Measures of Economic Freedom King Banaian and William LuksetichSt. 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: http://www.heritage.org/research/features/index/

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. Freedom 1.00

Trade 0.69 1.00

Fiscal 0.21 0.14 1.00

Gov't inter. 0.43 0.19 -0.01 1.00

Mon. pol. 0.53 0.22 -0.03 0.07 1.00

For. Inv. 0.78 0.46 0.04 0.33 0.32 1.00

Banking 0.79 0.46 0.17 0.46 0.33 0.66 1.00

Wage/price 0.72 0.40 -0.02 0.38 0.38 0.61 0.61 1.00

Property rights 0.86 0.60 0.07 0.24 0.34 0.63 0.58 0.56 1.00

Regulation 0.82 0.50 0.14 0.23 0.34 0.60 0.57 0.56 0.81 1.00

Informal mkts 0.85 0.60 0.14 0.19 0.36 0.60 0.56 0.51 0.86 0.75 1.00

Overall Trade Fiscal Gov't inter.Mon. pol. For. Inv. Banking

Wage/price

Property rights

Regulation

Informal mkts

Principal components of Heritage Economic Freedom Index

Variable Factor 1 Factor 2 Factor 3 Factor 4 Trade -0.762 -0.087 -0.121 -0.037 Fiscal -0.087 -0.988 -0.000 -0.022 Government Intervention -0.056 0.026 -0.907 -0.080 Monetary Policy -0.185 0.016 -0.048 0.942 Foreign Investment -0.620 0.013 -0.468 0.250 Banking & Finance -0.506 -0.183 -0.628 0.263 Wage/Price Control -0.480 0.099 -0.542 0.383 Property Rights -0.904 0.018 -0.170 0.164 Regulation -0.818 -0.073 -0.191 0.221 Informal Markets -0.885 -0.071 -0.109 0.193 Eigenvalues 4.9556 1.1356 1.0168 0.80376 Cumulative% 0.496 0.609 0.711 0.791

Sorted index of economic freedom

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

1 15 29 43 57 71 85 99 113 127 141

Ind

ex (

1-5)

Note the pattern: A large group “in the middle”

Nobody’s perfect

How free is free?

2624

21

1619 20

11

47 6

0 00

5

10

15

20

25

30

0 1 2 3 4 5 6 7 8 9 10M

ore

Number of times scored 1 or 2

Fre

qu

en

cy

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

How unfree is unfree?

3

8 7

15

69

18

25

13

32

18

00

5

10

15

20

25

30

35

0 1 2 3 4 5 6 7 8 9 10

Mor

e

Number of times score 3, 4, 5

Fre

qu

ency

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?

Property Rights

0 0

21

46

5 00

20

40

60

1 2 3 4 5 More

Score

Freq

uenc

y

Regulation

0 013

52

70

0

20

40

60

1 2 3 4 5 More

Score

Freq

uenc

y

Regardless of how these countries scored otherwise, none scored “free or mostly free” in property rights or regulation.

What’s inconsistent?

Monetary Policy

25

1519

7 60

0

10

20

30

1 2 3 4 5 More

Score

Freq

uenc

y

Government Intervention

1

4

1412

14

1113

3

0 00

5

10

15

11.

5 22.

5 33.

5 44.

5 5M

ore

Score

Fre

qu

ency

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

Fiscal Policy

9

02468

10

Count

Freq

uenc

y

Wage/Price Controls

0

15

54

3 0 00

20

40

60

1 2 3 4 5 More

Count

Freq

uenc

yBanking and Finance

0

14

3025

2 00

10

20

30

40

1 2 3 4 5 More

Count

Fre

qu

ency

Informal Markets

3

13

33

7

16

00

10

20

30

40

3 3.5 4 4.5 5 More

Count

Fre

qu

ency

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

Component Coefficient std. error R2

Overall score 1.757 0.139 0.51Trade 0.839 0.099 0.32Fiscal policy 0.304 0.182 0.01Government Intervention 0.212 0.153 0.01Monetary Policy 0.437 0.102 0.10Foreign Investment 0.901 0.129 0.24Banking & Finance 0.672 0.116 0.18Wage and price controls 0.855 0.170 0.14Property Rights 1.059 0.076 0.56Regulation 1.326 0.112 0.48Informal Markets 1.139 0.068 0.65

Bold indicates significance at 1% level. Italics indicates signficance at 5% level.Results are simple regressions of per capita GDP on each measure.No controls are used, 153 countries in sample.

Table 2. Living Standards and Aspects of Economic FreedomDependent variable is log of per capita GDP (1990 international dollars)

What matters with property rights?

Coefficient Property Rights std. error R2

Property rights alone 1.0591 1.2466 0.5613.96

Trade 0.27068 0.90266 1.193 0.582.789 9.706

Fiscal policy 0.18752 1.051 1.2352 0.561.546 13.89

Government Intervention -0.13259 1.0825 1.2416 0.561.268 13.89

Monetary Policy 0.11678 1.0171 1.235 0.561.555 12.69

Foreign Investment 0.05735 1.0311 1.2532 0.560.452 10.51

Banking & Finance -0.02132 1.0702 1.2546 0.560.205 11.44

Wage and price controls -0.14037 1.1081 1.2473 0.560.956 12.1

Regulation 0.4679 0.77889 1.1964 0.582.708 6.114

Informal Markets 0.85888 0.3255 0.9739 0.666.58 2.502

Table 4. Property Rights Plus Other Measurements

Property rights, trade and informal markets

Property Rights 0.86359 0.27415 0.319298.996 2.073 2.447

Trade 0.26797 0.160382.773 1.805

Monetary Policy 0.11306 0.053881.539 0.8798

Informal Markets 0.8105 0.843486.126 6.385

Standard error 1.1823 0.9594 0.9762R² 0.58 0.66 0.66

Table 5. Property Rights, Trade and Other Elements of Freedom

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

Component Value is 2 Value is 3 Value is 4 Value is 5 std. Error R2 Trade 0.59155 0.54819 2.6545 3.5337 1.3181 0.39 1.939 1.689 8.657 3.681 Monetary Policy -0.39291 0.31394 0.72469 1.3764 1.5998 0.10 0.574 0.569 1.332 2.759 Foreign Investment -0.35198 0.24625 1.5536 2.6991 1.449 0.26 0.503 0.367 2.254 3.454 Banking & Finance -0.05617 0.55104 1.064 2.7566 1.504 0.20 0.103 1.061 2.019 4.547 Wage and price controls -0.71107 -0.99381 0.73973 2.5339 1.4656 0.24 0.84 1.317 0.9818 1.546 Property Rights 0.07594 0.88584 2.6703 3.5076 1.1553 0.59 0.2145 2.439 6.343 9.019 Regulation 0.30979 2.3052 3.2266 4.0034 1.3756 0.52 0.871 6.35 7.558 5.329

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) = 1.94 + 6.63*recoded property rightsR² = 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