(Reprinted from HKCER Letters, Vol.57, January-February 2000)
Economic Freedom and Growth
Determining Economic Growth Factors
Governments manage economies with the aim to achieve economic growth. However, several crucial questions need to be answered for successful economic policies to be planned and implemented. What causes economic success? What are the practices of economically successful countries and regions? What are the implications of successful economic strategies? Why do some countries succeed and others fail? For economists, historians and political scientists, resolving these issues can provide important insights for understanding basic economic assumptions and blueprinting basic economic success factors.
We try to answer these questions by comparing the economic freedom and economic growth relationship in two economies - Hong Kong and Venezuela. Since the 1950's, Hong Kong has built economic strength from an impoverished economic infrastructure, whilst Venezuela's economic health has declined despite its relatively strong economic structure. Figure 1 shows that in 1950, Hong Kong's income per person was approximately half of Venezuela. During that period, Hong Kong came under tremendous economic and social pressure due to an influx of immigrants from China and a lack of natural resources to support growth. Meanwhile, Venezuela was resource-rich and had a relatively stable population. In the 1950's, economists may have bet on Venezuela to pursue sustained economic growth. Instead comparisons in the 1990s showed Venezuela's income per person was much lower than 1950 in real terms while Hong Kong's was dramatically greater.
While Venezuela's economic decline may be attributed to its high population growth (adversely impacting economic growth), it can be proved that Hong Kong also experienced tremendous population growth over the past few decades (Figure 2). In addition, Hong Kong lacked the natural resources to support its population growth and resorted to importing all its basic needs to support the economy.
The main argument then, explaining the variation in economic performance can be attributed to the differential economic freedom between the two countries. Figure 3 shows that during the 1970s and through the 1990s, Hong Kong continued to achieve higher levels of economic freedom than Venezuela. More importantly, economic freedom in Venezuela deteriorated during the same period. By 1997, Hong Kong had over 50% more economic freedom than Venezuela (Figure 4). However, such comparisons are not rare when viewing global economies as stories of economic asymmetries abound around the globe.
Economic Freedom Evaluation
A project has been developed to discover methods to measure economic freedom and explore its connection with other measures. Although some economists believe economic freedom cannot be measured, physicist Enrico Fermi pointed out that we all make comparisons. What Fermi emphasizes is that when we make a comparison, we make measurements. While the concept of economic freedom remains difficult to measure, continued efforts are made to accurately gauge comparisons by refining measurement methodology.
Measuring economic freedom consists of three main elements:
1. The right to engage in voluntary acts of trade and exchange, without interference by government or others via force or fraud;
2. The ability to access an impartial judiciary or the enforcement of property rights;
3. The right of citizens to retain a majority of the income they earn.
An Economic Freedom Index has been designed to identify various factors that make a country economically free, by using a compendium of 23 freedom factors based on objective data or independent surveys. It is a ranking of 123 countries according to the extent to which they are free.
The Economic Freedom Index's components consist of:
1. Government size.
2. Economic structure - extent of government ownership over the means of production.
3. Monetary and price stability - does the government provide citizens with a stable unit of account and transaction, or does the government use inflation and taxation to take away assets of its citizens?
4. Freedom to use alternative currencies - the right to use foreign currencies to engage in foreign trade.
5. Legal structure and property rights - enforceability of contracts and security of property rights.
6. International exchange - the extent to which citizens can trade with foreigners.
7. Freedom of exchange in capital markets - the right to engage in capital transactions with foreigners, the right to have access to credit facilities.
Taking into consideration all aspects of the Economic Freedom Index, Hong Kong and Singapore emerge as the "Most Free Countries" while New Zealand is ranked the third most open economy amongst the 123 countries in 1999. Hong Kong has enjoyed high levels of economic freedom since the 1970's. During the past few decades, Hong Kong has continued to be the top ranked jurisdiction in the world. Although Hong Kong's overall economic freedom rating in 1999 was up since 1990, it was still down from a peak score of 9.8 (out of a possible score of 10) in 1995. This slip can be attributed to a decline in the Legal Structure and Property Rights Index section2. However, in other areas of the index, Hong Kong consistently maintained or improved its scores since 1995. Since 1997, its rating has been tied with Singapore, due to the lagged effect of concern on contract repudiation when Hong Kong became the Special Administrative Region. Since contracts entered by the Hong Kong government did not have the complete involvement of the People's Republic of China prior to 1997, there was initial concern that after Hong Kong's handover to China, some contracts (including one for Hong Kong's airport) would not be honored. The passing of this uncertainty means future ratings should see Hong Kong achieve higher scores in the Index's Viability of Contracts rating.
