Prof. Bryan Caplan

Econ 345

Fall, 1998

Week 14: Simple Econometrics and Indices of Economic Freedom

  1. Measuring Economic Freedom
    1. Several major historical events have suggested to many that economic freedom causes prosperity.
      1. U.S. in 19th century
      2. "Asian Tigers" after WWII
      3. West vs. East Germany; North vs. South Korea; Taiwan and Hong Kong vs. mainland China
      4. Collapse of Communism in Eastern Europe and USSR
    2. We have a number of quantitative measures of prosperity (e.g.: real per-capita GDP), but no prominent measures of economic freedom. But, just because it is hard to measure something does not mean that it is unimportant, as we've learned.
    3. Several fairly recent attempts to quantify economic freedom over time and between countries, and to check the association of economic freedom and prosperity.
      1. Freedom House
      2. Heritage Foundation
      3. Economic Freedom of the World, 1975-1995
    4. For a number of reasons, the 3rd index is probably the best. It covers a lot more years, includes more variables, and tries to avoid "subjective" measures:
    5. "Most of the components of our index are objective variables (for example, standard deviation of the inflation rate or government consumption as a share of the total) designed to measure important elements of economic freedom. In cases where subjective judgements would influence the relative standing of countries, we use survey data or evaluations by others rather than injecting our own views. Note We also present the underlying data set used to rate countries and carefully explain how it was used to derive the component ratings. We wanted our index to be transparent in order to enhance its credibility." Economic Freedom of the World

    6. We're mainly going to just examine the author's effort to quantify economic freedom, and look at preliminary evidence on it's correlation with prosperity. The main point is to expose you to an effort to quantify a complex issue, and see how much is "lost in the translation."
  2. Components of the Index of Economic Freedom
    1. Important problem: If "economic freedom" causes prosperity, you shouldn't define economic freedom to mean prosperity. That would be a serious flaw, and the authors of the study try to avoid it.
    2. Countries rated on a scale of 0 (lowest) to 10 (highest); as a short-hand:
    3. Number Ranking

      Letter Grade















    4. Four classes of components of the index:
        1. Money and inflation
        2. Government operations and regulations
        3. Takings & discriminatory taxation
        4. Restraints on international exchange
  3. Breaking Down the Four Classes of Components (Exhibit 1-1)
    1. Money and inflation
      1. Average annual growth rate of the money supply during the last five years minus the potential growth rate of real GDP (virtually equivalent to inflation rate)
      2. Standard deviation of inflation rate during the last five years
      3. Freedom to own foreign bank account domestically (=0 if no, =10 if yes)
      4. Freedom to maintain a bank account broad (=0 if no, =10 if yes)
    2. Government operations and regulations
      1. General government consumption expenditures as a % of total consumption
      2. Role and presence of government-operated enterprises
      3. Price controls
      4. Freedom of private business and cooperatives to compete
      5. Equality under the law
      6. Absence of policies that cause negative real interest rates (interest rate ceilings plus high inflation)
    3. Takings and discriminatory taxation
      1. Transfers and subsidies as a % of GDP
      2. Top marginal tax rate (+ income threshold)
      3. Conscription
    4. Restraints on international exchange
      1. Taxes on international trade/(Ex+Im)
      2. Difference between official exchange rate and black market rate
      3. Actual size of trade sector compared to expected size (based on geographic size, population, and location of the country); suggests non-tariff trade barriers
      4. Restrictions on capital transactions with foreigners
    5. Which of these measures are most objectionable (i.e., measure prosperity more than economic freedom)? Which are least objectionable?
    6. Determination of weights: weights determined by average weights given by members of expert panel.

    "How should each component in the index be weighted? In the previous edition, we presented three summary indices based on alternative component weights. In most cases, the variation in the weights exerted only a small impact on the summary rating. Given their similarity, presentation of the three alternative ratings was unnecessarily confusing. Therefore, in this edition we will present only one summary index, the one with weights based on a survey of the participants in the Fraser-Liberty Fund Symposia Series. (Note: This index was referred to as the Is1 summary index in Economic Freedom of the World: 1975-1995.) We constructed a survey instrument which described the 17 components in our index and asked the participants of these conferences to provide us with their views concerning the weights that should be attached to each of the components. Since all of these people attended at least one of the conferences, we were reasonably sure of their familiarity with the concept of economic freedom and the factors that influence it. The average weight suggested by the respondents was then used to weight the components and derive the summary index for each of the years."

  4. What the Index Says
    1. Average rankings: Stagnant from 1975-85; shoots up in 1990 and 1995. (A rise from an average of 4 to an average of 5).
      1. Note: More countries were added each period, and usually it is the poorer and less economically free countries for which data is scarce. So you should expect a decline with each (measured) average if economic freedom were actually constant.
    2. Ranking of countries. (Exhibit 2-2)
      1. Highest-ranked countries: Hong Kong, Singapore, New Zealand, U.S., Mauritius
      2. Lowest-ranked countries: Algeria, Croatia, Syria, Burundi, Haiti
    3. Changes in country rankings. (Exhibit 2-3)
      1. Largest increases: New Zealand, Chile, Mauritius, Iceland, Portugal
      2. Largest decreases: Venezuela, Haiti, Nicaragua, Iran, Honduras
  5. Economic Freedom and Prosperity: The Preliminary Evidence
    1. Several ways to check for a link. Most obvious one: Per-Capita GDP and its relation to Economic Freedom. (graph)
    2. But this has some problems - you wouldn't expect overnight prosperity just from good policies. So perhaps a better comparison would be between Economic Freedom and the Growth of Per-Capita GDP (graph)
    3. Another good thing to check for: If the economic freedom of a country changes a lot, does it's growth rate change a lot - and in the predicted direction? Yes. (see graph)
  6. Sachs in The Economist
    1. Economic policy matters:
      1. On (different) 10-point scale, each point associated with .2% higher annual growth. (North Korea gets 1; Hong Kong and Singapore get a 10).
      2. Openness to trade: +1.2% growth
      3. Each rise of 10 percentage points of GDP in government savings raises GDP growth by +1%. (Or, 10 percentage points of GDP of government borrowing reduces by 1%).
    2. But other factors matter too:
    3. Geography:
      1. Landlocked:-.7%
      2. Tropics: -1.3%
    4. Catch-up: everything else equal, poorer countries have higher growth rates.
    5. Demographics: higher birth rates mean lower growth rates of per-capita GDP. (But could mean higher growth in the long-run).