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Freedom's Measuring Stick

By James Call

"Greed is good. Greed works. Greed is right...and greed, mark my words, will save not only Teldar Paper but that other malfunctioning corporation called the U.S.A.

Gordon Gecko, the corporate raider played by Michael Douglass in the 1987 movie, Wall Street, became an icon when he explained in plain language his guiding principal of capitalism.

Greed—an excessive desire to acquire wealth and power beyond what one needs—is topical. The collapse of Enron, the Arthur Andersen conviction, and an avalanche of corporate scandals have renewed a discussion about greed and America. The soul searching comes after the longest economic expansion in the country's history, a time when conspicuous consumption and a desire for more seemed almost fashionable.

Two hundred years before Gecko, English economist Adam Smith published his take on why capitalism works in The Wealth of Nations: "It is not the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own self-interest."

Freer World? Rating above is based on information that 123 countries provided to the World Bank and the International Monetary Fund. Source: The Economic Freedom of the World Annual Report 2000.

Smith's renowned "invisible hand" concept ensures everything works out best for society when a consumer seeking the lowest price meets up with a merchant seeking a profit. Of course, in such an exchange it may be difficult to decide who is greedy and who is acting in his or her own self-interest—a selfish regard for one's personal advantage. But there is a difference. Just as there is between providing a legal product for money and persuading an auditor to say you found a tree that grows dollars.

"Greed works," James Gwartney says with a laugh at the mention of Gecko. "Incentives do matter. A motivating factor to undertake economic activities and trying out new ideas is a financial reward," the Florida State University economics professor said.

Gwartney is in Smith's camp; capitalism works best for a society when people are free to pursue their self-interest. And he says he can prove it.

Since 1989, Gwartney has been immersed in a project started by Nobel laureate Milton Friedman that has involved more than 100 economic scholars worldwide. Known as the Economic Freedom Project, the effort produces a widely quoted annual report, The Economic Freedom Index, (EFI) published by a network of institutes worldwide including the Cato and Fraser institutes in the U.S. and Canada respectively. The first index was released in 1996.

Serving as the report's co-author Gwartney has since gained a stature uncommon among his academic peers. In 1999, he began a two-year term as the chief economist for the Joint Economic Committee of Congress, and the following year he lectured in Moscow at the request of President Vladimir Putin.

Gwartney and his like-minded colleagues define "economic freedom" as the phenomenon that exists when individual choice holds more power in the marketplace than government mandate. His annual index consistently shows where in the world low taxes, light regulations and few state-owned enterprises conspire to create greater wealth and more civil liberties. The more economically free countries tend to do a better job of protecting the civil liberties of their people, Gwartney said. An added benefit of relying on market forces rather than government mandates is that because the market is self-correcting there is less chance of a severe recession.

Since 1808, the U.S. has had 19 recessions, periods characterized by overproduction, falling consumption, and high unemployment. For most of the 20th century, conventional economic wisdom had it that the remedy to recessions was government intervention. Gwartney argues that approach was wrong and created more problems than it solved.

"Once the view was that the market economy was inherently unstable, so we needed to have economists tell us to pull the right tax and expenditure levers," says Gwartney. "That's no longer the view."

Big Bad Government

A new view of how to manage a national economy took hold in the 1980s and has since swept through most of the world. It's based on the writings of Frederick von Hayek, (1899-1992) an Austrian-born economist who one biographer called "the most prodigious classical liberal scholar of the 20th century." Hayek said that a formula of sound money, the rule of law and few regulations produces the best economic system and quality of life. His followers, Gwartney among them, call this approach economic freedom and show how its roots reach back to post-World War II Europe.

The post-war era was a time when a big active government seemed capable of accomplishing anything the mind imagined. Government marshalling resources and people on an unprecedented scale had defeated Fascism. Now it would lead the way in rebuilding Europe. Flush with success, policy makers believed that through central planning government would put a man on the moon, eliminate poverty and create a world where all of mankind lived in peace. Such talk may sound nave today but it scared Hayek, wary of big government, to death.

In The Road to Serfdom, first published in 1944 and since reprinted by the University of Chicago Press, Hayek warned that a powerful government eventually becomes abusive and enslaves its citizens.

In 1948 he convened a meeting of economists, government officials and assorted pundits in Mont Pelerin, Switzerland to discuss his concerns and thus was born the Mont Pelerin Society. Its members would create think tanks, finance scholar chairs and build the intellectual foundation for a market-based philosophy.

Jame Gwartney addresses a news conference at the Cato Institute..

A mountain retreat was an appropriate setting for the meeting because the participants would spend much of the next 30 years wandering in the academic wilderness. Since the Great Depression and until the 1980s, Keynesian economics had been the dominant school of thought in the West. John Maynard Keynes and Hayek were colleagues at Oxford and while some considered Keynes the savior of capitalism Hayek was viewed as a fringe character oddly seduced by Adam Smith's invisible hand. One reviewer noted that the intelligentsia sneered when Hayek published his theories.

