Friday, December 10, 2010

The Index of Economic Freedom

            For the past fifteen years, The Heritage Foundation and the Wall Street Journal have computed the Index of Economic Freedom. This index measures and ranks the economic freedom of countries around the world. It does so by measuring 10 broad economic factors:
  1. Business Freedom
  2. Trade Freedom
  3. Monetary Freedom
  4. Government Size
  5. Fiscal Freedom
  6. Property Rights
  7. Investment Freedom
  8. Financial Freedom
  9. Freedom from Corruption
  10. and Labor Freedom
Each of these factors are weighted equally and measured on a 0-100 scale where 0 represent no freedom and 100 represents absolute freedom.

The Benefits Economic Freedom
            The main assumption in the index is that economic freedom is a positive cultural and societal influence. It is geared towards the idea that the ideal economy to be a capitalistic system. Honorable Elaine L. Chao, 24th United States Secretary of Labor, said of economic freedom:
“History has proven that trade freedom is the best economic strategy for all of the world’s peoples. History has also shown that we are prone to ignore history.
Since 1979, the value of world exports has risen by an average of 7.1 percent annually. During that same period, world income has skyrocketed. Gross domestic product (GDP) for the world as a whole, measured in constant 2000 U.S. dollars, has risen from $17.5 trillion in 1979 to $40.3 trillion in 2008. Even on a per capita basis, GDP growth has been impressive, jumping from $4,002 to $6,023...
Few would doubt the relationship between increased trade flows and the rapid worldwide economic growth at the end of the 20th century…”
(Terry Miller and Kim R. Holmes. 2010 Index of Economic Freedom. New York: Wall Street Journal, 2010. PG 13.)

While it is true that most would agree that economic freedom is good, individuals such as Jeffrey Sachs, an American economist and Director of the Earth Institute at Columbia University, contest that economic openness... in his book The End of Poverty in which Sachs' argues that poor countries are stuck in poverty which there is no escape except by significant contributions of foreign aid. 
Although the benefits of economic freedom could be contended it is said by one of his students that Sachs admitted that “the path to long-term development would only be achieved through private sector involvement and free market solutions". Although the degree to which economic freedom provides utility may be disputed, it is a general consensus that economic freedom is a good thing and an economical beneficial system.

The Factors of the Index

The ten factors that constitute the Index of Economic Freedom are defined as follows (as is described by the organization itself):

Business Freedom
Business freedom is a quantitative measure of the ability to start, operate, and close a business that represents the overall burden of regulation as well as the efficiency of government in the regulatory process. The business freedom score for each country is a number between 0 and 100, with 100 equaling the freest business environment. The score is based on 10 factors, all weighted equally, using data from the World Bank’s Doing Business study… Each of these raw factors is converted to a scale of 0 to 100, after which the average of the converted values is computed.

Trade Freedom
Trade freedom is a composite measure of the absence of tariff and non-tariff barriers that affect imports and exports of goods and services. The trade freedom score is based on two inputs: The trade-weighted average tariff rate and Non-tariff barriers (NTBs).
Different imports entering a country can, and often do, face different tariffs. The weighted average tariff uses weights for each tariff based on the share of imports for each good. Weighted average tariffs are a purely quantitative measure and account for the basic calculation of the score using the following equation:

Fiscal Freedom
Fiscal freedom is a measure of the tax burden imposed by government. It includes both the direct tax burden in terms of the top tax rates on individual and corporate incomes and the overall amount of tax revenue as a percentage of GDP. Thus, the fiscal freedom component is composed of three quantitative factors: The top tax rate on individual income, The top tax rate on corporate income, and Total tax revenue as a percentage of GDP.
In scoring the fiscal freedom component, each of these numerical variables is weighted equally as one-third of the factor.

