Tuesday, February 11, 2014

Economic Freedom

Classical Liberals and Libertarians have long been proponents of free trade, private property rights, and free markets (economic freedom). But will these things lead to prosperity for everyone? Luckily, researchers over the past few decades have used quantifiable measurements as performance indicators of countries around the world to see how varying countries with varying amounts of economic freedom compare. The Heritage Foundation and the Fraser Institute use the following to quantify economic freedom:

1. Rule of Law (property rights, freedom from corruption);
2. Limited Government (fiscal freedom, government spending);
3. Regulatory Efficiency (business freedom, labor freedom, monetary freedom); and
4. Open Markets (trade freedom, investment freedom, financial freedom).

Empirical research continually finds that countries which score higher on the economic freedom indexes have higher living standards, higher average incomes, less corruption, less political violence, and faster economic growth than countries which score lower on the index. 1 Indeed, one study on the relationship between economic freedom and economic well-being found concluded, “regression analyses indicate that growth in economic freedom and the level of economic freedom have a significant impact on the growth in per-capita GDP and the level of per-capita GDP.” 2

Another study attempting to discern the same relationship found that when measuring real GDP growth per capita from 1980-2000 of 94 countries, the most economically free countries had the fastest growing economies. According to the study, “the persistently free group [of countries] achieved an average annual growth rate of 3.44%, compared to 1.67% for the middle group and 0.37% for the least free group.” 1

They also found that foreigners were more willing to invest in countries which had liberalized (free) economies. “foreign direct investment per worker of the persistently free economies was more than 45 times the figure for the persistently unfree group.” 1 Indeed, investment per worker in economically unfree countries was a fraction of what it was in free countries (see below).

Lastly the study noted that when comparing countries with low national incomes, the ones that had more economic freedom grew richer, faster, than the ones with less economic freedom. In fact, “the average annual growth rate of these countries [countries which scored highly on the Economic freedom index] was 4.2% compared to 1.0% for the other countries [which scored lower]. The ten freest economies among those with low incomes in 1980 grew more than four times the average of the other countries” 1

A study by the Independent Institute analyzed the benefits of economic freedom and stated, “Free Markets are conducive to growth, which is why measures such as privatization, freedom to establish new businesses, freer pricing, more flexible contract laws, and less regulation of domestic and international trade and of capital transactions are important” 3. This study also summarizes the findings of decades of research on the relationship between economic freedom and economic growth. Here is a small excerpt:

“Hanke and Walters (1997) study the relationship between economic freedom and GDP per capita and find it to be significant and positive. Leschke (2000) shows that, in particular, the framework within which the market economy functions and the degree of interventionism in the political process are of great importance for the wealth of nations… Wu and Davis (1999) investigate the relationship between economic and political freedom and growth. They find that economic freedom is important for growth and that a high income level is important for political freedom.” 3

You get the point; economic freedom is correlated with economic growth. A neat graph (below) presents the observed relationship between a country’s Economic Freedom and its real per capita income. Keep in mind, per capita income is the average income of a country (national income/ total number of citizens).

However, correlation does not prove causation. Can we be sure that that economic freedom is causing prosperity? A study titled, "Causality in the freedom-growth relationship" set out to find out whether or not economic freedom causes economic growth (and thus prosperity). The author uses a Granger causality test, a method of determining causality, to test the relatioship. According to the study:

"We then use Granger causality tests to address the issue of causality in the relationship
between various measures of institutions and growth across countries. The results suggest
that the overall level of economic freedom appears to cause growth, while changes in
freedom are jointly determined with growth. Among the underlying areas of economic
freedom, levels of freedom relating to use of markets and property rights appear to be
driving the causal relationship between economic freedom and growth. These results
emphasize the importance of economic freedom, in general, and the role of free markets
and property rights, in particular, in fostering long-run economic prosperity...When the Granger analysis is extended to the relationship between economic freedom and investment, we find evidence that both the level and changes in the broad measure of freedom cause investment."10

Another study by James D. Gwartney et. al, titled, "Economic freedom and the environment for economic growth" found that, “The empirical results show that economic freedom is a significant determinant of economic growth, even when human and physical capital, and demographics are taken into account.”11

On the other hand, many may argue that the income gains of economic growth only benefit the very wealthy. People who make this claim assume that income concentrates among the top 10% of income earners whereas the rest of the populace sees no gains at all. May I remind those people that economic freedom is positively correlated with income EQUALITY. Recent research has found that, “the empirical evidence reveals that there is a positive relationship between changes in economic freedom and equality: the more a country increased its economic freedom between 1975 and 1985, the higher the level of equality around 1985. Most important in this regard is trade liberalization and financial deregulation.4 

Another study published in the Journal of Regional Analysis and Policy stated, "We find evidence that increases in economic freedom are associated with lower income inequality, but the dynamic relationship between the two variables depends on the initial level of economic freedom”15 These findings do not prove that economic freedom promotes income equality, but they do cast doubt on the claim that the gains from economic growth go solely to the super wealthy. 

