Economic freedom, development and the changing world economy

Economic development and growth are driven by gains from trade, innovation and private investment. Economic freedom is central to each of these sources of growth. Without economic freedom, trade, innovation and investment will be stifled. Because of its importance, beginning more than three decades ago, the Canadian Fraser Institute set out to clearly define and develop a comprehensive measure of economic freedom. Milton and Rose Friedman joined Fraser Institute President Michael Walker as the host of a series of six conferences held between 1986 and 1994. In addition to the Friedmans, approximately 60 of the world’s leading economist, including Nobel laureates Gary Becker and Douglass North, participated in the project.

The Economic Freedom of the World (EFW) annual report is an outgrowth of these conferences. Initially available in 1996, the EFW annual report is now published by a network of think tanks in 90 countries headed by the Fraser Institute.1

As the report states, “The cornerstones of economic freedom are personal choice, voluntary exchange, open markets, and clearly defined and enforced property rights [Gwartney et al. 2018].” The EFW index uses 42 distinct variables to develop a summary measure of economic freedom for 162 countries. The data are available for approximately 100 countries back to 1980.

Thus, the EFW data makes it possible to examine the relationship between economic freedom and performance of economies over a period of several decades. In addition to the summary measure, the EFW index measures the degree of economic freedom present in five major areas: (1) size of government, (2) legal system and security of property rights, (3) sound money, (4) international exchange, and (5) regulation.

The world’s freest economies

Figure 1 indicates the summary rating (ten-point scale) for the world’s ten freest economies. These ratings are for 2016, the most recent year for which comprehensive data are available. Hong Kong and Singapore, as has been the case for many years, occupy the top two positions. The next highest-ranking nations are New Zealand, Switzerland, Ireland, United States, Georgia, Mauritius, United Kingdom, and Australia and Canada, tied for 10th place. See Figure 1

Figure 1, showing Top Ten Countries EFW Index, 2016

The rankings of some other major countries are Germany (20th), Japan (41st) Italy (54th), France (57th), Mexico (82nd), Russia (87th), India (96th), China (108th), and Brazil (144th). The ten lowest-rated countries are: Sudan, Guinea-Bissau, Angola, Central African Republic, Republic of Congo, Syria, Algeria, Argentina, Libya, and Venezuela, ranking last among the 162 countries.

Expanding economic freedom in developing countries

Economic freedom has been increasing in the developing world. There are 102 developing countries for which the EFW data are available for both 1995 and 2016. Figure 2 shows the average summary EFW rating of the developing countries, along with their ratings for the legal system, sound money, trade openness, and marginal tax rates. The average summary EFW rating increased from 5.7 in 1995 to 6.7 in 2016. Given the concentrated scale, this one unit increase is sizeable. See Figure 2

Figure 2, showing The average EFW ratings in the Summary Index of various sub-categories for 102 developing countries: 1995 versus 2016

In the early 1980s, the World Bank classified 21 countries as “high-income industrial.” These 21 countries are comprised of the high-income countries of western Europe, plus Canada, United States, Japan, Australia, and New Zealand. Historically, these countries have generally had relatively high levels of economic freedom. In 1995, the average EFW summary rating of the 21 high-income countries was 7.5, 1.8 units higher than the 5.7 average rating of the developing countries. In 2016, the average summary rating of the 21 high-income countries was 7.7, only one unit higher than the average rating for the 102 developing countries. Thus, the developing countries have not only improved their economic freedom, they have narrowed the gap relative to the world’s high-income countries.

The primary factors underlying the higher EFW ratings of the developing countries were improved monetary policy, more open trade, and lower marginal tax rates. As Figure 2 shows, the EFW area rating of the developing countries for access to sound money increased from 5.8 in 1995 to 8.1 in 2016, a whopping increase of 2.3 units. The trade openness area rating rose from 6.4 in 1995 to 6.9 in 2016. This increase reflects lower tariffs, less restrictive non-trade barriers, and less prohibitive use of exchange rate and capital market controls. The marginal tax rate variable reflects both the marginal tax rate on income and the income threshold at which the top rate applies. Countries with lower top marginal tax rates that apply only at high income levels receive higher ratings for this component. The average rating for the developing countries for the tax rate component was 6.7 in 2016, up from 5.9 in 1995.

