Ratings, Rankings, and Highlights

This chapter focuses on the presentation of the updated ratings and highlights some of the interesting changes that have taken place during the last two decades. Section 1 presents the 1995 component ratings and explains how they were used to derive the summary ratings. Section 2 focuses on the 1995 rankings. Section 3 indicates the countries that have experienced the largest changes in economic freedom during various time periods. Finally, the concluding section illustrates the basic relationship between economic freedom on the one hand and per capita GDP and growth of income on the other. Graphics are used freely in the chapter in order to help the reader quickly grasp the major points.

1995 COUNTRY RATINGS

Exhibit 2-1 presents the 1995 ratings for each of the 17 components in our index, as well as area ratings, and the summary index. The underlying data and the country ratings for each of the 17 components are presented in the tables of Appendix II. We also derived both component and summary ratings for 1975, 1980, 1985, and 1990. Appendix I contains this information—similar to that of Exhibit 2-1—for the earlier years. The roman numeral and letter labels of the tables in Appendix II match the component labels of Exhibits 1-1 and 2-1. The note following each of the tables in Appendix II indicates both the source of the data used to derive the rating for the component and precisely how the underlying data are converted to the zero to ten rating scale used for all components. Readers interested in the details of the relationship between the underlying data and the component ratings will want to review Appendix II carefully. Throughout, a component rating of "10" indicates that for this dimension of economic freedom the nation is among the freest in the world. On the other hand, a rating of zero indicates that the country is among the least free in the category measured by the component.

Click here to view Exhibit 2-1: Component, Area, and Summary Index Ratings: 1995

Exhibit 2-1 (right side) also presents ratings for the four areas covered by our index and the aggregate summary rating. Both the area and summary ratings reflect the aggregation of the component ratings, based on the component weights presented in Exhibit 1-1. As in the case of the component ratings, higher area and summary ratings are indicative of greater economic freedom.

Let us look at the various component ratings for a few countries and consider their significance. The United States, Japan, Belgium and Denmark (and several others) received a rating of ten for component I-A, monetary expansion adjusted for the estimated growth rate of potential output. The ten rating indicates that the growth of the money supply of these countries during the last five years (1991-1995) would have placed them in the top 1/11th of the countries during the base year (1985) in terms of the least monetary expansion adjusted for the potential growth of real output. (Note: see Chapter 1, endnote 7 for details concerning the importance of the base year.) At the other end of the spectrum, Brazil received a rating of zero, indicating that the growth rate of its money supply during 1991-1995 would have placed it in the bottom 1/11th of countries—those with the most rapid growth rates of the money supply—during the 1985 base year. (Note: the annual growth rate of the money supply in Brazil was 1,111% during 1991-1995.) Of course, intermediate ratings closer to ten reflect moderate rates of money growth, while the ratings closer to zero reflect more money growth.

The second component (I-B) in the index is the instability in the price level as measured by the standard deviation in the rate of inflation during the last five years. Countries with the lowest standard deviation (least variability) in the inflation rate are given the highest ratings. The ratings of ten for the United States, Canada, Australia and Japan, for example, indicate that the small variability in the inflation rate in each of these countries during 1991-1995 would have placed them in the top 1/11th of the countries with the least variability in the inflation rate during the base year period. The zero ratings of Brazil and Nicaragua indicate that the fluctuations in the inflation rates of these countries during 1991-1995 would have placed them in the bottom 1/11th of all countries during the base year period.

The next two components, freedom to maintain a foreign currency bank account domestically (I-C) and freedom to maintain a bank account abroad (I-D) have only two possible outcomes—it is either legal or illegal for citizens to maintain these accounts. A rating of ten indicates that the accounts were legal in the mid- 1990s; a zero rating indicates that the accounts were illegal.