(See citation #13 for source of graph)

It's also worth noting that the poor in economically free countries are far better off than their counterparts in less free countries. In fact, the poorest 10% of citizens are MUCH RICHER in economically free countries than countries which lack such freedom. The poorest 10% earn $823 a year in the least economically free countries compared to $6,877 in the most economically free countries (in 2002). 5

What is the relationship between the size of government and economic growth?

The majority of empirical research has found a negative relationship between government spending and economic growth.  A recent study published by the Research Institute for Industrial Economics noted that:

“The most recent studies [on the relationship between government spending and economic growth] find a significant negative correlation: An increase in government size by 10 percentage points is associated with a 0.5 to 1 percent lower annual growth rate.….When we singularly focus on studies that examine the correlation between growth of real gross domestic product (GDP) per capita and total government size over time in rich countries (OECD and equally rich), the research is rather close to a consensus: the correlation is negative.” 6

The Fraser Institute has also made a similar conclusion:

“A survey of the literature shows that numerous studies document a negative empirical relationship between government size and economic growth rates. As well, there seems to be an association between smaller public sectors and greater efficiency in public service provision, as well as better performance outcomes” 7

Even when controlling for other relevant factors, government spending continues to be a burden on the economy. According to the same Fraser Institute study:

"After controlling for the effect of confounding variables, public sector size remains a potent long-term determinant of economic growth... A government expenditure to GDP ratio of 30 percent is associated with a per capita GDP growth rate of just under 3 percent, while a ratio of 40 percent is associated with a growth rate of 2.1 percent.7

Lastly, and most convincingly, in a study prepared for the US government's Joint Economic Committee, researchers showed that when measuring countries over time, the economic growth rates of those countries increased as the size of government (measured as a % of GDP) decreased, and decreased when the size of government increased. According to the researchers:

“Government expenditures as a share of the economy for each of the countries in the top part of Exhibit 6 [below] exceeded the OECD average (27.0 percent) in 1960. At the same time, their average growth rate (4.3 percent) during 1960-65 was less than the OECD average (5.5 percent). This situation was exactly the opposite for this same set of countries in the 1990s. By the 1990s, government expenditures as a share of the economy for those in the top group were below the OECD average, while their average growth rate (2.7 percent) exceeded the OECD average (1.9 percent)… It would have been difficult for a researcher seeking to isolate the impact of size of government on economic growth to have designed a more relevant experiment”12 

(Graph taken from citation #12)

What is the economic growth maximizing size of government?

Most empirical research shows that the ideal size of government (as a % of GDP) is between 10-26%. An article in the Economic Inquiry in fact reported, "The optimal government size is 23 percent (+/-2 percent) for the average country. This number, however, masks important differences across regions: estimated optimal sizes range from 14 percent (+/-4 percent) for the average OECD country to…16 percent (+/-6 percent) in North America." 8 Another study published by the Institute for Market Economics made similar conclusions. According to the authors:

"The evidence indicates that the optimum size of government, e.g. the share of overall government 
spending that maximizes economic growth, is no greater than 25% of GDP (at a 95% confidence level) based on data from the OECD countries. In addition, the evidence indicates that the optimum level of government consumption on final goods and services as a share of GDP is 10.4% based on a panel data of 81 countries. However, due to model and data limitations, it is probable that the results are biased upwards, and the “true” optimum government level is even smaller than the existing empirical study indicates."14

Total government spending in the United States is currently around 40% of GDP.

In conclusion, Classical liberals and Libertarians haven’t been promoting small government for no reason, we do so because we know it will lead to the best outcomes for everyone while preserving individual liberty and the rights of all people to engage in voluntary exchange, without the coercive power of the state manipulating their lives. If you have a friend or family member that believes larger government is the answer, perhaps you should share this information with them. Even if they disagree with libertarianism philosophically, the evidence is overwhelming that economic freedom is the key ingredient in improving the standard of living for the lot of all men and women.

As Nobel Laureate Milton Friedman once said:

There is no alternative way so far discovered of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by the free-enterprise system.9


[1] http://www.cato.org/pubs/efw/efw2004/efw2004-2.pdf
[8] http://www.heritage.org/research/reports/2005/03/the-impact-of-government-spending-on-economic-growth
[9] http://www.goodreads.com/author/quotes/5001.Milton_Friedman
[11] http://www.jstor.org/stable/40752161
[12] http://frihetspartiet.net/function.pdf
[13] http://www.creativeclass.com/_v3/creative_class/2010/04/20/free-tolerant-and-happy/
[14] http://ime.bg/uploads/335309_OptimalSizeOfGovernment.pdf

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