Part 2 Final Thoughts on Institutions and Policy

Economic theory has clearly established that the seven elements outlined in this part of the book will exert a positive impact on the performance of economies. How big an impact? To answer this question, a measure of institutional quality is needed. In the mid-1980s, the Fraser Institute of Vancouver, Canada, began work on a project designed to develop a cross-country measure of economic freedom. Several leading scholars, including Nobel laureates Milton Friedman, Gary Becker, and Douglass North, participated in the endeavor. The result was the Economic Freedom of the World (EFW) index. Now published by a worldwide network of institutes in more than 90 countries, this index measures the extent to which a country’s institutions and policies are consistent with economic freedom—that is, with personal choice, private ownership, voluntary exchange, and competitive markets.

The EFW measure uses forty-two separate components to derive ratings in five major areas: size of government, protection of property rights and enforcement of contracts, access to sound money, international exchange, and regulation of credit, labor, and business. Summary ratings on a 0–10 ten scale are available for 123 countries. The index is updated annually.

To a large degree, the EFW index reflects the seven key elements outlined earlier in this book. To achieve a high EFW rating, 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 that deter either domestic or international trade, and rely more fully on markets than government expenditures and regulations to allocate products and resources.

Some might think that the EFW index is a measure of “capitalism” at one end of the spectrum and “socialism” at the other. Because these terms are ambiguous, meaning different things to different people, we seldom use them. Strictly speaking, socialism implies government ownership of the primary means of production. ”Socialism” is sometimes used to refer to systems in countries like Denmark, Finland, and Sweden that have a high level of government expenditures. A close investigation of these Scandinavian countries reveals that although each may have a larger than average public sector and higher taxes than desirable, they are still characterized by private ownership, free trade, minimal regulation of business, and widespread use of markets. These attributes are virtually the opposite of socialism. The economic organization of Scandinavian countries is vastly different from that of Venezuela, Cuba, North Korea, and China, socialist countries with government ownership in many sectors of the economy.

Similarly, capitalism is often used to refer to economies that differ substantially in the degree of regulation, price controls, trade restrictions, and security of property rights. In place of such ambiguous terms as “capitalism” and “socialism,” the EFW index provides a more accurate measure of the degree to which countries rely on personal choice, voluntary exchange, and market-determined prices, rather than on political decision-making and central planning to allocate available resources and guide investments.

If the institutional and policy factors outlined here are important, countries with persistently high EFW ratings should achieve better economic outcomes than those countries with persistently low EFW ratings. Let’s see if this is the case.

Exhibit 13 presents data on the 2019 per capita income and its growth for the ten countries with the highest and lowest EFW ratings during 2000–2019. Among the 123 countries and jurisdictions for which the EFW data are available over these two decades, the following countries rise to the top of the list of persistently free economies: Hong Kong, Singapore, Switzerland, New Zealand, and the United States. At the other end of the spectrum, Algeria, both Congos, Myanmar, and Venezuela are among the least-free economies.

How do incomes and growth rates compare? The average per capita income of the ten most-free economies was $62,476, nearly 14 times the figure ($4,520) for the ten least-free economies. Not only did the ten most-free economies have a substantially higher income level, they also grew more rapidly. The growth rate of per capita GDP of the ten most-free economies averaged 1.7 percent annually during 2000–2019, compared to 1.41 percent for the ten least-free economies. Alert readers may notice that Exhibit 13 and Exhibit 14 that follows report incomes using a strange currency called “international dollars”, evaluated at purchasing power parity. PPP is simply a statistical way of enabling comparisons when prices for the same product (usually one that is hard to trade like a haircut) differ across countries. If barbers charge $3 for a haircut in Tashkent and $40 in New York, comparing actual incomes would understate the well-being of Uzbeks. By convention non-US currencies are revaluated to be able to buy the same physical set of goods as could be bought for that amount in the US.⁽⁷³⁾

Exhibit 14 provides data from 2005 to 2021 for the EFW score, 2021 GDP per capita, and the growth rate of GDP per capita for several transition countries. Both Georgia and Armenia have high EFW ratings and are included in the economically most free country group, indicating a favorable environment for economic freedom. The growth rates of GDP per capita for both countries are also relatively high. In contrast, Azerbaijan and Ukraine fall in the least free country group. It is essential, however, to acknowledge that the economic performance of these developing nations is shaped by a myriad of factors extending beyond their EFW ratings. Influences such as geopolitical complexities, ongoing military conflicts, vulnerability to external shocks, diverse resource availabilities, and the inherent instability of GDP growth can collectively contribute to the observed differences in GDP per capita and growth rates.