Using the component weights of Exhibit 1-1, the four Money and Inflation components are aggregated into an area rating. These results are presented in Part 2 of Exhibit 2-1. Of course, countries with high ratings for the four monetary components will also receive a high rating in this area. For example, the Money and Inflation area ratings of the United States and Japan (among others) were ten because they received a rating of ten for each of the four components in this area. The monetary area rating of Canada was slightly lower (9.7) since it received a 9 for the money expansion component (I-A) and a ten for the other three components. The area ratings are merely a reflection of the component ratings that comprise them.

Finally, the component ratings were used to derive a summary rating for each country. In the calculation of the summary rating, each component was assigned the weight indicated in Exhibit 1-1. [If the data for a component could not be obtained for a country, the weight for that component was distributed proportionally among the other components when deriving the summary index for the country.] Of course, countries with high ratings for most components (and particularly for those that are weighed more heavily) will have the highest summary ratings. On the other hand, countries with a large majority of low component ratings will have the lowest summary ratings.

In order to make comparisons across countries easier, we assigned letter grades to various ranges of summary ratings. Countries with a summary rating of 8.0 or more were assigned a letter grade of "A." (A rating of 9.0 or more was assigned an A+). Countries with summary ratings in the 7.0 to 7.9 range were assigned a "B." Below that point, one letter grade was subtracted for each decline of 1.0 in the summary rating. Thus, countries with a summary rating of less than five, were given a letter grade of "F." When the summary rating for a country was less than 4.0, indicating low ratings for most of the components of our index, an F- grade was assigned.

Exhibit 2-1 makes it easy to compare ratings of the industrial countries and within regions. Among the high-income industrial countries, only New Zealand earned a rating of "A" in 1995. The 7.9 rating of the United States was just below the cutoff for an "A." In addition to the United States, Australia, Switzerland, and United Kingdom earned "B" ratings. Canada's 6.9 rating was just below the "B" cutoff. Denmark, Italy, Spain, and Sweden had the lowest ratings among the industrial nations. In general, the ratings of the industrial nations were lowest in the Takings area. Most rated high in the monetary and international areas.

Taking a closer look at the summary ratings within regions, the highest ratings in South and Central America—a low B—were earned by Costa Rica and Panama. Most nations in this region earned either "C" or "D" grades. The lowest rated countries in this region were Brazil, Haiti, Nicaragua, and Venezuela—all of which were assigned grades of either F or F-.

The summary ratings of the non-industrial European and the Middle Eastern nations were quite low. Only Bahrain and Oman were able to earn grades of "C." The lowest ratings in this region went to Albania, Croatia, Iran, Romania, Russia, Slovenia, Syria, and Ukraine. All of these countries earned a grade of F-, indicating that their policies and institutions were highly inconsistent with economic freedom.

In Asia, the summary index ratings were highly diverse. Hong Kong (A+) and Singapore (A) registered the highest ratings. Malaysia, Philippines, and Thailand earned a "B" grade, while Taiwan and South Korea were assigned a high "C." At the other end of the spectrum, Bangladesh, China, India, and Pakistan posted F ratings, while Nepal registered an F-.

The economic freedom ratings of the African countries were extremely low. Except for the "B" of Mauritius and the "D" grades of Botswana, Kenya, and South Africa, the other 26 African nations included in our study earned grades of either F or F-. (Note: There was insufficient data to give Somalia a summary rating in 1995.)

1995 COUNTRY RANKINGS

By a significant margin, Hong Kong was the highest rated country in the world.

Exhibit 2-2 presents the 1995 summary ratings arranged from high to low. This makes it easy to identify the countries with the highest and lowest ratings (and therefore rankings). By a significant margin, Hong Kong was the highest rated country in the world in 1995, a spot that it also achieved during each of the four prior rating years. Singapore, New Zealand, United States, and surprisingly, Mauritius round out the Top Five. Switzerland, United Kingdom, Thailand, and Costa Rica occupy spots six through nine. Four countries—Malaysia, Philippines, Australia, and Panama—are tied for the tenth place ranking. Several of the countries in the Top Ten occupied this lofty position throughout the 1975-1995 period. Hong Kong, Singapore, United States, and Switzerland fall into this category. Malaysia has also ranked in the Top Ten since 1985. The other Top Ten members have improved their relative position substantially during the last decade. This is particularly true of Mauritius, Costa Rica, Thailand, and Philippines.

