This report is a continuation of an ongoing process designed to develop a comprehensive and accurate measure of economic freedom across countries. The roots of the project go back more than a decade. Motivated by a stimulating discussion concerning the differences between political freedom and economic freedom, Michael Walker, the Executive Director of the Fraser Institute, organized a series of symposia focusing on the measurement of economic freedom. Milton and Rose D. Friedman agreed to co-host the series with Michael Walker, and the Liberty Fund of Indianapolis, Indiana provided the necessary financial support. The series attracted some of the world’s most talented economists and challenged them to help develop a reliable measure of economic freedom. The participants included Nobel Prize winners, Milton Friedman, Gary Becker, and Douglass North; development economist Peter Bauer; Sweden’s Assar Lindbeck; and Sir Alan Walters. Alvin Rabushka of Stanford, Ronald Jones and Alan Stockman of the University of Rochester, Governor Ramon Diaz of the Central Bank of Uruguay, Steven Easton of Simon Fraser University, and Gerald Scully of the University of Texas at Dallas were among those presenting symposium papers that moved the process forward. [For those interested in the papers and a summary of the discussion from the Fraser Institute / Liberty Fund series, see Michael A. Walker, ed., Freedom, Democracy, and Economic Welfare, (Vancouver: Fraser Institute, 1988); Walter Block, ed., Economic Freedom: Toward a Theory of Measurement, (Vancouver: Fraser Institute, 1991); and Stephen T. Easton and Michael A. Walker, eds., Rating Global Economic Freedom, (Vancouver: Fraser Institute, 1992). For additional details on the historical background of the index, see Michael Walker ÒIntroduction: Historical Development of the Economic Freedom IndexÓ in Economic Freedom of the World: 1975-1995 (Vancouver: Fraser Institute, 1996).]

As the result of our participation in several of the conferences, we co-authored (with Walter Block), Economic Freedom of the World: 1975-1995. James Gwartney, Robert Lawson, and Walter Block, Economic Freedom of the World: 1975-1995 [(co-published by the Fraser Institute in Canada, Cato Institute in the United States, the Institute of Economic Affairs in England, and institutes in eight other countries, 1996).] Published in early 1996 by a consortium of 11 institutes from around the world, this book presented an index designed to identify the consistency of a nation’s institutions and policies with economic freedom. Following the publication of this book, Milton Friedman and Michael Walker hosted a conference in San Francisco that led to the formalization of the Economic Freedom Network, which had grown to a group of 47 institutes interested in the development of a quality index of economic freedom. The institutes that consituted the Network agreed to assist us in the updating of the index (with minor modifications) through 1995 and publish the results in our 1997 Annual Report. The Economic Freedom Network also plans to broaden the index and seeks to provide more detailed information on factors that influence economic freedom in subsequent annual reports.

THE CONCEPT OF ECONOMIC FREEDOM

Development of a sound measure of economic freedom requires one to clearly define the concept. The central elements of economic freedom are personal choice, freedom of exchange, and protection of private property. When economic freedom is present, individuals are free to make economic choices such as how to use their time and other resources, what goods to consume, and what business and investment alternatives to pursue. Of course, they will often find it advantageous to cooperate with others and markets will coordinate their choices and bring them into harmony.

The use of government—whether directed by a monarch or a democratic process—to decide what (and how) goods will be produced and who will consume them violates personal economic freedom. Other things constant, freer economies will rely more on markets and less on government to answer these basic economic questions. This is not to say that government has no role. Protection of property acquired without the use of force, fraud, or theft from physical invasions by others is also an integral element of economic freedom. [Of course, the most basic property right of individuals is the property right to their person. This protection of individuals from invasions by others is the central element of criminal law.] This protection generally involves a legal structure and other institutional arrangements (for example, monetary arrangements consistent with price stability) that enhance the operation of markets. Governments promote economic freedom when they provide these structures.