Keynes believed a strong government was needed to smooth out the rough edges of a market economy and to step in whenever the market failed. Hayek argued that the market was self-correcting and government power came at the expense of individual freedom.

His theories eventually formed the basis of Ronald Reagan and Margaret Thatcher's policies. Both implemented a key Hayekian principal that the proper role of government is to provide stable currency, a strong legal system and easy access to the market. Given this infrastructure the economy would take care of itself.

FSU economist James Gwartney defines "economic freedom" as the presence of personal choice, voluntary mercantile exchange, freedom to compete and governmental protection of personal and property rights..

In Hayek's view this was government's legitimate role in stimulating economic growth. The thinking was, and among economic conservatives still is, that a strong legal system deters theft of property and ideas; strong currency prevents inflation from stealing the rewards people seek for bringing new ideas to market; and an absence of regulations frees people to enhance products and services through competition. Government builds the infrastructure that transforms the market into a laboratory of creativity, the force that drives prosperity and social progress.

As a developing scholar during the Reagan years, Gwartney seemed puzzled that anyone would think otherwise. He saw that freedom was valued not just in politics but in science and the arts as well. He saw the intrinsic good sense of creating a community where if a neighbor wants to use your idea, for example, and doing so violates no ethical, civil or criminal code, then government approval shouldn't be required to strike a deal.

When economists talk about the magic of the market it's this interaction between individuals, neighbors who are also an entrepreneur and consumer, a seller and buyer that they're thinking about.

"Without the freedom to engage in an exchange process innovations won't spread throughout a society," says Gwartney. "Hayek brought out this discovery process as a key source of economic progress."

His explanation comes with a Jeffersonian twist when he noted that genius often comes from unexpected sources, such as from individuals one might not expect to come up with life-changing ideas. As examples, he mentioned a 55-year old milkshake seller, Ray Kroc, who thought it would be worthwhile to franchise hamburger stands, and a failed university student, Ted Turner, who decided to broadcast a television station via satellite.

Freedom's Bottom Line

Hayek's followers were at a disadvantage in economic debates because they had no empirical data to support their theory. Chile implemented policies based on Hayek and experienced growth in the mid 1970s but it was a dictatorship, unable to testify on behalf of freedom.

Then inspiration struck via George Orwell, the novelist. At a 1984 meeting of the Mont Pelerin Society discussion turned to Orwell and whether his prediction for the year had come to pass. A consensus formed that Orwell had missed the mark of an omnipresent government monitoring all activities of a citizen's private life but he was dead on when it came to economics.

In economic affairs, government was everywhere, the society concluded. In its view, tentacles of taxes, regulations and subsidies were choking economic growth, entrepreneurs and personal freedom. Consensus was that Western democracies were traveling on Hayek's "road to serfdom."

The following year, the Fraser Institute began planning a series of conferences to discuss the state of economic freedom. At the third conference in 1989 Gwartney took the floor and made an observation much like the little boy who noticed the emperor was naked. He told the group that their discussion lacked any meaning since freedom, at least for the purpose of the discussion, was undefined.

How could anyone argue that Americans were less free than Britons when there was no way to measure the impact of government in something as complex as the economy of a modern society, Gwartney demanded to know.

For his insight, the society presented Gwartney with the challenge to come up with a tool for measuring economic freedom throughout the world. It took nearly 10 years of research, but the FSU economist delivered. In 1996, he and his colleague Robert Lawson, a professor at Capital University in Columbus, Ohio, launched their Economic Freedom of the World Index (EFI), an annual report on the health of the world's economic well-being. The two economists have since honed their methods into what many leading economists believe is the best yardstick out there for measuring how freedom is tied to growth and government.

The components of Gwartney and Lawson's index fall under one of five criteria. The tool measures to what extent a country's economic systems are consistent with personal choice, private property rights, freedom of exchange, freedom to compete and a strong judicial system to protect people and enforce contracts. When applied to 123 countries that provide survey information to international organizations like The World Bank, International Monetary Fund and the Organization for Economic Cooperation and Development the index reveals an interesting trend, says Gwartney.

The numbers coalesce into a pattern whereby small governments wind up delivering more economic growth than governments heavily involved in running the economy through such things as high taxes, strict regulations and government-run industries. The growing economies also tend to be in nations where there are more civil liberties and political freedoms.

Gwartney says this pattern is proof that economic freedom provides a source of power independent of government. It is from this source that political freedom and civil liberties eventually flow.

Gwartney recognizes that the finding begs the question: What indeed makes a society free? Is it because of democratically held elections, freedom of speech or when citizens decide how they will make a living?

"If government takes most of the income you earn, if enterprises are run by government rather than private companies and you don't have the opportunity to compete then you've lost a lot of your freedom," he answered.

Not so fast, say critics.

After reviewing the first index released in 1996 Max Sawicky, an economist at the Economic Policy Institute, a Washington-based think tank, dismissed it as a "gross simplification."