While the developing countries moved toward economic freedom in the monetary, trade, and tax areas, there was little improvement in the quality of their legal systems. The area rating for legal system and protection of property rights rose only from 4.7 in 1995 to 4.9 in 2016. This confirms an important point: the legal systems of developing countries provide uncertain protection of property rights and enforcement of contracts. This shortcoming is a major deterrent to economic progress in the developing world.

Economic freedom and the growth of developing economies

As the developing countries have moved toward economic freedom and narrowed the institutional gap compared to high-income countries, how have they performed? It is important to examine growth rates over a lengthy time frame, such as one or two decades, in order to minimize the impact of business cycle and other short-term factors that might alter growth rates. Figure 3 shows the 15-year moving average growth of real per capita GDP of the high-income countries, the non-African developing countries, and the African economies for 1965-2015. Prior to 1975, the high-income countries had a higher growth rate than the developing economies. This began to change during the 1980s. The 15-year average growth of per capita GDP of the non-African developing countries was similar to that of the high-income countries during the 1980s and 1990s. In contrast, the growth of African countries lagged behind the other two groups prior to 2000. However, since 2000, the situation has changed dramatically. Both of the developing groups have grown much more rapidly than the high-income economies in recent years. See Figure 3

Figure 3 showing Annual growth rates for the high-income, non-African developing, and African countries, 1965-2015 (15 year moving average)

Economic freedom and growth by region

It is also revealing to compare the growth rates of the regional leaders in economic freedom with the growth of the 21 high-income countries. This section examines the growth rates of the developing countries of each region that are ranked in the Top 50 among the 162 countries with EFW ratings in 2016. The countries are ordered according to their 2016 economic freedom rating and their annual growth rate of per capita GDP during 1995-2016 is shown in parentheses.

In South and Central America, the following five countries ranked in the Top 50 in 2016: Chile (3.0), Guatemala (1.3), Panama (4.0), Costa Rica (2.5), and Peru (3.2). There were also five developing countries in Asia among the Top 50. These countries were Hong Kong (2.5), Singapore (2.9), Taiwan (2.8), South Korea (3.6) and Mongolia (4.7).

Five African countries also ranked among the world’s 50 freest economies. They were Mauritius (3.8), Rwanda (4.6), Uganda (2.9), Botswana (2.7), and Gambia (0.4). Except for Gambia, which ranked 49th in the 2018 report, the annual growth rates of the African countries were impressive. Finally, nine of the former centrally planned economies of Eastern Europe ranked among the 50 most free economies in the latest EFW report. The nine countries were: Georgia (6.7), Lithuania (5.2), Estonia (4.3), Romania (3.5), Latvia (5.0), Czech Republic (2.3), Armenia (6.3), Albania (4.7), and Bulgaria (3.6).

How did the growth rates of these 24 developing economies compare with the 21 high-income countries? The average annual growth rate of per capita GDP of the 21 high-income countries during 1995-2016 was 1.5 percent. By way of comparison, the parallel growth figure of the 24 developing countries was 3.6 percent, more than twice the figure of the high-income countries. Twenty-two of the 24 developing countries achieved growth rates of 2.3 percent or more. Only Guatemala and Gambia had growth rates lower than the average for the high-income countries. These comparisons provide strong evidence that when developing countries adopt institutions and policies supportive of economic freedom, they achieve impressive growth rates and narrow the income gap relative to their high-income counterparts.

Since 2000, the developing economies have grown rapidly and closed the income gap compared to high-income countries. While the popular media has focused on rising income inequality within some high-income countries, worldwide income inequality has been moving in the opposite direction. There was a sharp decline in worldwide income inequality during 2000-2015. By 2015, worldwide income inequality was at its lowest level in more than 65 years [Gwartney, Montesinos, and Connors 2018].

