Estudios Legales (CITEL), Peru The Center for
Research and Communication, Philippines Centrum
im. Adama Smitha, Poland Causa Liberal,
Portugal Romania Think Tank, Romania Institute of
Economic Analysis, Russia The F.A. Hayek
Foundation, Slovak Republic The Free Market
Foundation of Southern Africa, South
Africa Pathfinder Foundation , Sri
Lanka International Research Foundation (IRF),
Sultanate of Oman Timbro, Sweden Liberales
Institut, Switzerland Arthur Lok Jack Graduate
School of Business, The University of the West
Indies, Trinidad, W.I. Association for Liberal
Thinking, Turkey The Ukrainian Center for
Independent Political Research, Ukraine The
Institute of Economic Affairs, United
Kingdom CATO Institute, USA The Centre for the
Dissemination of Economic Knowledge (CEDICE),
Venezuela Research Center for Entrepreneurship
and Development Policies, Vietnam Free Market
Center (FMC), Yugoslavia Zambia Institute for
Public Policy Analysis (ZIPPA), Zambia
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5 Areas of Economic Freedom of the World (EFW)
Index

• Size of Government Expenditures, Taxes, and
  Enterprises
• Legal Structure and Security of Property Rights
• Access to Sound Money
• Freedom to Trade Internationally
• Regulation of Credit, Labor, and Business

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Area 1 Size of Government

• Government Consumption ( of C)
• E.g., Frances G/(GC) 29.9
• (Vmax-Vi)/(Vmax-Vmin)10
• (40-29.9)/(40-6)10 3.0
• B. Transfers Subsidies ( of GDP)
• C. Government Investment ( of I) Government
  Enterprises
• D. Marginal Tax Rates (top rate threshold-2
  sub-components)

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Area 2 Legal Structure and Security of Property
Rights

• A. Judicial Independence (GCR)
• B. Impartial Courts (GCR)
• C. Protection of Intellectual Property (GCR)
• D. Military Interference (ICRG)
• E. Integrity of Legal System (ICRG)

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Area 3 Access to Sound Money

• A. Money Growth (minus economic growth)
• B. Inflation Variability (st. dev. of inflation)
• C. Inflation Rate (recent annual rate)
• D. Freedom to Own Foreign Currency Bank Accounts
  Domestically and Abroad

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Area 4 Freedom to Exchange with Foreigners

• A. Taxes on International Trade (3
  sub-components)
• B. Regulatory Trade Barriers (2 sub-components)
• C. Trade Sector Size (actual compared with
  expected)
• D. Black Market Exchange Rates
• E. Capital Market Controls (2 sub-components)

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Area 5 Regulation

• A. Credit Market Regulations (5 sub-components)
• B. Labor Market Regulations (5 sub-components)
• C. Business Regulations (5 sub-components)

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Highest Economic Freedom Ratings, 2005
Source EFW 2007, Exhibit 1.2.
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Economic Freedom Ratings of Selected Countries,
2005
Source EFW 2007, Exhibit 1.2.
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Average Economic Freedom Rating, 1980-2004
Chain-linked index. Source EFW 2007, Exhibit
1.4.
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Case Study Ireland

• Transfers Subsidies fell to 11.7 from 21.8.
• Top marginal tax rates fell to 42 from 65.
• Tariff rate fell to 2.7 from 8.8 .
• Sound Money rating increased to 9.7 from 5.8.

GDP per capita growth, 1995-2005 5.97
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Case Study Chile

• Top marginal tax rates fell to 40 from 58.
• Tariff rate fell to 4.9 from 30.
• Inflation rate fell to 3.1 from 30.7.
• Capital market controls lifted.

GDP per capita growth, 1995-2005 2.99
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Case Study Venezuela

• Government consumption increased to 20.3 from
  14.4.
• Transfers subsidies increased to 15 from 2.
• Inflation remains high at 16.
• Foreign currency accounts restricted.
• Military interference rating fallen to 0.8 from
  5.6.