Exhibit 15 breaks the 123 countries into quartiles or four equal groups, arrayed from low to high by their EFW ratings. The 31 countries with the highest average economic freedom rating comprise the top quartile. The 31 with the next highest average ratings make up the next quartile, and so on. The average income level and growth rates for each of the four groups are expressed in terms of a common currency, the 2017 U.S. dollar.

The same pattern emerges in Exhibit 15 as that presented in Exhibit 13. The freer economies among the 123 countries achieve both higher per capita income levels and grow more rapidly. The most-free countries had an average 2019 per capita income of $50,619, more than eight times the $5,911 average for the least-free countries. Note the strong positive relationship between economic freedom and per capita GDP across quartiles. Although the figures of Exhibit 15 are not adjusted for other factors that might influence per capita income, more detailed statistical analysis indicates that the strong positive relation between persistently high levels of economic freedom and income remain after adjustment for other major factors that might influence income levels. Similarly, as Exhibit 15 shows, the average annual growth rate of the top group was 2.2 percent, compared to 1.3 percent for the bottom group. Note the average growth rates of the three least-free quartiles were similar, but all were substantially less than the average for the top quartile.

Sources

• World Bank, World Development Indicators (2022);

• Gwartney et al., Economic Freedom of the World: 2021 Annual Report (Vancouver: Fraser Institute, 2021).

• Note: The growth data were adjusted to control the change in economic freedom during the period and the initial level of income.

Some argue that market economies leave the poor behind. So how did the poverty rates in the more-free economies compare with the rate in countries with less economic freedom? The World Bank provides data on extreme and moderate poverty rates. The extreme poverty rate is the percentage of the population with an income of less than $2.15 per day, whereas the moderate poverty rate is the share of the population with an income of less than $3.65 per day (measured in 2011 international dollars).

Exhibit 16 provides data for both the extreme and moderate poverty rates in 2019, according to economic freedom quartiles arranged from lowest to highest. Clearly, the poverty rates were much lower in the freer economies. The extreme poverty rate in 2019 was 34.1 percent for the least-free economies, but only 0.9 percent in those that were most free. Correspondingly, the moderate poverty rate was 53.2 for the least-free quartile, compared to only 2.0 percent in the most-free quartile. The two middle quartiles had both extreme and moderate poverty rates between those of the least and most-free economies.

Source: Gwartney et al., Economic Freedom of the World: 2021 Annual Report (Vancouver: Fraser Institute, 2021).

Moreover, more detailed analysis indicates that countries that move toward more economic freedom achieve larger poverty rate reductions than did those that were less free. These relationships held even after adjustments for geographic and locational factors, receipt of foreign aid, and political institutions.

It is evident from these data that economic performance is much better in countries with greater economic freedom. What about the impact of economic freedom on some broader indicators of quality of life, such as life expectancy and environmental quality?

Exhibit 17 presents the World Bank’s life expectancy figures for the countries in the quartile groups. People living in countries with more economic freedom live longer. On average, the life expectancy of persons living in the most economically free quartile of countries was 81.1 years, compared to only 65.9 years for persons living in the least-free quartile of countries. Thus, people living in the freest economies enjoy more than 15 additional years of life relative to those in the least-free quartile.

Source: Gwartney et al., Economic Freedom of the World: 2021 Annual Report (Vancouver: Fraser Institute, 2021).

Environmental issues have become increasingly important in public discussions in recent years. What impact does economic freedom have on the environment? The Yale Center for Environmental Law & Policy publishes a comprehensive Environmental Performance Index (EPI) for 180 countries. This index rates the quality and performance of countries in a broad set of environmental areas. The scale of this index ranges from 0 to 100, with higher figures indicating greater environmental quality. Exhibit 18 shows the average EPI score of countries for the economic freedom quartile groups. The average EPI for the most economically free quartile was 73.7, compared to 62.7 for the second-freest quartile, and 52.8 and 45.0 for the two least-free groups. These figures show that there is a strong positive relationship between economic freedom and the quality of the environment. To a large degree, the demand for a cleaner environment increases with income. Therefore, as economic freedom increases per capita income, it also increases the demand for environmental quality. Thus, the positive relationship between economic freedom and the quality of the environment is an expected result.

