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Wednesday, November 24, 2010

The Decline in Economic Freedom

In the early 1980s, both the United States and the United Kingdom reduced marginal tax rates, brought inflation under control, and relaxed both regulations and trade barriers. Many other countries soon followed, and the result was a quarter-century of expansion in both economic freedom and the growth of income. These movements can be observed in the data of the just-released Economic Freedom of the World 2010 Annual Report available at

The Economic Freedom of the World (EFW) index measures the consistency of a nation’s institutions and policies with economic freedom. Put simply, institutions and policies are consistent with economic freedom when they permit individuals to choose for themselves, enter into voluntary agreements with others, and protect individuals and their property from aggressors.

To achieve a high EFW rating on our zero-to-ten scale, a country must provide secure protection of privately owned property, evenhanded enforcement of contracts, and a stable monetary environment. It also must keep taxes low, refrain from creating barriers to both domestic and international trade, and rely more fully on markets than the political process to allocate goods and resources.

From 1980 to 2007, there was a gradual but steady movement toward economic freedom. (The graph includes only the countries that have been in the index since 1980.) However, as the world confronted financial instability and economic decline in 2008, the average economic freedom rating fell for the first time in several decades. Of the 123 countries with ratings in 2007 and 2008, 88 (71.5 percent) exhibited rating decreases and only 35 (28.5 percent) recorded rating increases.

The rating of the United States is down from 8.45 in 2000 to 7.93 in 2008, which has sent the accompanying ranking down to sixth from third in 2000. The rating reduction in the United States was primarily the result of lower ratings in the area of “Legal Structure and Security of Property Rights,” but the huge recent increase in government borrowing was also a contributing factor. The increased government expenditures, larger deficits, and increased regulations of the past two years are sure to push the U.S. economic freedom rating even lower in the years immediately ahead.

We now know more about the sources of growth and prosperity than ever before. Economic growth is primarily the result of gains from trade, capital investment, and the discovery of improved products, lower-cost production methods, and better ways of doing things. Numerous studies have shown that countries with more economic freedom grow more rapidly and achieve higher levels of per capita income than those that are less free. Similarly, there is a positive relationship between changes in economic freedom and the growth of per capita income. Moreover, as per capita income has grown, the world’s poverty rate has declined, and most of this progress has occurred in countries that have made substantial moves toward higher levels of economic freedom.

Dangerous Trends

Given how governments around the world have responded to the financial crisis, earlier positive trends are in danger of slowing or even reversing. The world now faces a situation similar to that of the Great Depression. During the 1930s, perverse economic policies transformed a cyclical downturn into a decade of hardship and suffering. The length and severity of the Great Depressionwere the result of a sharp monetary contraction, imposition of trade restrictions, higher taxes, increases in government spending financed with debt, Institutions and policies are economically free when they permit individuals to choose for themselves, enter into voluntary agreements with others, and protect individuals and property from aggressors.price controls, and uncertainty created by constant policy changes that were supposed to hasten the end of the crisis. This is ironic since perverse policies caused the Great Depression in the first place.

While the current economic downturn is far less severe than the Great Depression, both the fundamental cause and the policy responses are similar. In the United States, perverse credit expansion and regulatory policies were the primary cause of the current crisis. Seeking to promote more affordable housing, politicians expanded the availability of credit and imposed regulations that contaminated the quality of mortgages (including loans with little or no down payment, excessively large loans relative to income, and loans to unqualified borrowers with poor credit histories).

The result: an unsustainable housing price boom followed by the bust and eventually increases in the default and foreclosure rates as heavily indebted borrowers were unable to make the payments on the loans the regulators had arranged for them. The downturn in the housing industry soon spread to other sectors as the contaminated, mortgage-backed securities were marketed throughout the world, leading to a financial crisis.

Undermining Incentives

The policy response to the crisis has also been similar to that of the Great Depression: more regulation, growth of government spending financed by debt, and constant policy changes that have created uncertainty and undermined private-sector activity. This is unfortunate because there is a dramatic difference in the incentive for productive action between a market economy and one managed by the political process. With markets, profits and losses will direct people toward productive actions and away from unproductive and counterproductive ones. If a business is going to succeed in a market economy, it must bid resources away from others and use them to supply goods that people value enough to pay prices sufficient to cover their costs. Profits and losses also provide people with a strong incentive to innovate and discover production methods with lower costs and new products that people value highly relative to cost. This incentive to use resources productively and discover better ways of doing things is the driving force underlying economic growth and progress.

The incentive structure of the political process is vastly different. There is nothing comparable to profits and losses that will consistently direct resources into productive projects and away from those that are counterproductive. Politicians will allocate resources toward the politically powerful—those who can provide them with the most votes, campaign funds, high-paying jobs for political allies and, yes, even bribes. There is no reason to expect that this incentive structure will channel resources into productive projects and away from counterproductive ones. Innovators and entrepreneurs will be disadvantaged by this system because it will not be enough to make products that consumers value highly relative to cost; one will also have to compete for political favoritism and cater to the views of the political class. The result: More resources will be used to obtain political favors—economists call this rent-seeking—and fewer channeled into productive activities.

Market Entrepreneurs vs. Crony Capitalists

It is important to distinguish between market entrepreneurs and crony capitalists. Market entrepreneurs succeed by providing customers with better products, more reliable service, and lower prices than are available elsewhere. They succeed by Rather than create wealth, crony capitalists form a coalition with political officials.creating wealth—by producing goods and services that are worth more than the value of the resources required for their production. Crony capitalists are different: They get ahead through subsidies, special tax breaks, regulatory favors, and other forms of political favoritism. Rather than providing consumers with better products at attractive prices, crony capitalists form an alliance with politicians. The crony capitalists provide the politicians with contributions, other political resources, and, in some cases, bribes in exchange for subsidies and regulations that give them an advantage relative to other firms. Rather than create wealth, crony capitalists form a coalition with political officials to plunder wealth from taxpayers and other citizens.

We are now in the midst of a great debate between the proponents of limited government and open markets on the one hand and those favoring more collectivism and political direction of the economy on the other. The outcome of this debate will determine the future of both economic freedom and the prosperity of Americans and others throughout the world.

  • Joshua Hall is an associate professor of economics and Co-Director of the Center for Free Enterprise in the College of Business and Economics at West Virginia University. 

  • Robert Lawson is the Jerome M. Fullinwider Endowed Centennial Chair in Economic Freedom in the O’Neil Center for Global Markets and Freedom. He is a member of FEE Board of Scholars.