Measures of Economic Freedom King Banaian and William Luksetich St. Cloud State University CGU Workshop on Political Economy Data and Analysis 7 October 2005

What kind of freedom is good? Economic or political? Degrees of freedom Are all freedoms create equal? – These types of questions are often subsumed in any index of freedom.

Heritage says… “The 2005 Index of Economic Freedom measures 161 countries against a list of 50 independent variables divided into 10 broad factors of economic freedom. Low scores are more desirable. The higher the score on a factor, the greater the level of government interference in the economy and the less economic freedom a country enjoys. “These 50 variables are grouped into the following categories : Trade policy, Fiscal burden of government, Government intervention in the economy, Monetary policy, Capital flows and foreign investment, Banking and finance, Wages and prices, Property rights, Regulation, and Informal market activity” Source: / /

Our critique has two parts First, some of the components of the overall index are more likely to be determinants of economic freedom, while others are expressions of the degree of economic freedom. –What are the dimensions of freedom? Or, at least, how many are there? –What are the causal relationships between the factors?

CORRELATION MATRIX OF VARIABLES Overall ec. Freedo m 1.00 Trade Fiscal Gov't inter Mon. pol For. Inv Bankin g Wage/ price Propert y rights Regula tion Informa l mkts OverallTradeFiscalGov't inter. Mon. pol.For. Inv.Banking Wage/pric e Propert y rights Regula tion Informa l mkts

Principal components of Heritage Economic Freedom Index

Sorted index of economic freedom Note the pattern: A large group “in the middle”

Nobody’s perfect Nobody scores “free or mostly free” in all ten categories. Only 26 aren’t free or mostly free in any category.

Countries that are free will likely have no more than two categories with scores over 2. But many countries score 3-5 in eight or more categories. What does this mean?

Looking at intermediate behavior Behavior of those in the middle are interesting. –Are there institutions that come before others? That would require causality testing, beyond our scope. –One way to be sure our results aren’t sensitive to outliers. So we look here at the 72 countries that Heritage classifies as “mostly unfree”

What’s consistent about these countries? Regardless of how these countries scored otherwise, none scored “free or mostly free” in property rights or regulation.

What’s inconsistent? Here are two measures all over the map. Odd to see that monetary policy looks pretty good for mostly unfree countries!

Here are four others

What does that tell us? Countries that are mostly unfree seem to have three freedoms lacking: –Property rights –Regulation –Maybe informal markets Seem to have no strong pattern anywhere else. Unsurprisingly, those three freedoms appear to correlate well to growth, and to each other.

How many categories make you free? Although it is not possible at this stage of academic research to know with a high degree of certainty which factors are more important than others for economic freedom, it is clear that, for a country to achieve long-term growth and economic wellbeing,it must perform well in all 10 factors. (Index of Economic Freedom 2001)

Not all things effect living standards

What matters with property rights?

Property rights, trade and informal markets

Second half of critique Is the relationship continuous or discontinuous? –Is a certain amount of freedom needed to create growth? –What does it mean to be “mostly unfree”? Or “partly free”?

Does it look continuous? Or is there a threshold?

A precursor, not an indicator But this isn’t what the Index is meant for. –“The Index is not designed to measure the proportionate contribution of a set of statistically independent variables to economic growth. … Rather, the authors of the Index identify a set of institutional factors that, taken together, determine the degree of economic freedom in a society. It is this institutional environment that is viewed as necessary for economic growth in the first place. (Index of Economic Freedom 2001)

Regressions of steps on growth

Do we really need a whole index? What may work for living standards is much less. If you code a dichotomous variable 0 if property rights are a 4 or 5 on the score and 1 if 1, 2, or 3, you get log(GDPPPP) = *recoded property rights R² = 0.33

Taking Heritage seriously Should we skip the notion of estimating the effect of freedom on living standards? If there’s a threshold for freedom, we currently aren’t measuring it very well. –We are working on some techniques to get at the threshold question. We also want to know about causal links within the index. –Do we have enough time periods? Perhaps

Taking measuring freedom seriously Aggregation and cardinality are problems. Is freedom a means to an end or an end in itself? –How would you measure freedom’s value without reference to output or happiness? Proxies for freedom –Determinants vs. expressions