In an economically free society, the fundamental function of government is the protection of private property and the provision a stable infrastructure for a voluntary exchange system. When a government fails to protect private property, takes property itself without full compensation, or establishes restrictions (and follows policies) that limit voluntary exchange, it violates the economic freedom of its citizens. [See Ronald W. Jones and Alan C. Stockman. "On the Concept of Economic Freedom" in Stephen T. Easton and Michael A. Walker (ed.), Rating Global Economic Freedom, (Vancouver: The Fraser Institute, 1992) and Alvin Rabushka, "Preliminary Definition of Economic Freedom," in Economic Freedom: Toward a Theory of Measurement, ed. Walter Block, (Vancouver: The Fraser Institute, 1991), pp. 87-108. for additional background on the meaning of economic freedom and an analysis of how it might be measured.]

CONSTRUCTION OF THE INDEX

A sound measure of economic freedom will identify the extent to which individuals are free to choose for themselves and engage in voluntary transactions with others, and have their rightly acquired property protected from invasions by others. Like a compass, these criteria guided us as we developed the Index of Economic Freedom. When constructing the index, we tried to design components that were both (a) good indicators of economic freedom across a large number of countries and (b) based on objective information that could be updated regularly. To the extent possible, we sought to minimize the significance of "judgment calls" and subjective evaluations.

As Exhibit 1-1 illustrates, the index contains 17 components that are divided into four major areas: (1) money and inflation, (2) government operations and economic structure, (3) takings, and (4) international trade. These components provide an indication of the degree to which a nation’s institutional arrangements and policies are consistent with sound money, reliance on markets, avoidance of plunder and discriminatory taxes, and freedom of international exchange. While they may not be as comprehensive as we would like, nonetheless, they comprise central elements of economic freedom.

Click here to view Exhibit 1-1: Components of the Index of Economic Freedom

Since a detailed description of the components and procedures used to construct the summary rating was provided in Economic Freedom of the World: 1975-1995, we will present only a brief overview here. The four components in the Money and Inflation area reflect the availability of sound money. Expansionary monetary policy (rapid growth in the money supply) "waters down" the outstanding monetary units and thereby erodes their value. This is wrongful seizure of property. Monetary institutions and policies that lead to substantial variations in the general level of prices create uncertainty and undermine the efficacy of money. Therefore, countries with high rates of monetary growth (relative to potential real GDP) and large variations in the inflation rate are given low ratings. The highest ratings go to the countries with less money growth and more stable (and therefore more predictable) rates of inflation.

Money offered by other monetary authorities is a substitute for money issued by the government of a given country. When residents are allowed to maintain bank accounts in foreign currencies, it is easier for them to avoid the uncertainties accompanying an unstable domestic monetary regime. Thus, countries that permit their citizens freely to maintain bank accounts in other currencies—both domestically and abroad—are given higher ratings.

The six components in the Government Operations and Regulations area are designed to identify the extent that resources are directed by personal choice and markets rather than political planning and coercion. Consumption is the ultimate objective of all economic activity. As more and more of total consumption expenditures are undertaken by the government, consumers exert less and less impact on what is produced and consumed. Government consumption reduces the ability of consumers to decide for themselves. Thus, countries are given a lower rating as government consumption increases as a share of the total (government + private consumption).

No private business firm, regardless of its size, can force potential consumers to purchase its products. Private firms must provide consumers with sufficient value to induce them to pay a price that will cover unit production costs. Government is fundamentally different. Governments can levy taxes and thereby force citizens to pay for goods regardless of the value received. Similarly, government-operated firms can be used to produce goods even when consumers are unwilling to cover the production cost. Thus, countries are given a lower rating as state-operated enterprises comprise a larger portion of the economy.

Since price controls both constrain exchange and take property from owners, they are inconsistent with economic freedom. Freedom to compete in the marketplace; a legal structure that clearly defines property rights, enforces contracts, and provides a mutually agreeable mechanism for the settlement of contractual and property-right disputes; and a competitive and stable credit market are also important foundations for the operation of a market economy. Countries providing this infrastructure are given higher ratings.