Economic freedom and progress against poverty

The World Bank’s [2018] poverty measures are the most widely used indicators of global poverty. The bank defines the extreme and moderate poverty rates as the percentage of a country’s population that lives on $1.90 per day and $3.20 per day, respectively, in 2011 constant PPP adjusted international dollars. Those who live in extreme poverty face the most difficult aspects of poverty. It is difficult to maintain a diet with adequate nutrition or to obtain the most basic type of housing which would protect one from the elements. As such, illness and poor health are common. Those who live in moderate poverty are generally able to obtain a diet with adequate nutrition and have some basic housing but are unable to afford much beyond these basic needs.

Using the World Bank poverty figures from Connors and Montesinos [2018], Figure 4 provides a synopsis of what has happened to global poverty in the developing world since 1980. Panel A displays the poverty rates by quartile groups based on the average EFW rating during 1995-2016. Each quartile contains 25 percent of the countries with EFW data and the groups are arranged from the least free to the most free. The difference in the poverty rates between the least free and most free quartiles is striking. Countries in the least free quartile had an average extreme poverty rate of 31.7 percent and a moderate poverty rate of 51.7 percent. In contrast, countries in the most free quartile had an extreme poverty rate of 1.5 percent and a moderate poverty rate of 4.3 percent. These data indicate that severe forms of poverty are still a significant problem in countries lacking economic freedom, but extreme and moderate poverty are virtually absent in countries with a high degree of economic freedom. See Figure 4

Figure 4
Click to enlarge.

Panel B of Figure 4 shows the trend of the extreme and moderate poverty rates in the developing world since 1980. The reductions in poverty over this period are historic. In a span of 35 years, the extreme poverty rate declined from a high of 58.9 percent in 1980 to 14.5 percent by 2015. The moderate poverty rate experienced a similar decline. In 1980, 75.3 percent – that is, three-fourths of the developing world’s population – lived in moderate poverty. By 2015, 31.4 percent – less than one-third – remained in moderate poverty. Much poverty remains, but developing countries have come a long way in a short amount of time. Moreover, as Figure 4 illustrates, reductions in extreme and moderate poverty are most likely to occur in countries that move toward economic freedom.

Economic freedom, the transportation-communication evolution and the changing world economy

The movement of developing countries toward economic freedom in recent decades has been central to their growth and development. In addition, the sharp reduction in transportation and communication cost has facilitated the integration of developing countries into the world market network. Propelled by standardized steel containers, larger ships, and the mechanization of loading and unloading, the real costs of long-distant transport of goods has declined by an estimated 75 to 90 percent since 1970 [Glaeser and Kohlhase 2003].

This lower transport cost increases the payoff of movements toward economic freedom. More than at any time in history, it is now possible to produce goods in locations far from the world’s major markets. As a result, developing countries that improve their institutions have a greater opportunity to attract investment and gain from trade with people throughout the world. This change – it might be called the Transportation-Communication Revolution – is changing our world just as the Industrial Revolution did two centuries ago. However, while the Industrial Revolution exerted its major impact on a small set of countries in western Europe, North America and Oceania, the impact of the Transportation-Communication Revolution is much broader. It is expanding the opportunities available to people in Asia, Latin America, Africa and other parts of the developing world.

The movements toward economic freedom and lower transportation and communication costs are changing our world. Today’s world is characterized by acceleration in the growth of developing countries, substantial reductions in worldwide income inequality, historic progress against poverty, and more interaction of people living in low and high-income regions than at any time in history. Change can be difficult, but it is an exciting time for innovators, investors, and entrepreneurs seeking business opportunities.

ENDNOTES

1 The 2018 report is available at https://www.fraserinstitute.org/studies/economic-freedom-of-the-world-2018-annual-report.

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Joseph Connors
Assistant Professor of Economics, Barney Barnett School of Business and Free Enterprise at Florida Southern College
James Gwartney
Professor of Economics, Florida State University

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