Click here to view Exhibit 2-2: Summary Ratings and Rankings 1995

At the other end of the spectrum, our index indicates that the economies of Algeria, Croatia, Syria, Burundi, Haiti, Iran, Nigeria, Zaire, Ukraine, and Albania were the least free in the world in 1995. In total, there were 24 countries with ratings of less than 4.0. Ratings in this range (F-) are indicative of low or middle-low ratings for all or almost all components.

CHANGES IN THE ECONOMIC FREEDOM OF COUNTRIES

As we previously mentioned, country ratings were also derived for 1975, 1980, 1985, and 1990. In many ways, the change in a country's rating is more interesting than the rating at a point in time. If our index is a good measure of economic freedom, an increase in a country's summary rating indicates that it is moving toward liberalization—that the economic freedom of the citizenry is expanding. In contrast, a reduction in the summary rating suggests a decline in economic freedom.

Which countries have made the most progress toward economic freedom— Exhibit 2-3 (left frame) presents the summary ratings for 1975, 1985, and 1995 of the ten countries that registered the largest rating increases during the last two decades. The summary ratings of these countries were at least 2.6 units higher in 1995 than in 1975. New Zealand registered the largest increase, a jump from 4.2 in 1975 (and 4.1 in 1985) to 8.0 in 1995. As an inspection of the "country profile" data (see Chapter 3) for New Zealand reveals, improvement was made in most rating categories. Monetary policy was more stable, foreign currency bank accounts were legalized, privatization reduced the size of the state enterprise sector, transfers and subsidies were reduced, the top marginal tax rate was chopped (from 66% in the mid-1980s to 33% in the 1990s), and trade policies were liberalized. Interestingly, most of these changes took place during the last decade. [For an excellent survey of recent economic policy in New Zealand , see Lewis Evans, Arthur Grimes, Bryce Wilkinson, and David Teece, "Economic Reform in New Zealand 1984-1995: The Pursuit of Efficiency," Journal of Economic Literature (December 1996).]

Click here to view Exhibit 2-3: The Ten Countries with the Largest Increases and Largest Decreases in Economic Freedom, 1975 - 1995

The rating increases of Chile and Mauritius were only marginally lower than those of New Zealand. In contrast with New Zealand, Chile moved significantly toward economic liberalization during 1975-1985 and that trend continued during 1985-1995. In the mid-1970s, the Chilean economy was characterized by triple- digit annual increases in both the money supply and the price level. In recent years the money growth has fallen to the 20% range—still more rapid than ideal, but a substantial improvement compared to the 1970s—and the inflation rate has fallen to single-digit levels.

Chile legalized the use of foreign currency bank accounts both domestically and abroad. Reductions in government consumption and the privatization of state enterprises also contributed to Chile's improvement. The most important factors pushing up Chile's rating were lower marginal tax rates and a reduction in the size of the transfer sector. Chile has reduced its top marginal tax rate during every five year period since 1975. In 1975 the top marginal tax rate was 80 percent. That rate was sliced to 60% in 1980, 57% in 1985, 50% in 1990 and 45% in 1995. The primary factor under- lying the reduction in transfers and subsidies was the adoption of a private savings and investment plan instead of a pay-as-you-go social security system. (See country profile for Chile in Chapter 3.)

Like Chile, Mauritius has moved steadily toward a freer economy throughout the last two decades. A more stable monetary policy boosted its summary rating during 1975-1985. The marginal tax rate was cut from 50% in 1980 to 35% in 1985 and 30% in 1995. More recently, legalization of foreign currency bank accounts, elimination of exchange rate controls, and liberalization of restrictions on the mobility of capital have enhanced the summary rating of Mauritius. As the result of this improvement, along with its relatively small government consumption and transfer sectors, this small country now has one of the freest economies in the world.