Taken together the six components in the Government Operations area indicate a great deal about the structure of the economy. Who determines what will be consumed: the private choices of individual consumers or the central planning of the government? Are goods produced by private firms directed by markets or by state-operated enterprises? Do the prices and interest rates reflect market forces or are they controlled by the government? Is entry into markets open? Does the legal structure protect private property, enforce contracts, and are individuals treated equally under the law? High ratings in each of these areas reflects reliance on personal choice and market allocation; low ratings indicates political choices and centralized planning are used to allocate goods and resources.

The three components in the Takings and Discriminatory Taxation area indicate the degree to which governments honor and protect property rights rather than engage in plunder activities. When governments tax income from one person in order to transfer it to another, they are denying individuals the fruits of their labor. The larger transfers and subsidies as a share of GDP the lower the rating for this component. High marginal tax rates discriminate against productive citizens and seize wealth from taxpayers without providing them any equivalent increase in service. Thus, countries are given lower ratings as they impose higher marginal tax rates that take affect at lower income thresholds. Conscription denies draftees the property right to their labor services. It is also an in- kind tax that is not registered through the budgetary process. As a result, the budget figures for both taxes and expenditures are understated in the case of those countries that utilize conscription to obtain military personal. A lower rating for this component is necessary to adjust for this bias.

Finally, the four components in the International Exchange area indicate the consistency of policies with free trade. Taxes on international trade limit the freedom of domestic residents to trade with foreigners. Thus, the larger the taxes on trade relative to the volume of international trade, the lower the rating. Exchange rate controls often make it difficult for individuals and businesses to obtain the foreign exchange (other currencies) required to trade with foreigners. The black market exchange rate provides an indicator of the degree to which exchange rate controls limit trade with foreigners. Thus, the larger the black market premium, the lower the rating for this component. Many nations restrain trade through the use of quotas, monopoly grants, "buy local" schemes, and various other types of discriminatory regulations. Such restrictions reduce the volume of international trade. A model was developed and used to derive an "expected size of the trade sector" for each country which was then compared with the actual size of the country’s trade sector. A smaller trade sector relative to the expected size (given the geographic size, population, and location of the country) suggests that the country imposes move non-tariff trade barriers. Thus, countries with the smallest trade sectors (relative to the expected size) are given the lowest ratings for this component. [Factors such as geographic size, population, and location will also influence the size of the trade sector. In order to adjust for these factors, we regressed country size (in terms of area), population, whether it was land-locked, and the proportion of the population living with 150 miles of a potential trading partner on the size of trade sector for the countries in our study. The characteristics of each country were then plugged into the equation and used to derive an expected size of the trade sector. A large trade sector would imply that few regulatory constraints were imposed on trade. Thus, when the actual size of the trade sector as a share of GDP was large relative to the expected size, the country was given a high rating. See Economic Freedom of the World: 1975- 1995 (Chapter 1, footnote 28) for additional details.]

Many countries require foreigners to get permission from the government in order to make an investment or remit their earnings. The freedom of their citizens to make investments abroad may also be limited. The greater the restrictions on the mobility of capital, the lower the rating for this component.

Data for each of these 17 components were compiled for 115 countries and statistical procedures used to determine the component rating for each. [The data series used for the price controls component (I-C) was available for only 1990 and 1995. The data for the freedom of entry into business (I-D) and equality under the law (I-E) components were only available for 1995. Thus, the index has only 15 components in 1990 and only 14 components for the years 1975, 1980, and 1995.] Since we want the ratings to be easily comparable across countries and time periods, a zero to ten rating scale was used for each component in the index. Countries were given higher component ratings when their institutions and policies were more consistent with economic freedom. A ten represented the highest possible rating and a zero the lowest.

