What is Economic Freedom and Why is it Important?

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By Chris Schlegel, BA Economics, Simon Fraser University

Almost anyone should be forgiven for asking that question; after all, when you’ve done your title search on "economic freedom" in a popular database of journal articles you’ll find no more than 43 matches, just short of the 1,822 matches for international trade and also not quite up there with matches for monetary policy (2,990). So economic freedom must not be important enough in any- one’s life to forego an afternoon’s worth of cricket, you might allow. Well, you’re wrong. It is because the fuzzier sciences (political science, law, sociology) have beaten the subject half to death that economists might have recently thought the entry costs into this arena were just above the benefits (at the margin). Alternatively, economists might have stared long enough in disbelief at the occasionally clumsy treatment of the subject by the fuzzies, and are only of late sufficiently outraged to ask for grants to clean up that mess. Quite simply, or perhaps not so, the task at hand is to grab that fuzzy notion, be rather explicit about it, and report the regression coefficient.

What is it?

As on too many other occasions, the term is more frequently used than it is defined. Now, rather than amuse yourself at my dilemma defining the term, how would you go about defining economic freedom? A fruitful way of tackling the untacklable is to be outright preposterous or, more formally, to visit the boundary conditions of the proposed system.

If you can not do what you want to do, if your budget set is not at least tangent with your subjective utility set, there will always be a divorce between outcome and intent. Does that restrict your economic freedom? And moving right along, does it matter who or what restricts your freedom so long as the outcome is unchanged? Whether a natural constraint prevents a market transaction (ferocious tornado clips phone lines), the market itself prevents you from transacting (unfavourable terms of trade), or the government gets in the way with prohibitive taxation, you are an unserved customer in all three cases. Never mind whether what got in the way was intentional or not, you do not possess the freedom to carry out your choices. This would make the budget constraint the greatest restricter of economic freedom.

Most of us have by now accepted that jumping out of a 43rd story window is a one-time experience. Nature imposed that constraint, and unbelievers leave the sample rather quickly. But what if it were possible and government said it was not allowed more than once. Would that be any different?

Next, suppose government, however un- or democratically empowered, took away 100 of your dollars and compensated you with services (bridge access, Stanley Park lawns) that you value at exactly 100 dollars. Another way of posing this part of the question is to consider a government that has managed to restrict every single transaction except for A and B. You go home and do your maximization calculation and find out that

surprise, your utility maximizing transaction is A and B. Any loss in economic freedom in either case?

Bear with me for one more visit to the boundary: with not a single person on this planet except you, would your economic freedom be perfect? No one around to tax you, dump old tires in your backyard, or spit on the sidewalk. What is the state of economic freedom in that world?

This sort of inquiry is not a trivial exercise in dispensing question marks, but rather a way to help chisel stuff off a block that is supposed to say "economic freedom" when we’re done. In that spirit, what can we chop off the block without damaging the print? What must become apparent is that political and various civil types of freedom are proper subsets of economic freedom, and that economic freedom is the ability to exercise a choice freely given a set of assigned property rights, where these property rights were obtained in free and voluntary exchange.

So, if government replaced your earnings with equally valued services you would be worse off because you did not make that choice on your own.1 This means that economic freedom is valued for its own sake, it is a separate argument in the utility function,2 and it is therefore treated just like any other good in that it is has a marginal rate of substitution vis-à-vis some Hicksian composite and ought to be twice continuously differentiable over some range: people choose to trade off their freedom all the time in return for what they see as adequate compensation (a wage, for example). The difference is that they choose to it trade off, rather than be appropriated in some manner. The conclusion here is that with no change in individual net wealth you are made worse off by the amount you value your freedom every time government makes a decision for you.

