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World Economy

The Foundation has encouraged the rigorous study of the levels of economic freedom prevalent in many countries around the world and has supported the development of the Historical Index of Economic Freedom (HIEL) developed by Professor Leandro Prados de la Escosura. This space collects the results for X countries in this Index and offers useful instruments of analysis for teachers, researchers and people interested in the comparative study of the levels of economic freedom and its components in the world, as editors of the series and systems of comparison and presentation of data.

Economic liberty is a ‘negative’ freedom, defined as a lack of interference or coercion by others on an individual’s economic decisions. Personal choice, voluntary exchanges, access to markets, and protection of persons and their property from aggressions are its constitutive elements.

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A country can be considered economically free in so far people and privately owned property are securely protected, contracts enforced, prices stable, barriers to trade small, and resources mainly allocated through the market. Assessing the consistency of a nation’s institutions and policies with these requisites is the purpose of any index of economic freedom.

Four main dimensions of economic freedom are distinguished: legal system and property rights, sound money, international openness, and regulation.

For each dimension of economic freedom an index, consistent over space and time, is computed on the basis of different indicators.

When the indicator’s value is inversely related to the degree of economic freedom, it has been transformed into index form using the expression

Iij = 10*(VMAXVij) /(VMAXVMIN)

Where Vij represents the value of country i indicator at year j and VMAX and VMIN, its maximum and minimum values

Alternatively, when the value of the indicator is directly related to the value of economic freedom, it is the following expression the one used,

Iij = 10*(VIJVMIN) /(VMAXVMIN)

Thus, in either case, the resulting index of economic freedom ranges between 0 (minimum) and 10 (maximum).

The period considered is that of the spread of modern capitalism, namely, the epoch covering from the emergence of free trade and laissez faire in the mid-nineteenth century to the present.

Legal System and Property Rights

The rule of law, security of property rights, judicial independence, and impartial courts are major components of a legal structure consistent with economic liberty. Indicators have been chosen for the following dimensions:

  • Judicial independence
  • Impartial courts
  • Integrity of the legal system
  • Contract Enforcement

An aggregate index has been obtained as the unweighted arithmetic average of these four sub-indices.

Sound Money

The main contribution of a monetary system to protect economic freedom is to provide stable prices. Inflation erodes the value of property held in monetary instruments. Furthermore, high and volatile inflation rates distort relative prices and alter long-term contracts, making it difficult for individuals to plan for the future.

The measures chosen to assess the consistency of monetary policy and institutions with long-term price stability are:

  • Inflation rate
  • Standard deviation of inflation as a measure of volatility
  • Differential money growth –the difference between the average annual growth of the money supply in the last five years and the average annual growth of real GDP in the last ten years–. Its rationale is that high rates of monetary growth lead to inflation.

An aggregate index has been derived as the unweighted arithmetic average of these three sub-indices.

International Openness

Free trade represents a key dimension of economic liberty as it provides individuals with the widest possible choice of goods and services and facilitates specialisation along comparative advantage. By not interfering with the freedom to enter and compete in international factor and commodity markets, governments promote economic freedom.

In order to assess economic freedom in international trade a variety of restraints need to be considered including tariffs, the exchange rate, and capital controls. Three indicators have been used:

  • Tariffs. Weighted nominal protection measured as the ratio of total tariff revenue to the value of total exports and imports.
  • Factor Mobility. It is the average of indices for capital and labour mobility
  • Black Market Premium measured as the difference in logs between the official and the parallel (black market) exchange rate (from 1946 onwards).

An aggregate index has been obtained as the unweighted arithmetic average of the three sub-indices.

Regulation

Regulation of economic activities can restrict market freedom of entry by interfering with individuals’ decision to engage in voluntary exchange. Three types of regulation have been distinguished.

Credit market regulation

It is composed of two indicators,

  1. Interest rate control approximated by real short-term interest rates (that, is the nominal short-term interest rate less inflation).
  2. Private Sector Credit proxied by the government fiscal deficit as a proportion of GDP.

A sub-index of credit market regulation has been obtained as the unweighted arithmetic average of these two indices.

Labour market regulation

Laws and regulations affecting wages and working conditions may restrict negative economic liberty by constraining labour market flexibility. Three indicators have been chosen:

  1. Freedom of domestic movement.
  2. Freedom from forced labour.
  3. Employment protection legislation (EPL), an index that proxies the regulation in the labour market in the post-1950 era.

And its unweighted arithmetic average provides the sub-index of labour regulation.

Business regulation

  • Impartial public administration

An aggregate index has been derived as an unweighted arithmetic average of the three sub-indices.

Table 1: Dimensions of the Historical Index of Economic Liberty (HIEL) and their Components
Legal System and Property Rights Sound  Money International Openness Regulation
Judicial Independence Inflation Rate Weighted Nominal Protection Credit Market Regulation
Impartial Courts Inflation Variability International Factor Mobility Labour Market Regulation
Integrity of the Legal System Differential Money Growth Black Market Premium (post-1950) Business Regulation
Contract Enforcement      

An Aggregate Index of Economic Liberty

Then, the indices for each dimension (namely, property rights, money, international trade, and regulation) are combined as an unweighted average into a historical index of economic liberty (HIEL), which ranges between 0 and 10.

Thus,

HIEL = (IEL property rights + IEL money + IEL openness + IEL regulation) / 4

Alert: measuring changes in the index

By how much did economic liberty improve over the long run? Given the bounded nature of the index (it ranges from 0 to 10), the use of conventional procedures to summarize its evolution -say, the percentage change or the logarithmic rate of variation-, would be misleading as increases achieved at low levels cannot be matched at high levels. It is preferable, therefore, to consider the absolute shortfall of actual economic freedom from the upper bound (a value of 10) at the initial point in time and, then, computing the relative decline in the shortfall over a given period. Thus, the improvement achieved in economic liberty is measured as the proportion of the maximum possible.

This means that if in 1850/54 the initial gap with respect to the maximum potential level (10) was 3.48 points for the unweighted OECD average, and by 2016/20 it had been cut down to 1.36 points, the shortfall would have declined by 61 percent [(3.48-1.36)/3.48=0.611].

However, the shortfall reduction approach is not additive meaning that the percentage shortfall reductions over two periods, say, 1850-1914 and 1914-1950, does not amount to the shortfall reduction from 1850-1950.

References

Gwartney, J., R. Lawson, J. Hall, and R. Murphy (2022), Economic Freedom of the World: 2022 Annual Report, Vancouver: Fraser Institute.

Prados de la Escosura, L. (2023), Economic Freedom in Retrospect, EHES Working Paper 236

Prados de la Escosura, L. (2016), Economic Freedom in the Long Run: Evidence from OECD Countries (1850-2007), Economic History Review 69(2): 435-468.

* The Historical Index of Economic Liberty (HIEL) is inspired on the Fraser Institute’s Economic Freedom of the World Index (EFW) (Gwartney et al., 2022). The main departure from the EFW is the exclusion of “the size of government” as a component of the index. A detailed explanation of the sources and procedures used to construct the index can be consulted in this website. A discussion of the concept and earlier results are provided in Prados de la Escosura (2016).

External links

VOX EU: Economic freedom, 1850–2020: New evidence 

Historical Index Economic Liberty by Leandro Prados de la Escosura is licensed under CC BY 4.0

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