GDP per capita growth, 1995-2005 -0.36
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Case Study Zimbabwe

• Legal Structure/Property Rights rating has fallen
  to 3.7 from 5.5.
• Annual inflation has increased to 349 from 6.5.
• Foreign currency bank accounts are illegal.
• Tariff rates increased to 16.7 from 8.7.
• Price control rating 0.0!

GDP per capita growth, 1995-2005 -3.43
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Economic Freedom and Income
Source EFW 2007, Exhibit 1.6.
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Sample of Press Coverage for 2007
Postman, Estonia L'Agefi Suisse, France Press
Digest, Hong Kong Reuters, Hong Kong Standard,
Hong Kong Budapest Business Journal, Hungary MTI
Eco News, Hungary Business Weekly,
Iceland Frettabladid, Iceland Business Standard,
India Times of India, India Economist,
International Zeev Klein, Israel Corrier
Economica, Italy Il Corriere della Sera, Italy Il
Tempo, Italy Indiscreto, Italy Jakarta Post,
Jakarta Korea Economic Daily, Korea Korea Herald,
Korea Korea Times, Korea Seoul Daily, Korea Yon
Hap News, Korea Latvian News Agency,
Latvia Bernama Daily, Malaysia Business Times,
Malaysia Daily Express, Malaysia
El Economista, Mexico El Financiero, Mexico El
Universal, Mexico Tiempo, Mexico Daily News,
Montenegro Daily Press, Montenegro Mina business,
Montenegro Pobjeda, Montenegro Faz.Net,
Netherlands International Herald Tribune, New
Zealand Business Recorder, Pakistan Poland Today,
Poland Rompres, Romania BBC Monitoring,
Russia Kommersant, Russia Biz Day, South
Africa Business Day, South Africa Mail and
Guardian, South Africa News 24, South
Africa Sunday times, South Africa Libertad
Digital, Spain Taipei Times, Taiwan Bangkok Post,
Thailand Turkish Daily News, Turkey Business
Journal, US TCS Daily, US Washington Times, US El
Universal, Venezuela
All Africa, Africa Ambito Financiero,
Argentina El Litoral, Argentina Daily News,
Bahrain Daily Star, Beirut Mmegi,
Botswana Ekonomika, Bratislava Capital Weekly,
Bulgaria Investor, Bulgaria Novinar,
Bulgaria Sega, Bulgaria Sofia Echo,
Bulgaria Calgary Herald, Canada Vancouver Sun,
Canada Globe and Mail, Canada National Post,
Canada South China Morning Post, China Xinhua
News Agency, China Business Day, Colombia La
Colombiano, Colombia La Republica,
Colombia Portafolio, Colombia La Prensa Libre,
Costa Rica Baltic Business Weekly, Estonia
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Over 200 journal citations, including

• Journal of Accounting Research
• Journal of Business Finance and Accounting
• Journal of Corporate Finance
• Journal of International Money and Finance
• Journal of Law and Economics
• Journal of Monetary Economics
• Journal of Money, Credit and Banking
• Journal of Political Economy
• Journal of Portfolio Management

• Journal of Finance
• Journal of Banking and Finance
• Quarterly Journal of Economics
• Applied Economics
• Economic Inquiry
• IMF Staff Papers
• World Bank Economic Review
• Journal of Economic Behavior and Organization
• Academy of Management Journal

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Over 200 journal citations
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Other EF Indexes

• Economic Freedom of the Arab World
• Economic Freedom of North America
• Marketization Index of Chinese Provinces
• Economic Freedom Index of Indian States
• Economic Freedom Index of Argentinean Provinces
• Economic Freedom of the World, Europe, and Italy.

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Economic Freedom and Growth

• EF (and changes in EF) are highly correlated with
  economic growth.
• deHaan et al. (2006) survey the literature
• ...It is clear from these studies that EF seems
  to have a positive association with growth. None
  of the studies summarized reports that economic
  freedom is bad for growth.