Sources

• Gwartney et al., Economic Freedom of the World: 2021 Annual Report (Vancouver: Fraser Institute, 2021);

• Z. Wendling et al., The 2018 Environmental Performance Index Report (New Haven, CT: Yale Center for Environmental Law and Policy, 2018), epi.envirocenter.yale.edu.

• Note: EPI data are missing for Hong Kong and Syria.

Does economic freedom guarantee that a country will be able to achieve high income levels? Can a country with little economic freedom nonetheless achieve a high per capita GDP? Examination of the economic freedom and per capita GDP of the 123 countries with EFW data during 2000–2019 sheds light on both questions. These data indicate that, essentially without exception, countries with persistently high economic freedom ratings grow more rapidly and achieve high levels of income. Conversely, except for a few of the world’s leading oil exporters, no country has been able to achieve a high level of per capita income without having a high degree of economic freedom. This close linkage between economic freedom and high per capita income highlights the importance of economic institutions.

The test of a theory is its ability to predict actual outcomes. Both economic theory and the empirical evidence indicate that countries grow more rapidly, achieve higher income levels, and make more progress against poverty when they adopt and maintain policies along the lines outlined in this section. It is clear that adoption of institutions and policies supportive of economic freedom is a key ingredient for economic growth and development.

Technology, Trade, Entrepreneurship, and the Remarkable Growth of the Past Half Century.

Let us return to the historical pattern we described at the beginning of this part of the book. Look back at Exhibit 5. We saw that there was little change in the per capita income of the world prior to 1800. Most people spent their entire lives in villages and farms only a few miles from their places of birth. They had little knowledge or contact with those living outside of these small areas. The size of markets was small, gains from trade and capital formation minimal, and per capita income hovered near the subsistence level.

But after around 1800, technological improvements and capital formation propelled incomes upward. As Exhibit 5 shows, per capita income in the West (the high-income countries of Western Europe, North America, Oceania, and Japan) grew substantially during the 150 years following the start of the Industrial Revolution. But the situation did not change that much outside the West. Income levels in the rest of the world remained at or near subsistence levels. As recently as 1950, the per person income of developing countries was approximately $4 per day.

During the past half century, however, there has been a remarkable change. Many developing countries have grown rapidly. During the past 50 years, the per person income of developing countries has increased by an even larger amount than the income of the high-income countries during the 150 years following the Industrial Revolution.

What accounts for the remarkable economic progress of the past half century? During this period, huge reductions in transportation and communication costs and the accompanying growth of international trade have enabled the world to expand production and achieve substantially higher income levels. The change was so dramatic that the period beginning around 1970, may properly be thought of as the Transportation-Communication Revolution. Although there is widespread recognition of the economic progress that accompanied the Industrial Revolution, in many ways, the Transportation-Communication Revolution of the past half century is even more remarkable. It is time for this more recent economic revolution to be acknowledged as well.

This huge reduction in the real cost of transportation and communication provides a large part of the answer. Driven by improvements in technology and entrepreneurship, the cost per ton of ocean shipping declined by more than 50 percent during 1974–2016 (adjusted for inflation). The air freight shipping cost per ton-kilometer declined by an even larger amount during the same period. Standardized steel containers and mechanization reduced the cost of loading and unloading ocean freighter cargo from $48 per ton in 1956 to 18 cents in 2006, a reduction of over 99 percent. The cost reductions for several forms of communication have been so dramatic they are difficult even to estimate. As recently as 1990, international telephone calls were of uncertain quality and cost several dollars per minute. Today, calls involving both audio and video transmission, including conference calls, can be made over the internet at a cost close to zero.

This sharp reduction in transportation and communication costs contributed to a substantial increase in international trade, increased gains from entrepreneurial activities, and improved economic institutions. These factors enhanced economic performance throughout the world, but the impact in developing countries was particularly dramatic. Widely published statistics on the importance of trade in the global economy can be very confusing. They are usually reported as a ratio of trade to GDP. Trade, however is defined as the SUM of imports plus exports, in effect double counting trade. During the 1960s, this measure of international trade as a share of GDP averaged 19 percent of world output, implying that the goods sent between countries were slightly less than 10% of global product. This ratio increased steadily in the decades that followed, and by 2023 international trade was approximately two and a half times the figure of the 1960s. The importance of trade in today’s economies becomes even more obvious when one realizes that many components of GDP such as haircuts or restaurant meals are not easily traded.

