(Economic) Freedom’s Just
Another Word for...Crisis-Prone

By John Miller

This article is from the September/October 2009 issue of Dollars & Sense: Real World Economics available at http://www.dollarsandsense.org

This article is from the September/October 2009 issue of Dollars & Sense magazine.

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In “Capitalism in Crisis,” his May op-ed in the Wall Street Journal, U.S. Court of Appeals judge and archconservative legal scholar Richard Posner argued that “a capitalist economy, while immensely dynamic and productive, is not inherently stable.” Posner, the long-time cheerleader for deregulation, added, quite sensibly, “we may need more regulation of banking to reduce its inherent riskiness.”

That may seem like a no-brainer to you and me, right there in the middle of the road with yellow lines and dead armadillos, as Jim Hightower is fond of saying. But Journal readers were having none of it. They wrote in to set Judge Posner straight. “It is not free markets that fail, but government-controlled ones,” protested one reader.

And why wouldn’t they protest? The Journal has repeatedly told readers that “economic freedom” is “the real key to development.” And each January the Journal tries to elevate that claim to a scientific truth by publishing a summary of the “Index of Economic Freedom,” an annual report put out by the Heritage Foundation, Washington’s foremost right-wing think tank. But Heritage’s index turns out to be a barometer of corporate and entrepreneurial freedom from accountability rather than a guide to which countries are giving people more control over their economic lives and over the institutions that govern them.

This January was no different. “The 2009 Index provides strong evidence that the countries that maintain the freest economies do the best job promoting prosperity for all citizens,” proclaimed this year’s editorial, “Freedom is Still the Winning Formula.” But with economies across the globe in recession, the virtues of free markets are a harder sell this year. That is not lost on Journal editor Paul Gigot, who wrote the foreword to this year’s report. Gigot allows that “ostensibly free-market policymakers in the U.S. lost their monetary policy discipline, and we are now paying a terrible price.” Still, Gigot maintains that “the Index of Economic Freedom exists to chronicle how steep that price will be and to point the way back to policy wisdom.”

What the Heritage report fails to mention is this: while the global economy is in recession, many of the star performers in the Economic Freedom Index are tanking. Fully one-half of the ten hardest-hit economies in the world are among the 30 “free” and “mostly free” economies at the top of the Index’s ranking of 179 countries.

Sources: International Monetary Fund, World Economic Outlook: Crisis and Recovery, April 2009, Tables A1, A2, A3; Terry Miller and Kim R. Holmes, eds., 2009 Index of Economic Freedom.

Here’s the damage, according to the IMF. Singapore, the Southeast Asian trading center and perennial #2 in the Index, will suffer a 10.0% drop in output this year. Number 4 Ireland, the so-called Celtic tiger, has seen its rapid export-led growth give way to an 8.0% drop in output. The foreign-direct- investment-favored Baltic states of Estonia (#13) and Lithuania (#30) will each endure a 10.0% loss of output this year. Finally, the economy of Iceland (#14), the loosely regulated European banking center, will contract 10.6% in 2009.

As a group, the Index’s 30 most “free” economies will contract 4.1% in 2009. All of the other groups in the Index (“moderately free,” “mostly unfree,” and “repressed” economies) will muddle through 2009 with a much smaller loss of output or with moderate growth. The 67 “mostly unfree” countries in the Index will post the fastest growth rate for the year, 2.3%.

So it seems that if the Index of Economic Freedom can be trusted, then Judge Posner was not so far off the mark when he described capitalism as dynamic but “not inherently stable.” That wouldn’t be so bad, one Journal reader pointed out in a letter: “Economic recessions are the cost we pay for our economic freedom and economic prosperity is the benefit. We’ve had many more years of the latter than the former.”

Not to Be Trusted

But the Index of Economic Freedom cannot and should not be trusted. How free or unfree an economy is according to the Index seems to have little do with how quickly it grows. For instance, economist Jeffery Sachs found “no correlation” between a country’s ranking in the Index and its per capita growth rates from 1995 to 2003. Also, this year’s report cites North America as the “freest” world region, but it logged the slowest average growth over the last five years, 2.7% per year. The Asia-Pacific region, rated “less free” than every other region except Sub-Saharan Africa, posted the fastest average growth over the last five years, 7.8% a year. That region includes India, China, and Vietnam, among the world’s fastest growing economies, which ranked 123, 132, and 145 respectively and were all classified as “mostly unfree.” And there are plenty of relatively slow growers among the countries high up in the Index, including Switzerland (#9).

The Heritage Foundation folks who edited the Index objected to Sachs’ criticisms; their claim, they say, is that growth is tied to changes in economic freedom, not the level of economic freedom. But even that claim doesn’t hold up. Economic journalist Doug Henwood found that a rising index ranking from 1997 to 2003 could explain no more than 10% of GDP growth.

But even more fundamental flaws with the Index render any claim about the relationship between prosperity and Heritage’s version of “economic freedom” questionable. Consider just two of the ten components used to rank countries: fiscal freedom and government size.

Fiscal freedom (what we might call the “hell-if-I’m-going-to-pay-for-government” index) relies on the top personal and corporate income tax brackets as two of its three measures of the tax burden. These are decidedly flawed measures. Besides ignoring the burden of other taxes, singling out these tax rates doesn’t get at effective income tax rates, that is, how much of a taxpayer’s total income goes to paying these taxes. For example, on paper U.S. corporate tax rates are higher than those in Europe. But nearly one-half of U.S. corporate profits go untaxed. The effective rate of taxation on U.S. corporate profits currently stands at 15%, far below the top official rate of 35%. And relative to GDP, U.S. corporate income taxes are no more than half those of other OECD countries.

Their third measure of fiscal freedom, government tax revenues relative to GDP, bears little relationship to economic growth. After an exhaustive review, economist Joel Selmrod, former member of the Reagan Treasury Department, concludes that the literature reveals “no consensus” about the relationship between the level of taxation and economic growth.

The Index’s treatment of government size, which relies exclusively on the level of government spending relative to GDP, is just as flawed. First, “richer countries do not tax and spend less” than poorer countries, reports economist Peter Lindhert. Beyond that, this measure does not take into account how the government uses its money. Social spending programs—public education, child care and parental support, and public health programs—can make people more productive and promote economic growth. That lesson is not lost on Hong Kong (#1) or Singapore (#2). Both provide universal access to health care, despite the small size of their governments.

The size-of-government index also misses the mark because it fails to account for industrial policy. This is a serious mistake, because it overestimates the degree to which some of the fastest growing economies of the last few decades, such as Taiwan and South Korea, relied on the market and underestimates the positive role that government played in directing economic development in those countries by guiding investment and protecting infant industries.

Still More

Beyond all that, the Index says nothing about political freedom. Consider once again the two city-states, Hong Kong and Singapore, which top their list of free countries. Both are only “partially free” according to Freedom House, which the editors have called “the Michelin Guide to democracy’s development.” Hong Kong is still without direct elections for its legislators or its chief executive, and proposed internal security laws threaten press and academic freedom as well as political dissent. In Singapore, freedom of the press and rights to demonstrate are limited, films, TV and the like are censored, and preventive detention is legal.

So it seems that the Index of Economic Freedom in practice tells us little about the cost of abandoning free market policies and offers little proof that government intervention into the economy would either retard economic growth or contract political freedom. In actuality, this rather objective-looking index is a slip-shod measure that would seem to have no other purpose than to sell the neoliberal policies that brought on the current crisis, and to stand in the way of policies that might correct the crisis.

John Miller teaches economics at Wheaton College and is a member of the Dollars & Sense collective.