Commentary

Economic Freedom Is on the Rise

When Ronald Reagan and Margaret Thatcher came to power in the U.S. and the U.K. respectively, Soviet central planning was widely admired and thought to be highly successful. Ten years later, when the Reagan-Thatcher era closed, things were very different. Totalitarian socialism in the East was collapsing and democratic socialism in the West was showing signs of strain in the form of slow economic growth and high unemployment. Meanwhile, the economies of the U.S. and U.K. were stronger and more vibrant than ever.

Did the Reagan-Thatcher revolution exert a lasting impact? Has there been a shift toward economic liberalism and away from government intervention during the last two decades? The new Economic Freedom of the World: 2004 Annual Report (EFW) indicates that the answer to both of those questions is: Yes.

The EFW index measures the degree to which countries protect private property, allow freedom of exchange, control the size of government, keep taxes low, and generally let markets work. The index can be used to track the path of economic reform around the world over time. Overall, the index shows that economic freedom is on the rise. In 2002, the average rating for the 104 countries with complete data since 1980 was 6.5 (out of 10), up from 5.1 in 1980.

When looking at the component parts of the index, it’s easy to see why the overall trend is upward. During the last two decades, many countries have followed a more stable monetary policy, cut marginal tax rates, reduced tariffs, liberalized or eliminated exchange rate controls, and expanded trade. Consider the following:

  • In 2002, only 15 of these 104 countries had double-digit inflation rates compared to 76 in 1980.
  • The use of extremely high marginal tax rates fell sharply. In 2002, not a single country imposed a 60 percent marginal tax rate on personal income; in 1980, 49 did.
  • Exchange rate controls were liberalized substantially. In 2002, there were only four countries with a black-market exchange rate premium of 25 percent or more compared to 36 countries with such a premium in 1980.
  • Tariff rates were reduced. In 2002, the average tariff rate was 10.4 percent compared to 26.1 percent in 1980.
  • The size of the trade sector expanded. Between 1980 and 2002, on average, exports plus imports as a share of GDP increased by 25.2 percent.

Many countries have seen marked improvements in their economic freedom ratings.

  • Chile’s rating improved from 3.6 in 1975 to 5.8 in 1985 and 7.5 in 1995.
  • China’s rating rose from 3.8 in 1980 to 4.3 in 1990 and 5.8 in 2000.
  • India’s rating has improved substantially since 1990. After stagnating between 4.1 and 4.9 throughout the 1970-1990 period, India’s rating rose to 5.5 in 1995, 6.2 in 2000 and 6.3 in 2002.
  • Ireland’s rating jumped between 1985 and 1995. It rose from 6.2 in 1985 to 7.0 in 1990 and 8.2 in 1995 though, during the last few years, Ireland’s rating has receded slightly to 7.8 in 2002.
  • United Kingdom was a big gainer during the Thatcher years when its rating rose from 6.1 in 1980 to 7.0 in 1985, 7.7 in 1990, and 8.2 in 1995, where it has remained during the last several years.
  • Substantial increases in economic freedom have also been achieved by several other countries, including Botswana, up to 7.4 in 2002; Ghana, 6.4; Mauritius, 7.2; and New Zealand, 8.2.

This is quite a geographically and economically diverse group. It contains the world’s two most populous countries, India and China. It includes some of the world’s poorest economies, as well as some that are relatively rich.

Contrary to the conventional wisdom when Reagan and Thatcher were elected, economic freedom improves performance. Countries with more economic freedom during 1980-2000 attracted more investment, grew more rapidly, and achieved higher levels of income. Countries with EFW ratings of more than seven during 1980-2000 grew at an annual rate of 2.8 percent during the last two decades, compared to 1.4 percent for countries with ratings between five and seven and 0.1 percent for those with ratings of less than five.

While these figures show only the simple relationship, more detailed analysis indicates that similar differentials exist even after the effects of cross-country differences in initial income level, education, tropical location, and percentage of the population residing near an ocean coastline are taken into account. Moreover, the relationship between economic freedom and growth is even stronger for less-developed countries than for those with high incomes.

The Reagan-Thatcher policies played a key role in the liberation of the former centrally planned economies from the grip of Soviet domination. During the last decade, many of these economies made substantial moves toward economic liberalization. These include Estonia, Latvia, Lithuania, Hungary, the Czech Republic, Poland, and the Slovak Republic. While Bulgaria, Romania, Russia, and Ukraine lag behind the countries listed above, they too are showing some signs of movement toward economic freedom.

The world has changed mightily since the first days of Reagan and Thatcher. Their confidence in free economies has been proven correct. Broader recognition of that point will mean an even brighter future.

Economists Robert Lawson and James Gwartney are co-authors of the Economic Freedom of the World: 2004 Annual Report (2004), jointly published by the Fraser Institute and the Cato Institute.