Government Spending
 No attempt has been made to identify an ideal level of government expenditures. The ideal level will vary from country to country, depending on factors ranging from culture to geography to level of development. The methodology treats zero government spending as the benchmark, and underdeveloped countries with little government capacity may receive artificially high scores as a result. However, such governments, which can provide few if any public goods, will be penalized by lower scores on some of the other components of economic freedom (such as property rights and financial freedom).
The scale for scoring government spending is non-linear, which means that government spending that is close to zero is lightly penalized, while levels of government spending that exceed 30 percent of GDP receive much worse scores in a quadratic fashion (e.g., doubling spending yields four times less freedom), so that only really large governments receive very low scores.

Monetary Freedom
Monetary freedom combines a measure of price stability with an assessment of price controls. Both inflation and price controls distort market activity. Price stability without microeconomic intervention is the ideal state for the free market. The score for the monetary freedom factor is based on two factors: The weighted average inflation rate for the most recent three years and price controls.

Investment Freedom
 In an economically free country, there would be no constraints on the flow of investment capital. Individuals and firms would be allowed to move their resources into and out of specific activities both internally and across the country’s borders without restriction. Such an ideal country would receive a score of 100 on the investment freedom component of the Index of Economic Freedom.

Financial Freedom
 Financial freedom is a measure of banking security as well as a measure of independence from government control. State ownership of banks and other financial institutions such as insurers and capital markets reduces competition and generally lowers the level of available services.
The Index scores this component by determining the extent of government regulation of financial services; the extent of state intervention in banks and other financial services; the difficulty of opening and operating financial services firms (for both domestic and foreign individuals); and government influence on the allocation of credit. This analysis is used to develop a description of the country’s financial climate and assign an overall score on a scale of 0 to 100 through a comparison of standards.

Property Freedom
The property rights component is an assessment of the ability of individuals to accumulate private property, secured by clear laws that are fully enforced by the state. It measures the degree to which a country’s laws protect private property rights and the degree to which its government enforces those laws. It also assesses the likelihood that private property will be expropriated and analyzes the independence of the judiciary, the existence of corruption within the judiciary, and the ability of individuals and businesses to enforce contracts. The more certain the legal protection of property, the higher a country’s score; similarly, the greater the chances of government expropriation of property, the lower a country’s score.

Freedom from Corruption
Corruption erodes economic freedom by introducing insecurity and uncertainty into economic relationships. The score for this component is derived primarily from Transparency International's Corruption Perceptions Index (CPI) for 2008, which measures the level of corruption in 180 countries.
The CPI is based on a 10-point scale in which a score of 10 indicates very little corruption and a score of 0 indicates a very corrupt government. In scoring freedom from corruption, the Index converts the raw CPI data to a scale of 0 to 100 by multiplying the CPI score by 10
For countries that are not covered in the CPI, the freedom from corruption score is determined by using the qualitative information from internationally recognized and reliable sources. This procedure considers the extent to which corruption prevails in a country.

Labor Freedom
The labor freedom component is a quantitative measure that looks into various aspects of the legal and regulatory framework of a country's labor market. It provides cross-country data on regulations concerning minimum wages; laws inhibiting layoffs; severance requirements; and measurable regulatory burdens on hiring, hours, and so on.
Six quantitative factors are equally weighted, with each counted as one-sixth of the labor freedom component: Ratio of minimum wage to the average value added per worker, Hindrance to hiring additional workers, Rigidity of hours, Difficulty of firing redundant employees, Legally mandated notice period, and Mandatory severance pay.

Average Score Out of 179 Countries
Overall Freedom
     Business Freedom
     Trade Freedom
     Fiscal Freedom
     Government Freedom
     Monetary Freedom
     Investment Freedom
     Financial Freedom
     Property Rights
     Freedom from Corruption
     Labor Freedom

The Results
            Overall, there are 179 countries measure and ranked.  For a full list of rankings and score please see the full list on their website at Here I will only list the top ten economically free countries, as well as a few other countries of personal interest to me. Folloing is the map of economic freedom published by the society as well as the top ten free economic nation for the 2010 study:

(Click to Enlarge)