What about the difference between nature and government forbidding that the courageous jump off the 43rd floor? While it is true that the outcome may be the same (or maybe not!) in that you can not exercise that choice, the first constraint is an exogenously imposed endowment for the enrichment of no one and applicable to all, whereas the second is necessarily arbitrary and because it is endogenous does not always satisfy the Pareto criterion. Bumping up against Nature’s laws is not a relevant restriction on economic freedom because the rights to these restrictions can not be freely traded.3 And if the free market happens to restrict your economic freedom, then this is the optimal outcome of rational agents trading property rights.

Finally, if no other person was around to bug you there would also not be a whole lot of voluntary exchange, and so our definition doesn’t tell us much. Externalities would not be zero either (those annoying seagulls), and now they can’t even be made Pareto-irrelevant through trade (those birds never learn). This portion of our thought experiment may have overstepped the boundary. What it does allow us, however, is to ask what perfect economic freedom would be. Given the dependence of our definition on property rights, a zero transactions cost world would come pretty close: whatever you own, you would own perfectly with no appropriation or outright theft possible, and your assets could be sold or some of their properties rented at fair market value whenever you would see fit to do so. In this case, zero transactions costs and voluntary trade in property rights means perfect economic freedom.

Why is it important?

If economic freedom means all or at least some of the above, then its importance should be fairly difficult to overstate. Freedom to allocate your resources means the freedom to match price with marginal value,4 a general equilibrium outcome that also produces price equal to marginal cost of production. This trinity is a highly desirable state to be in because it ensures efficient economy-wide outcomes

whatever is valued is produced and that price clears all transactions.

Economic freedom also shapes incentives. Because the value of income is determined by its real purchasing power, reducing allocational freedom reduces the utility obtainable from that income and thus reduces any incentives to work more hours, acquire new skills, or generally expend much effort on something when its expected return has been lowered. This implies, for example, that inflationary policies are infringements on economic freedom because they erode property rights. A quantitative measure of economic freedom, as used by The Fraser Institute, might index the extent to which the purchasing power of income and savings has been preserved, although in practice it depends on how much of that inflation is anticipated and therefore hedgeable.

Further, by our definition, increasing economic freedom means lowering transactions costs. This increases the volume of trade in the broadest possible sense and thus raises private wealth. Furthermore, this has a strong tendency of becoming a cycle: more trade implies increased gains from exchange, which increases wealth, which in turn increases incentives to trade.

Finally, it should not be surprising that there is good empirical evidence that economic freedom can raise the growth rate of output. In a recent issue of the American Economic Review, Stephen Easton and Michael Walker estimate that if various Eastern European countries (Hungary, Poland, Romania, the Czech Republic) had opted for a level of economic freedom close to that of Hong Kong, they could have expected to see their steady state incomes increase by an estimated $6,350 per capita. Another study by Dawson finds that, holding political and civil freedoms constant, an initially high rating on the economic freedom scale can raise the growth rate of that country by close to 4 percent over the sample’s 15 year period. The same study concludes that economic freedom has a strong positive effect on total factor productivity (validating the conjectured income-incentive relationship made above) and that political and civil liberties lag behind the economic ones in explaining increases in output. An extensive survey by Hanke and Walters produces similarly impressive results: a 10 percent increase in economic freedom can be expected to raise output per capita from anywhere between 7.4 and 13.6 percent.

All of these numbers are considerable. These are not pennies lopped off long-run growth as a result of mildly clumsy policy. Even if some of the results are biased upward due to relevant but omitted factors, cutting the numbers in half leaves growth rates that are still impressive. The case for increasing economic freedom is incredibly strong. For why it has not been implemented one might consult the works of Mancur Olson or Milton Friedman.

For whom is it important?

The prescriptions for increasing growth rates exceed the number of opining economists by a factor cheerfully above one. However, the implications of the empirical results above for the "international experience" are clearly that countries like North Korea, Cuba, and Iran would seem to owe it to their citizens to open markets, further trade, and strengthen the link between work and reward. When or if this will happen is, unfortunately, not only an economic question.

Notes

References

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