But Douglass North, a 1993 Nobel Prize winner in economics, while calling the index "a one-dimensional measure of something very complicated," winds up conceding its merits. "It's not the whole story. But it is an important measure. It's the best we have."

Proponents nonetheless express confidence in the validity of the index. They note that six separate conferences have drawn several Nobel Prize winners, including Milton Friedman, who were involved in creating the concept behind it.

"It is extremely useful in judging the extent to which a society has adopted free market principles," Friedman told Research in Reviewwhen asked what he thought of Gwartney's index. "There were all these arguments concerning how do you judge freedom. (But the question is) how do you determine the consequences of freedom?

"If you rank a country's economic freedom you can then see how it (the country) ranks according to other indices. (Now) you have a good definition of what is freedom. And it has turned out to be feasible to construct a measure."

The 10% Rule

If nothing else, the EFI illustrates principles that make up the backbone of healthy capitalism, says Gwartney. With the power to tax, spend and regulate government can be a major force in any economy, he says. When government is too big a player then markets become politicized and may be unable to set accurate values of goods and services. Individuals spending their money tend to seek high value at low cost. A government official could have a different agenda.

"When products are not rationed by money then some other criteria is used," says Gwartney. "When politicians believe there is a political gain in some act they will commit it."

This is why he believes it's best to keep the political process a safe distance from the exchange process and confined to what it does best, maintaining a system that permits market forces to function.

In other words, the primary function of the state, he argues, is to build the stage upon which the market performs. A stable currency is needed so that cost can be predicted and a legal system protects people from coercion, property from theft and enforces contracts. Armed with sound money and the rule of law people have confidence that they will be rewarded for bringing a good idea to market. That is exactly what the index confirms, says Gwartney.

"When government goes beyond protective functions to becoming a player it undertakes a lot of activities it doesn't do well and it harms the exchange process." When people are not free to compete then the market begins to fail.

Gwartney's research has led him to conclude that the best economic performance occurs when government spending is held to 10 percent of a country's gross domestic product. Any more than that puts cuffs on Adam Smith's invisible hand concept and the natural forces of the market— incentives and innovations—are pushed to the side.

"Governments with spending that is 50 percent of GDP tend to have growth rates of one percent. When it's 30 percent the growth is two percent. The evidence is quite strong that the freer economies grow more," says Gwartney.

Despite the rocky, post-September 11 economy and a spate of lawmaking aimed at restoring consumer confidence in Wall Street, this is where the United States is headed. Federal spending dropped from an average of roughly 22 percent of GDP in the 1980s to 18 percent during the 1990s. From 1982 to 2000 the economy grew 199 out of 207 months, two long economic expansions interrupted by a short recession. President Bush's budget plan released last March would reduce government spending to 15.8 percent by 2011.

A world away, Gwartney points to Ireland like it was the brightest student in the class who shows up everyday with a bushel of polished apples. In the mid 1980s Ireland was nearly bankrupt and was denied an International Monetary Fund loan. Ireland was forced to adopt reforms when it joined the European Union.

The Five Elements of Economic Freedom, as defined by FSU economist James Gwartney, has gained more acceptance around the world in the last 20 Years, as this graph of average economic freedom indices from 123 countries suggests..

"Ireland went from a big government, high tariffs, high inflation. They were doing everything wrong in the 70s and mid-80s. Then they began doing everything right, cutting taxes, spending and tariffs and privatizing. And look, GDP grew by 3 percent during the last seven years," says Gwartney.

Other countries that have it right according to the EFI include Hong Kong, Singapore and New Zealand, countries that provide easy access to the market, even-handed enforcement of contracts and stress personal choice over collective choice.

And then there's Venezuela, moving in the opposite direction. Venezuela had the 16th-freest economy in the world in 1975 (when the EFI is applied to historical data) and the 82nd one in this year's report. The country also experienced a 15 percent drop in per capita GDP.

With a few exceptions, African and Latin American countries rate low because of a weak legal system. The Arab world's low rank stems from highly regulated markets.

Gwartney sees hope for Latin America in Mexico. Reform policies improved Mexico's EFI score from 4.5 in1985 to 6.3 in the 2002 report and attracted a dramatic increase in foreign investments. Mexico's share of investments coming into North America increased three-fold from 1998 to 2001 and totaled $2.7 billion for the first quarter of 2002.

"If Mexico upgrades its legal system and becomes the Irish miracle of the next decade then Latin America will follow," Gwartney predicted.

"This is why I'm so excited about this project," he continued. "Economic freedom—the entrepreneurship it unleashes—is the most important weapon for achieving higher living standards in the world."

Now that may sound similar to what big government advocates were promising a half-century ago. But Gwartney is a realist.

"If economic freedom does not provide prosperity then it will be less viable. That's what happened with communism. It failed to deliver the goods and the system collapsed."

Capitalism's Well