Of course, reduced transportation and communication costs enabled realization of economies of scale and higher incomes within as well as across countries, especially those of greater size. The rapid industrialization of the United States in the 19^th century was in large part due to the fact that the US Constitution (Article 1, Section 10) prevented states from imposing tariffs on products from other states. This clause became especially important in the second half of the 19^th century when long-distance railroads massively lowered transport costs bringing the resources of the Middle and Western states to producers in New England and the mid-Atlantic.

Lower transportation and communication costs also resulted in larger gains from entrepreneurship. Businesses and entrepreneurs in developing countries can adopt or access at a low cost the successful technologies and practices present in the more advanced economies. As interaction of people across national boundaries and knowledge of successful practices employed elsewhere expanded, gains from these sources soared.

Even the quality of institutions and policies was affected. Reductions in transportation and communication costs provide potential entrepreneurs and investors with greater flexibility and expand the range of possible country for locating their business activities. In turn, this increases the incentive of political decision-makers to adopt sound institutions and policies in order to attract these globally mobile entrepreneurs. Thus, in addition to their more direct impacts on the volume of trade and entrepreneurship, lower transportation and communication costs have generated positive secondary effects including enhancement of the incentives to remove trade barriers and improve the legal system. As restrictions declined, the quality of the legal system of less-developed countries has improved. Citizens can and will demand more from their governments the more they know about what is happening elsewhere. Autocrats and dictators are threatened like never before in a world with YouTube and VPNs.

Impacts due to communications can also be observed at very micro levels. Farmer share information about new seed varieties on Twitter. Sending a photo of a diseased vine to the agricultural extension agency for advice can happen in minutes rather than requiring an all-day journey to a nearby town. Mobile phone money enables immigrants to transfer funds to their families without paying exorbitant fees to intermediaries. Identities are easily established and many opportunities for corruption are eliminated by electronic IDs.

Some developing countries have grown far more rapidly while others have lagged well behind. Geographic factors, particularly climate and location, have contributed to this variation in economic growth. Jeffrey Sachs of Columbia University has been at the forefront of those arguing that geographic factors, such as people living in hot, humid climates located far from the major markets of Europe, North America, and Asia and having limited access to an ocean coast-line, face major economic disadvantages. Hot and humid tropical climatic conditions erode the energy level of workers and increase the risk of disabling and life-threatening diseases such as malaria and yellow fever. Locations distant from the world’s major markets make trade more costly and reduce the availability of potential trading partners. Limited access to ocean shipping, particularly when a country is land-locked, further reduces the attractiveness of a country for conducting business and the location of productive activities.

Climate, proximity to world markets, and access to ocean shipping matter. Developing countries with favorable climate conditions and locations closer to the world’s major markets have benefited substantially from the sharp reductions in transportation and communication costs. Their trade sectors have grown rapidly and per person income levels have increased substantially. In contrast, countries with hot, disease-prone climates located far from major markets have benefited much less. Predictably, those countries with larger geographic disadvantages have both smaller increases in trade and slower economic growth. Sub-Saharan African countries dominate the list of the world’s most geographically disadvantaged countries. Thus, it is not surprising that the growth of per person income in this region has lagged behind that of other developing countries.

What matters even more, however, are things that a society can control. The most important barrier encountered by countries where prosperity growth is lagging is conflict—coups, rebellions and civil wars. As seen in Figure 19, the Inernational Growth Centre estimates that a civil war⁽⁷⁴⁾ lasting four years reduces GDP by 18% while it is going on and that this lower income persists for more than 10 years after the start of the war.

• Note: Figure shows the simulated response of GDP per capita to a civil war of four years length (shaded area). Civil war is defined as a year with more than 0.08 battle-related deaths per 1,000 population based on PRIO/UCDP data. GDP per capita from the World Bank. See Mueller (2016, Economica) for the per capita measure and Mueller (2013) for the methodology. The simulation carries an error that increases over time.

Conclusion

Compared to the past, we now have better knowledge and stronger evidence about the types of economic institutions and policies that enhance human progress. Having knowledge about what works, however, does not mean that sound institutions will necessarily be adopted. Institutions and policies are outgrowths of the political process. Thus, if we want to understand the development of economic institutions, we need to examine the operation of the political process. This will be the focal point of Part 3.