How should each component in the index be weighted? In the previous edition, we presented three summary indices based on alternative component weights. In most cases, the variation in the weights exerted only a small impact on the summary rating. Given their similarity, presentation of the three alternative ratings was unnecessarily confusing. Therefore, in this edition we will present only one summary index, the one with weights based on a survey of the participants in the Fraser-Liberty Fund Symposia Series. (Note: This index was referred to as the Is1 summary index in Economic Freedom of the World: 1975-1995.) We constructed a survey instrument which described the 17 components in our index and asked the participants of these conferences to provide us with their views concerning the weights that should be attached to each of the components. Since all of these people attended at least one of the conferences, we were reasonably sure of their familiarity with the concept of economic freedom and the factors that influence it. The average weight suggested by the respondents was then used to weight the components and derive the summary index for each of the years. These weights are indicated by the number in parenthesis at the left of each component in Exhibit 1-1.

WHAT’S NEW IN THIS REPORT?

While the methodology employed in the construction of this index is identical to that of Economic Freedom of the World, the 1997 Report contains several additions and adjustments that improve both index and the accompanying material. We would like to highlight five of these factors.

1. More Countries Are Rated. In this report, we were able to obtain the required data for 115 countries compared to 102 for the prior index. The following countries were added: Albania, Bahamas, Bahrain, Barbados, China, Croatia, Estonia, Latvia, Lithuania, Oman, Russia, Slovenia, and Ukraine. Given their size, additions of Russia and China are particularly important.

2. The Assistance of Economic Freedom Network Institutes. Since the last edition was published, the number of co-publishing institutes of the Economic Freedom Network has increased from 11 to 47. Even more important, we were able to work closely with these institutes, use their expertise to verify information, supply missing data, and provide useful background material. Thus, the underlying data for this edition is more complete and the accompanying text of the country profile chapter is more comprehensive than in the prior edition.

3. Final 1995 Index. When the prior index was published, data for several components were only available through 1993. Thus, the mid-1990s index was preliminary. The 1995 data are now available (although not necessarily for every country). Thus, we were able to update the information and finalize the 1995 index. This provides us with economic freedom ratings covering a 20-year time period.

4. Expansion in Country Profile Chapter. The country profile chapter of this report contains detailed information for 81 countries, 23 more than in the prior edition. We have also included more supplemental data than in the prior edition. In this regard, inclusion of a graphic on total government expenditures as a share of GDP during 1975-1995 is particularly important. Trends in the size of government expenditures as a share of GDP will help us better interpret changes in our index of economic freedom. They also provide an indication of what would happen if the components related to government expenditures (government consumption and transfers and subsidies) were weighed more heavily in the index.

5. Marginal Improvements in the Index. Even though the underlying methodology is unchanged, some minor revisions were made in the index. First, discussions with other researchers convinced us that the government consumption component should be divided by total consumption (government plus private) rather than by GDP as was done in the last edition. We believe this revision provides a more accurate measure of the proportion of consumption that is directed by government rather than markets. Second, in a few cases, information supplied by recent publications and the cooperating institutes convinced us to revise a few component ratings for years prior to 1995. [Data provided by the World Bank Research Report, Bureaucrats in Business: The Economics and Politics of Government Ownership (Oxford: Oxford University Press, 1995) were called to our attention after the prior edition was published. This report provided information on the size of government enterprises as a share of the economy over a lengthy time period. A number of the country ratings for this component were revised in light of the information derived from this source.] These changes almost always involved only a one unit change in the rating for a component. Finally, the money, GDP deflator, consumer price index, and national account data used in this edition are from the International Monetary Fund rather than the World Bank. For most countries, these two data sets are identical, but this was not always the case. When there was a disparity, the IMF data, which are available more readily (from Monthly International Financial Statistics), were used in this edition. Taken together, these revisions exerted only a minor impact—changes of a few tenths of a point—on summary ratings prior to 1995.

DIFFERENCES FROM OTHER INDEXES

During the last several years, two other organizations—the Heritage Foundation and the Freedom House—have published measures of economic freedom. [Richard E. Messick, World Survey of Economic Freedom: 1995-1996,(New Brunswick: Transaction Publishers, 1996) and Kim R. Holmes, Bryan T. Johnson and Melanie Kirkpatrick, 1997 Index of Economic Freedom, (Washington, D. C.: The Heritage Foundation and The Wall Street Journal, 1997). The Heritage Foundation also published a similar index for 1995 and 1996.] It is encouraging to see others developing an interest in this topic. At our invitation, Richard Messick the editor and coordinator of the Freedom House Index and Kim Holmes and Bryan Johnson, the lead authors of the Heritage project, met with us at a San Francisco meeting of the Economic Freedom Network. Presentations on the background and nature of these two indexes, as well as our own, were made. While there are some similarities between the three indexes, there are also major differences.