Top 10 Countries of 2010
(Click to enlarge)
It is interesting to note that Hong Kong is, and has been, the top leader in Economic Freedom since the study was inarguated in 1995.  Looking at Hong Kong, it is inescapable to juxtapose it with China, which is ranked 140th (see Countries of Interest Table). Hong Kong has been extremely economically stable and productive. In 2009, Hong Kong netted 2.3 trillion dollars in initial public offering (IPO), which constitutes 22 percent of the entirety of worldwide initial public offerings (whereas Hong Kong only constitutes .13 percent of the population)
 This makes Hong Kong the largest IPO contributer of the world. The comparison between Hong Kong and mainland China is an excellent example of the benefits of laissez-faire capitalism. In comparison, the People's Republic of China is significantly less economically prosperous (Hong Kong GDP PPP - $42,653, Peoples Republic of China - GDP PPP - $6,778), China's efforts to integrate the best practices of private industry. 

In the top ten there are some large(relative) jumps in percentages. Hong Kong is a full 3.6 percent higher than Singapore, which in turn is 3.5 percent higher than the next highest country Australia making Hong Kong a full 8.4 percent higher than the third place Australia. The other big jump in the top ten is the 2.4 percent jump from position seven Canada and position eight the United States of America. 

Another interesting point to examine are the progress of the countries economic freedom from the previous years. This following year there were a two significant changes in the top ten free countries of 2010. The first and largest is the United States with one of the largest changes in the index this year with a decease of 2.7 percent. As can be seen in the graph below the United states has stayed for the most part stable on the high end of the chart but for the last four years the United States has been slowly decreasing in economic freedom with this year being the largest jump yet. The other significant change this year is Denmark (not shown in below graph) which decreased 1.7 percent. Denmark has only recently made it to this hight of economic freedom. In the early 2000's Denmark was scoring in the high 60's but last year scored a rounded 80 and has unfortunately decreased significantly this year.

  Examining the long term change shows interesting trend especially in a few of the below countries. Canada in particular has a very impressive increase in economic freedom showing relatively low rates in the mid 1990's but pulling out and ending up on a very impressive slope leading to where it is now. Also very impressive is Australia, New Zealand who shows persistent increase over time even when they have impressive above average scores. Mexico shows very rapid progress over the past few years. Somewhat troubling are the graphs for the United States and the United Kingdom who both had slow progress cumulating in 2006 but since has declined steadily for the past four year with this year being the most significant decrease. This could be attributed to the effects and measures taken during and after the financial crisis of 2007. 

Countries of Interest
Following are some countries' statistics of economic freedom that might be on interest to others, for a full list of rankings and score please see the full list on their website at . 

Economic freedom is the road to freedom and prosperity. As we continue to seek to promote personal freedom we help each other to create quality affordable products to aid us in our everyday lifestyle. We help progress technology by promoting worthwhile products and ideas. As we petition for greater economic freedom we can hope to see a better world for us and for our children.  

UPDATE 20011
Top Ten of 2011
1  - Hong Kong    (previously #1, 0.0)
2  - Singapore      (previously #2,    +1.1)
3  - Australia        (previously #3,     -0.1)
4  - New Zealand (previously #4,    +0.2)
5  - Switzerland    (previously #6,    +0.8)
6  - Canada          (previously #7,     +0.4)
7  - Ireland           (previously #5,     -2.6)
8  - Denmark        (previously #9,    +0.7)
9  - United States  (previously #8,     -0.2)
10- Bahrain          (previously #>10, +1.4)

We see that Ireland took a dive(-2.6) giving place for a steadily increasing Switzerland(+0.8) and Canada(+.04). It is cited that "its score has decreased... particularly for government spending and financial freedom...". America has also dropped a slot from last year with a net lost of 0.2 allowing denmark to take its place. Bahrain makes it into the top ten displacing Chile to the 11th position which actually increased by 0.2 from last year. Bahrain is the leader in economic freedom in the Middle East/Northern Africa area.

 The overall trend mentioned in the comparative graph above remains generally true: Canada and New Zealand(+0.2) has continued  to increase. Australia had a slight decline (-0.1) which may be ominous as the score seems to have somewhat platoued over the past several years hopefully it has not topped out. Both the United States and the United Kingdom continue their descent downward. The United Kingdom dropped 2 full points this past year due mainly to Government Spending and Fiscal Freedom.


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