Hong Kong has maintained a free economic market consistently as it embraced capital market principles several decades ago. However, for many other countries, economic freedom is only a recent phenomenon and there is no question that overall, the world is becoming more deregulated as countries decentralize economic power. Figures 5 and 6 show that during the 1990s, several Latin American and Eastern European countries achieved dramatic improvements in economic freedom ratings and rankings. Peru, Nicaragua, Argentina, El Salvador and Dominican Republic all improved ratings by at least 2 points. Amongst Eastern European nations, Russia, Hungary and Poland have greatly improved levels of economic freedom while countries which have experienced a decline in the level of economic freedom during the 1990s include Benin, Chad, Malaysia, Cameroon and Senegal (Figure 7).
Economic Freedom in Hong Kong vs. China
The economic freedom between Hong Kong and China provides an interesting comparison. In rating government jurisdiction and use of markets, China is rated dramatically lower than Hong Kong (Figure 8). However, ratings in monetary policy are not that different, but use of alternative currencies in Hong Kong remains far more open. In terms of international exchange and financial markets, Hong Kong also rates firmly ahead of China.
In 1997, there was great concern on behalf of international investors that contracts with the old Hong Kong government would not be respected by the new SAR administration. Perhaps as a result of this concern on economic freedom, China has exceeded Hong Kong's rating for legal structure and property. This is because evaluation of country risk was done to measure the rule of law as well as the repudiation of contracts and appropriation considerations related to the rule of law.
Economic Freedom and Growth
If we arrange all countries according to their economic freedom by quintile and then view other economic characteristics such as per capita income, interesting results emerge. One of the most compelling results of the study is the relationship between economic freedom and prosperity. In 1999, countries that score in the top quintile of the "most economically free" countries had an average per capita GDP of US$18,108 (Figure 9) and an average growth rate of 2.27% (Figure 10). As freedom declines, so does the average per capita GDP and average growth rate. The bottom quintile of economically free countries had an average per capita GDP of US$1,669 and an average growth rate of -1.32%. If we look at the countries' scatter diagram, it shows that 64% of economic variation amongst countries can be attributed to the level of economic freedom (Figure 11).
A significant question economists and political scientists continue to determine is whether countries have to make critical choices and compromise community values and social development to achieve economic development. Historic evidence shows the contrary. Community well-being and human development has been achieved primarily through economic freedom. The scatter diagram in Figure 12 refers to economic freedom against human development; it shows a basic factor that countries with higher development levels have higher levels of economic freedom.
These results are also affected by other economic measures such as life expectancy, adult literacy, human poverty, infant mortality, child malnutrition, and access to health care and income inequality. Similarly, cereal yield, access to safe drinking water, labor productivity and research and development as a percentage of GDP are also related to economic freedom. Factors such as size of the underground economy, corruption levels, political stability, degree of political rights, civil liberties and bureaucracy also add up to the level of economic freedom ensured in a country.
Data from Economic Freedom of the World Series and research studies that use the Economic Freedom of the World ratings confirm that countries with consistently high levels of economic freedom have better economic performance and higher domestic standards. The research indicates that political leadership that fosters more economic freedom creates foundations for a higher standard of living, increased economic growth and more human prosperity and development.
1This article is based on the transcript of a lunch talk given by Dr. Michael Walker on January 11, 2000. Dr. Walker is Executive Director of The Fraser Institute. He received his Ph.D. at the University of Western Ontario and his B.A. at St. Francis Xavier University. In 1992, he was awarded the Colin M. Brown Freedom Medal and Award by the National Citizens' Coalition.
2This score rates the security of private property rights, viability of contract, and the consistency of the legal structure with the rule of law.
Figure 1: Income per Person in Hong Kong and Venezuela
Figure 2: Hong Kong and Venezuela population growth 1950 - present
Figure 3: The Attitude of Success - Economic Freedom in Hong Kong and Venezuela
Figure 4: Hong Kong's Freedom Advantage over Venezuela
Figure 5: Nations That Improved (1990-1997)
Figure 6: Eastern and Former Soviet Transition Economies
Figure 7: Nations That Deteriorated (1990-1997)
Figure 8: Comparing Hong Kong SAR and China
Figure 9: Per Capital Income and Economic Freedom Quintile
Figure 10: Real Growth in GDP and Economic Freedom Quintile
Figure 11: Economic Freedom and Affluence
Figure 12: Economic Freedom and Human Development