First, our index is the only one of the three that starts with a clear presentation of what economic freedom is and then uses that as the foundation for the development of a measuring rod. Given the meaning of economic freedom, what variables should be used for its measurement? What weight should be given to each? What set of components would provide a sound measure for a specific category? We wrestled with these questions and related issues for several years. They were the focal point of the Fraser Institute / Liberty Fund symposia series. Input was obtained from numerous sources, including some of the world’s leading economists. We sought—and are continuing to seek—to develop objective indicators of economic freedom for all major areas. The variables in our index work together—for example, it is important to measure not only monetary and price stability, but it is also important to identify whether it is possible to shift to another currency if monetary instability is present. Since some factors that affect economic freedom are more important than others, accurate measurement requires that the more important factors be weighted more heavily. Neither Heritage nor Freedom House attempt to deal with any of the these issues. They simply average their components, which in effect weights them all equally.

Second, we developed ratings for five different years over two decades. This makes is possible to track the economic freedom of various countries over time. In contrast, both the Heritage and Freedom House Indexes cover only a few years in the mid-1990s.

Third, both the Heritage and Freedom House indexes are highly subjective. Neither presents an underlying set of data which is then used in a systematic manner in the rating process. While both list factors considered in their ratings, it is often unclear precisely how these factors influence their category ratings. Furthermore, evaluation of countries on the basis of the factors listed requires the authors to make numerous subjective judgements. [The following is a list of actual variables used by the authors of the Heritage Index to rate different countries:

Perhaps none of this would matter very much if it did not lead to some unusual outcomes. Consider the case of Bahrain, a country which the 1997 Heritage Index ranks as the third freest economy in the world. Bahrain is characterized by monetary stability and liberal financial markets. It deserves high marks in these areas. But it is also an economy dominated by government. In fact, 45% of all consumption expenditures are determined by the government rather than by the personal choices of its citizens. This is the largest share—more than Sweden, more than Russia, more than any former Soviet bloc country—among the 115 countries in our study. Can a country that uses central planning and political power to allocate almost half of total consumption be classified as one of the freest in the world? In essence, Bahrain is a big government welfare state financed with oil revenues. Since the Heritage Index gives very little weight to size of government, Bahrain earns an exceptionally high rating. [Consider the following: two of the variables in the Heritage Index are (a) government consumption as a share of GDP and (b) Can foreign companies receive local financing? While both of these variables influence economic freedom, their relative importance varies widely. However, this is not reflected in the index. A country where government consumption takes 50% of GDP, but denies local financing to foreign firms gets the same rating (for the aggregate of these two components) as another country with government consumption equal to 10% of GDP and a prohibition against the local financing. We expect that the authors of the Heritage Index would agree that government taking half of the income of citizens is a more significant violation of economic freedom than denial of financing to foreign investors. Their index, however, treats the two as equals.]

The Freedom House Index also has serious internal deficiencies that lead to unusual outcomes. One of the six categories in the Freedom House Index is "Freedom to Earn a Living." This is certainly a basic element of economic freedom. Inspection, however, reveals that this rating is primarily based on the freedom to organize labor unions. High taxation does not affect the rating received in the "freedom to earn a living" category. Apparently persons living in countries imposing 50%, 60% or even 100% tax rates would be "free to earn a living" as long as they could organize labor unions. The Freedom House Index ignores the size of government altogether. The use of government to channel 50% or 60% of GDP does not reduce a countryÕs economic freedom rating in the Freedom House survey. For example, in 1995 the total government expenditures of Sweden and Denmark summed to 68% and 61% of GDP, respectively. Thus, taxation, government expenditures, and political decision-making control more than three-fifths of the Swedish and Danish economies. Nonetheless, these two economies (tied with four others) are rated as the freest in the world by the Freedom House.