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Growth Theory

• 3 basic theories
• Neo-classical Output f(Inputs, Technology)
• Growth f(changes in inputs, changes in
  technology)
• Geography
• Sachs, Diamond
• Institutions
• North, Friedman
• EF Index
• These three views are not mutually exclusive

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Growth Regressions

• Neo-classical
• G a bGDP0 cINVk dINVh
• R2 0.30
• Plus Geography
• G a bGDP0 cINVk dINVh eTROPIC
  fCOAST
• R2 0.40
• Plus Institutions
• G a bGDP0 cINVk dINVh eTROPIC
  fCOAST gEF h?EF
• R2 0.60

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Growth Regression Results

• Standard result
• Growth a bGDP0 cINVk dINVh eTROPIC
  fCOAST gEF h?EF
• b lt 0 (convergence), c gt 0, d gt 0 (not robust),
  e lt 0, f 0, g gt 0, h gt 0.
• g 1.0, h 0.75
• R2 0.60
• Source Gwartney, Holcombe, Lawson (2006)

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Growth Regression Results

• But INVk f (EF, ?EF)
• EF ? Growth (direct effect)
• EF ? INVk ? Growth (indirect effect)
• If you factor in the direct and indirect
  influence of EF and ?EF as it works through INVk
• g 1.5, h 1.3
• Source Gwartney, Holcombe, Lawson (2006)

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EF Levels or Changes?

• deHaan et al. (2006) argue that it is not
  appropriate to include the level of EF and the
  change. They argue for including only the
  change.
• Lawson (2006) commented deHaan and Sturm (2006)
  replied Lawson and Cole (2007) commented and
  deHaan and Sturm, replied.
• Im right and theyre wrong!!

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Other EF Research Foreign Aid

• Easterly (2005) Controlling for initial income
  and not for economic freedom, aid has no
  significant effect on growth. Once you control
  for economic freedom, aid has a negative and
  significant effect on growth.

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Other EF Research Peace

• Gartzke (2005) finds The impact of free markets
  and limited government is substantial. The least
  free states have about a 7 percent chance of
  experiencing a (military) dispute, while the free
  states experience disputes in only about half of
  1 percent of the years examined.

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Other EF Research Contagious Capitalism

• Sobel and Leeson (2007) write, Capitalism is in
  fact contagious. Countries consistently catch
  about 20 percent of their geographic neighbors
  and trading partners levels and changes in
  economic freedom.
• If Frances neighbors (Spain, Germany,
  Netherlands, Luxembourg, Italy, Switzerland, and
  Belgium) increased EF by one point, then Frances
  rating would increase by 0.2 points.

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Other EF Research Equality

• Scully (2002) Economic freedom promotes both
  economic growth and equity, and that there is a
  positive but relatively small trade-off between
  growth and income inequality.

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Other EF Research Stock Returns

• Stocker (2005) The rate of increase in economic
  freedom is directly related to equity returns
  ..... an investment strategy based on economic
  freedom earned attractive investment returns.
• Lawson and Roychoudhury (Draft) Uses NAEFI to
  build stock portfolios by US state.

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Other EF Research Hayek-Friedman Hypothesis

• Historical evidence speaks with a single voice
  on the relation between political freedom and a
  free market. I know of no example in time or
  place of a society that has been marked by a
  large measure of political freedom, and that has
  not also used something comparable to a free
  market to organize the bulk of economic activity.
• -Milton Friedman, Capitalism and Freedom (1962 9)

The relation between political and economic
freedom is complex and by no means
unilateral. -Milton Friedman, Capitalism and
Freedom (1962 10)
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The HF Hypothesis
Not Economically Free (NEF)
Economically Free (EF)
Politically Free (PF)
Not Politically Free (NPF)
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(1985)
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(2005)
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