Commentary

Economic Freedom, Investment, and Prosperity

Economists know that the quality of political and economic institutions exerts a major effect on the growth and prosperity of nations. In general, we know that the greater the economic freedom, the greater the political freedom, and the greater the prosperity for all involved. The good news is that economic freedom can be measured.

The recently released “Economic Freedom of the World” report presents an economic freedom index, which uses 38 different components to rate 123 countries on a zero-to-ten basis. Government expenditures as a share of the economy, marginal tax rates, independence of the judiciary, tariff rates, non-tariff trade restraints, and price stability are among the components integrated into the index.

To get a high economic freedom rating, a country must rely primarily on voluntary exchange and markets rather than taxes and government spending to allocate goods and resources. It must also follow stable monetary policies, avoid regulations that limit entry into markets, and establish a legal regime that provides for the evenhanded enforcement of contracts and protection of property rights.

Hong Kong continues to rate as the world’s freest economy. But it is followed closely by Singapore, the United States, New Zealand, and the United Kingdom. Canada, Switzerland, Ireland, Australia, and the Netherlands round out the top 10. The rankings of other large economies include Germany, 20th; Japan, 26th ; Italy, 35th; France, 44th; Mexico, 69th; India, 73rd; Brazil, 81st; China, 100th and Russia, 112th. Myanmar, the Democratic Republic of Congo, and Zimbabwe are ranked the lowest among the 123 countries. However, a number of other nations for which data are not available, such as North Korea and Cuba, may have even less economic freedom.

African, Middle Eastern, Latin American, and former socialist countries dominate the bottom third of the rankings. There are, however, some interesting exceptions within these regions. Botswana (26th) is easily the highest ranked African country. Among the Middle Eastern countries, the United Arab Emirates, Oman, and Bahrain rate the highest. Chile (20th), El Salvador and Panama (tied for 23rd), and Costa Rica (tied for 26th) rank highest among the Latin American countries. Estonia at 16th stands out among the former centrally planned economies.

While the ratings and rankings during a given year are interesting, what matters is the maintenance of sound institutions and policies over an extended period of time. Economies that are persistently free will attract more investment and utilize their resources more efficiently. As a result, they will grow more rapidly and achieve higher levels of income. To investigate this proposition, we analyzed the economic freedom data for 1980-2000. The economic freedom ratings were continuously available (at five-year intervals) throughout these two decades for 99 countries. The investment rate of countries during 1980-2000 was closely linked with long-term economic freedom: Countries with more economic freedom attracted more investment. The investment rate of the top quintile of countries in terms of mean economic freedom ratings during 1980-2000 averaged 23.9 percent of GDP over the two decades, compared to 19.3 percent for the lowest rated quintile of countries.

The differences in terms of foreign direct investment are even more dramatic. For the top quintile, the annual foreign direct investment per worker averaged $2657 compared to $52 for the bottom quintile. Thus, the inflow of investment per worker into the freest quintile of economies was 50 times the figure for the least-free quintile.

Not only did the persistently free economies invest more, the productivity of their investment was higher. The productivity of investment in economies with an economic freedom rating of 7.0 or higher was 13.6 percent higher than for economies with economic freedom ratings of between 5.0 and 7.0, and 30 percent more than for those with mean economic freedom ratings of less than 5.0.

When both the impact on the level of investment and the productivity of resource-use are considered, our research indicates that a sustained one-unit increase in economic freedom enhances a country’s long-term annual growth of per capita GDP by between 1.0 and 1.5 percentage points. This indicates, for example, that countries like India and Poland with economic freedom ratings around 6.0 could increase their long-term annual growth by between 1.0 and 1.5 percentage points if they adopted policies that pushed their economic freedom rating up to 7.0, about the same level as Japan, Taiwan, and South Korea. Over a period of 20 or 25 years, increases in growth of this magnitude would exert a huge effect on income levels. Modern economic growth is primarily about investment and innovation, and economic freedom fuels both. Among the 26 countries with economic freedom ratings of less than 5.0 during 1980-2000, only Israel was able to achieve a 2000 per capita GDP of more than $10,000. In contrast, among the 15 countries with mean 1980-2000 economic freedom ratings of 7.0 or higher, only Taiwan had a 2000 per capita GDP of less than $20,000.

In the movie, “Field of Dreams,” a voice called out, “If you build it, he will come.” The same might be said of economic freedom. If a country builds institutions consistent with economic freedom, investors and entrepreneurs will come and economic growth will result. The sooner policymakers learn this lesson, the more prosperous the people of the world will be.

James Gwartney is professor of Economics at Florida State University and Robert Lawson is Professor of Economics and George H. Moor Chair at Capital University. They are co-authors of “Economic Freedom of the World,” an annual report published by a network of institutes in 58 countries, including the Cato Institute in the United States and the Fraser Institute in Canada.