The development of the Freedom House and Heritage indexes was based on a different set of objectives, including public relations and political considerations. At the October meeting in San Francisco, Freedom House made it clear that they sought to improve the image of economic freedom in circles—particularly among proponents of labor unions and activist government—where it has traditionally had a bad name. Perhaps, this explains why the Freedom House index does not consider high taxes and large government expenditures as an infringement on economic freedom. The Heritage Foundaton has made it clear that their index was designed to influence Congress, particularly the allocation of the foreign aid budget of the United States. As a result, the Heritage spolesmen explained, it was necessary to keep the index simple. [As one of the authors of the Heritage Index put it at the San Francisco conference, "Our index reflects what the Heritage Foundation is and where it is located. "On the opening page of Heritage Õinitial report, the authors stated that their index Ò.bóósan excellent tool for deciding how best to allocate development aid. "The first three chapters of that report focus on the foreign aid program. See Bryon T. Johnson and Thomas P. Sheehy, The Index of Economic Freedom, (Washington, D. C., Heritage Foundation, 1995)] Given these factors, the absence of a clear statement in either the Freedom House or Heritage publications concerning the meaning of economic freedom and the relationship between the concept and their index is not surprising.

The bottom line is this: the indexes of both the Heritage Foundation and Freedom House are ambiguous and poorly structured, and they often generate inaccurate and misleading outcomes. Measures of this type will leave many with the impression that economic freedom is nebulous and highly subjective, and therefore largely a meaningless concept. We reject this view; we believe that economic freedom is highly meaningful and that it is possible to measure it objectively. This is why we feel compelled to point out that our index is fundamentally different from those of Freedom House and the Heritage Foundation. We have one objective—to develop the best possible measure of economic freedom. In that regard, we realize that much more needs to be done.

IMPROVING THE MEASURE OF ECONOMIC FREEDOM

We recognize that economic freedom is multi-dimensional and that our index fails to incorporate all of its many facets. As we look to the future, we want to develop a more comprehensive index. In particular, we need to more fully incorporate regulatory restrictions into our index. Many countries use discriminatory tax concessions and other indirect subsidies to modify market outcomes. Regulations such as mandated benefits (for example, mandated severance pay, health care and other fringe benefits) and laws that impose a centralized wage setting structure exert a major impact on the labor market and the degree of economic freedom present in that market. In addition, there are sectors of the economy, such as housing and education, where arrangements more (and less) consistent with economic freedom can be identified. This is an ongoing project. Plans are already underway to develop a more comprehensive index that will provide a better measure of economic freedom in the future.

Additional analysis is also needed concerning the proper weighing of components. The importance of various components may differ across countries. For example, trade restraints may exert a lesser impact on economic freedom when applied to a large country than would be the case for a small nation. Correspondingly, restrictions in one area (for example, stable money) may be less important if economic freedom in other areas (such as freedom to use other currencies) provides individuals with an alternative means of reaching their goals. Highly imprudent policies—hyper-inflationary monetary policies or insecure property rights, for example—may effectively undermine both the market process and significance of economic freedom in other areas. All of these issues are related to how one combines the components into an index that provides the most meaningful measure of economic freedom. Additional research is needed in each of these areas.

The current index supplies valuable information on the consistency of institutional arrangements with sound money, reliance on markets, protection of private property, and free trade. While these are not the sum total of economic freedom, they are important elements. Thus, the current index provides researchers with a tool to undertake more serious analysis of the relationship between economic freedom and other important variables such as economic growth, democratic political institutions, civil liberties, and economic inequality. As this research moves forward, it will enhance our knowledge of economic freedom and provide information that will assist with the development of a still more accurate measure in the future.

Developing a better measure of economic freedom and enhancing our knowledge of how it impacts our lives is an exciting research agenda. This will be the focal point of the 1998 Annual Report of the Economic Freedom Network. We encourage other researchers to join with us as we pursue these topics.