Economic Freedom of The World 2000

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From the very beginning, our goal was the development of an objective measure of economic freedom rather than an index based on subjective assessments and "judgment calls." Therefore, the foundation of our index is a range of objective components that reflect the presence (or absence) of economic freedom. These components can be derived for a large number of countries from regularly published sources. This will make it possible both to calculate the index for earlier time periods and to update it regularly. We also wanted to combine the components into a summary index in a sound, objective manner. The measures presented in this report are an additional step in this direction. They are more comprehensive and based on more complete data than any prior measure of economic freedom; and they use value-free statistical procedures. Still, they are transparent. It is easy to see precisely how the various indexes are constructed, what data they reflect, and which factors produce rating differences across countries and time periods.

As Exhibit 1 illustrates, the index comprises 23 components designed to identify how consistent institutional arrangements and policies in seven major areas are with economic freedom. The seven areas covered by the index are: (I) size of government, (II) economic structure and use of markets, (III) monetary policy and price stability, (IV) freedom to use alternative currencies, (V) legal structure and security of private ownership, (VI) freedom to trade with foreigners, and (VII) freedom of exchange in capital markets.

Areas I and II are indicators of reliance on markets rather than the political process (large government expenditures, state-operated enterprises, price controls, and discriminatory taxes) to allocate resources and determine the distribution of income. Areas III and IV reflect the availability of sound money. Area V focuses on the legal security of property rights and the enforcement of contracts. Area VI indicates the consistency of policies with free trade. Area VII is a measure of the degree to which markets are used to allocate capital. Reliance on markets, sound money, legal protection of property rights, free trade, and market allocation of capital are important elements of economic freedom captured by the index. Of course, we recognize that economic freedom is heterogeneous and highly complex. No single statistic will be able to capture fully and accurately its many facets. However, the index outlined in Exhibit 1 does encompass key ingredients of the concept.

Our work on the measurement of economic freedom is an ongoing project. This publication represents an update and refinement of Economic Freedom of the World: 1998/1999 Interim Report, in which we altered the structure of the index and added (and in some cases deleted) components. We also changed the methodology for converting raw data to the zero-to-10 index ratings and for generating weights for the summary ratings to a more value-neutral procedure. The 1998/1999 Interim Report was the subject of the annual meeting of the Economic Freedom Network in Manila, Philippines, in November 1998. We were able to listen to, and reflect upon, many comments made by the representatives of the participating institutes of the Economic Freedom Network and, as a result, several minor changes were made to this edition of Economic Freedom of the World.2

We had hoped - and, indeed, still hope - to add an area to this index that measures regulation of the labour market but we have not yet found satisfactory data available on a scale that is wide enough, both geographically and over time, to do so. We have, however, constructed this index back to 1970 to aid in the long-term study of economic freedom. Obviously, the data are less complete in the earlier years than the later years but, nevertheless, we believe this index can become a useful tool in analyzing the impact of economic freedom (or lack thereof) in the longer run.

There are 125 nations included in this study. However, as the result of incomplete data or other factors (e.g., the split up of Czechoslovakia), we were only able to derive summary ratings for 123 countries in 1997, 122 in 1995, 115 i n 1990, 111 in 1985, 109 i n 1980, 83 i n 1975, and 57 in 1970. Data were assembled for each of the 23 components of the index. Since we wanted the ratings to be easily comparable across countries and time periods, they were placed on a scale from zero to 10. Higher ratings are indicative of institutions and policies more consistent with economic freedom.

How were the ratings derived? The ratings for 11 of the 23 components in the index reflect various categorical characteristics; those for the remaining 12 are based on continuous data. Countries with categorical characteristics more consistent with economic freedom are given higher ratings. For example, countries with few government enterprises are given higher ratings than those with widespread use of such enterprises. Similarly, countries where price controls are absent (or apply in only a few markets) are given higher ratings than countries where these controls are extensively applied.

Depending upon whether higher values are indicative of more or less economic freedom, alternative formulas are used to transform the 12 continuous variables into a zero-to-10 scale. When higher values are indicative of more economic freedom, the formula used to derive the zero-to-10 ratings is: (V_i - V_min ) / (V_max - V_min ) multiplied by 10. V_i is the country’s actual value for the component, Vmax the maximum value for a country during the 1990 base year, and V_min the minimum base-year value for the component. This formula is used to derive the ratings for all years. A country’s rating will be close to 10 when its value for the component is near the base-year maximum. In contrast, the rating will be near zero when the observation for a country is near the base-year minimum. As the actual values exceed the base-year minimum by larger and larger amounts, ratings will rise from zero toward 10. Whenever the actual value for the component is equal to, or greater than, the base-year maximum, a rating of 10 is assigned. When the actual value is equal to, or less than, the base-year minimum, the rating is zero.

Often times, higher actual values are indicative of less economic freedom. Inflation and size of the transfer sector provide examples. Increases in these variables reflect reductions in economic freedom. When higher values for a component are indicative of less economic freedom, the formula used to derive the zero-to-10 ratings is: (V_max - V_i ) / (V_max - V_min ) multiplied by 10. This formula will assign higher ratings to countries with actual values closer to the base-year minimum. In some cases, component values of zero represent an ideal - a benchmark that should be required for a rating of 10. For example, a zero mean tariff rate and a zero rate of inflation (perfect price stability) are benchmark outcomes representing maximum economic freedom. When zero represents an ideal benchmark value, this value was included as Vmin in the formula even if no country actually achieved this ideal during the base year. In some cases where extreme component values are present (for example, a 10,000 percent rate of inflation), Vmax is constrained at a level clearly warranting a rating of zero even if this was not the maximum observed value during the base year. If this had not been done, extreme observations would have created such a large range that the ratings would have been concentrated near 10. The precise formula used to derive the zero-to-10 ratings for each component is presented in Appendix 2, Explanatory Notes and Data Sources

The procedures used to convert the continuous component values to the zero-to-10 ratings have two important characteristics. First, if all (or almost all) countries improve (or regress) with the passage of time, the ratings will reflect the change. Second, the distribution of the country ratings along the zero-to-10 scale reflects the distribution of the actual values among the countries.

Principal-component analysis was used to determine the weight given to each component in the construction of the area index. This procedure partitions the variance of a set of variables and uses it to determine the linear combination - the weights - of these variables that maximizes the variation of the newly constructed principal component. In effect, the newly constructed principal component - an area rating, for example - is the variable that most fully captures the variation of the underlying components. It is an objective method of combining a set of variables into a single variable that best reflects the original data. The procedure is particularly appropriate when several sub-components measure different elements of a principal component. This is precisely the case with our index. Economic theory is a road map indicating components that are likely to capture various elements of a broader area (a principal component). In turn, principal-component analysis indicates the permissibility of grouping components together and the weights most appropriate to combine a set of sub-components into a principal component. In Exhibit 1, the component weights derived by this procedure are shown in parentheses; e.g. (50%). The same procedure was also used to derive the weights for the area components in the construction of what we will refer to as the summary index. In Exhibit 1, the weights for each of the seven areas are shown in bold-face type and enclosed within brackets: e.g. [11.0%].

Exhibit 1: Components of Index of Economic Freedom

Note: The numbers in parentheses, e.g. (27.1%), indicate the weights used to derive the area rating. The numbers in the brackets, e.g. [17.2%], indicate the percentage weight allocated to each area when the summary rating was derived. These weights are derived by principal component analysis.3

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Last Modified: Monday, January 10, 2000