As Exhibit 2-3 illustrates, Portugal has registered steady movement toward a freer economy since 1975 and the summary ratings of both Iceland and Argentina have increased substantially during the last decade. Uganda, Philippines, Norway, and Jamaica round out the list of ten recording the largest gains during the last two decades. Interestingly, with the exception of New Zealand and Norway, all of these countries were low-income, less developed nations at the beginning of the period.

Exhibit 2-3 also presents data for the ten countries that recorded the largest reductions in economic freedom during the last two decades. Venezuela has the dubious distinction of heading this list. In 1975 our index ranked Venezuela as the fifth freest economy in the world. Since that time, monetary policy has become more erratic; foreign currency bank accounts have been restricted; and price controls—including those imposed on the financial and foreign exchange markets—have become more restrictive. At a time when most of Latin America was moving toward economic liberalism, Venezuela moved in the opposite direction. In 1995, it ranked 92nd (among the 115 economies of our study), quite a plunge from its lofty position of 1975. (See country profile in Chapter 3 for additional details.)

Haiti, Nicaragua (despite a significant rating increase in the 1990s), Iran, Honduras, and Syria are also among the economies that have become substantially less free during the last two decades. Interestingly, all of the countries that have regressed during this period are from three regions—Latin America, Africa, and the Middle East.

Exhibit 2-4 presents the "honor roll" of most improved countries during the last decade (left frame) and during the most recent five years (right frame). Of course, there will be some overlap of these groups with the most improved economies for the entire 20-year period. But there are several "new entrants" into the most improved category. The ratings of both Peru and Poland rose significantly during both the late 1980s and the early 1990s. These economies are now considerably more free than during the mid- 1980s. The rating of Costa Rica rose sharply during the last half of the 1980s and the improvement was maintained and improved slightly during the 1990s. The ratings of Nicaragua, El Salvador, and Tanzania have also jumped sharply, but most of their improvement was during the 1990s. Russia, Bulgaria, Hungary, and Dominican Republic are also among the countries registering the largest rating increases during the last five years.

Click here to view Exhibit 2-4: Honor Roll of Most Improved: 1985 - 1985 and 1990 - 1995

With the collapse of communism, the economies of Eastern Europe and the former Soviet Union are currently going through a dramatic period of transition. In 1990 most countries in this region ranked among the world's 15 least free economies. Croatia, Ukraine, Albania, Russia, and Romania still fall into this category. As Exhibit 2-5 illustrates, these economies have made significant moves toward economic liberalism in the 1990s. Our index indicates they were "more free" in 1995 than in 1990. Several of the rating increases are substantial. For example, the ratings of the Czech and Slovak Republics were 5.2 and 4.9 respectively in 1995, compared to a 2.4 rating in 1990 for the former Czechoslovakia. The summary ratings of both Hungary and Bulgaria rose by more than 2 units between 1990 and 1995; Poland registered a 1.5 unit increase during the same period. Except for Romania, all of the rated former Soviet bloc countries recorded summary rating increases of at least 1.5 units between 1990 and 1995.

Click here to view Exhibit 2-5: Changes in Economic Freedom in Eastern Europe and the Former Soviet Union

In spite of these rating increases, the summary ratings of these countries are still low. Two Baltic states—Estonia and Lithuania —have the highest summary ratings within this group. The ratings of the Czech Republic and Hungary are only slightly lower. None of these countries was able to make even the Top Fifty among the 115 countries of our study. Estonia ranks 52nd; Lithuania 55th; the Czech Republic 62nd; and Hungary 63rd. At the other end of the spectrum, Croatia ranks 114th; Ukraine and Albania tied for 106th; Russia ranked 105th; and Romania 101st. Almost all of these countries received a very low rating (two or less) for both the money growth and inflation variability components. Several are now in a position to improve their ratings in these two areas during the next three or four years. This improvement, along with continued moves toward liberalization in other areas, could push several of these countries into the Top Thirty in the not too distant future.

ECONOMIC FREEDOM, INCOME, AND GROWTH

In the last edition, we had a chapter on economic freedom and growth. We will not address that topic in detail in this report. We would, however, like to present an exhibit illustrating the basic relationship between economic freedom, per capita income, and growth. We arrayed the summary ratings for our 115 countries from the highest to the lowest and divided them into quintiles—five groups of 23 (one group had 24 and another 22 as the result of ties). Then the average per capita GDP in 1996 and annual rate of growth during 1985-1996 were derived for each of the quintile groups. These figures are presented in Exhibit 2-6. [A similar exhibit in the last edition by grade level was widely reproduced by the media. Since there are so few countries in the grade "A" and "B" categories, this time, we thought it would be more meaningful to present the data by quintiles rather than grade level.] For the top quintile of "most free" economies, the average per capita GDP was $14,829. The figure for the next quintile was $12,369 and it declined for each quintile down to $2,541 for the countries comprising the "least free" quintile. Clearly, there was a strong positive relationship between per capita GDP and economic freedom as measured by our index.

Click here to view Exhibit 2-6: Per Capita GDP and Growth of Real Income by Quintile Ratings of Economic Freedom

The growth of real GDP between 1985 and 1996 (or the most recent year available) is also presented by quintile. The top quintile registered per capita growth of 2.9%. The figure for the second quintile fell to 1.8% and it continued to decline by approximately 1% as one moved down each quintile. For the least free quintile (countries in this group had summary ratings of 3.8 or less), per capita GDP fell at an annual rate of 1.9% during 1985- 1996. [Everyone of the countries in the "most free" quintile achieved a positive growth rate of real GDP during 1985-1996. Four of the economies in the second freest quintile experienced declines in real GDP. The number of countries with a negative growth rate rose to 7 for the third quintile, 10 for the fourth quintile and 13 for the "least free" quintile. Since the growth data were unavailable for newly-formed countries (Slovenia, Ukraine, Russia, and Croatia) during this period, they were omitted from the average growth rate calculation. Thus, the growth figures were available for only 18 countries in the least free quintile. Thirteen of the 18 experienced reductions in per capita GDP.]

Thus, both per capita GDP and its growth rate are positively linked with economic freedom. This relationship is not an artifact of the construction of the index. The components of the index were all indicators of institutional structure and economic policy. None of them were "proxies" for level of income or development. If economic freedom did not exert a positive impact on growth and eventually the level of income achieved, there would be no reason why the income and growth figures would be positively correlated with the index rating. They could just as well have been negatively correlated. Or there could have been no relationship at all. This positive correlation suggests that countries that follow policies more consistent with economic freedom reap a payoff in the form of more rapid economic growth that leads to higher living standards. [In some ways, the strong linkage between level of economic freedom and growth of per capita GDP is a bit surprising because both economic theory and more detailed analysis indicate that changes in economic freedom will also influence growth. Some of the low-rated countries have experienced significant increases in economic freedom, which would tend to increase their growth rate. Correspondingly, some countries with a relatively high rating have experienced recent reductions in economic freedom, which tend to adversely affect their growth. Both of these factors would weaken the simple relationship between economic freedom and growth. Of course, as a country shifts toward policies more consistent with economic freedom, it will take time to convince potential investors and other decision-makers that the shift is permanent. Thus, there may often be a time lag between a move to a freer economy and a significant positive impact on economic growth. See Chapter 4 of Economic Freedom of the World: 1975-1995 for additional analysis of these topics.]

LOOKING AHEAD

The focal point of this Annual Report is the expanded country profile section. The following chapter presents this material.