Definition and Description

Definition and Description2017-08-10T13:29:53+00:00

Historical Index of Economic Liberty [1]

Economic liberty is a ‘negative’ freedom, defined as lack of interference or coercion by others in an individual’s economic decisions. Personal choice, voluntary exchanges, access to markets, and protection of persons and their property from aggressions are its constitutive elements.

A country can be considered economically free in so far people and privately owned property are securely protected, contracts enforced, prices stable, barriers to trade small, and resources mainly allocated through the market. Assessing the consistency of a nation’s institutions and policies with these requisites is the purpose of any index of economic freedom.

Four main dimensions of economic freedom are distinguished: legal structure and security of property rights, value of money, freedom to trade internationally, and regulation.

For each dimension of economic freedom an index, consistent over space and time, is computed on the basis of different indicators.

When the indicator’s value is inversely related to the degree of economic freedom, it has been transformed into index form using the expression:

Iij = 10 (VMAXVij) / (VMAXVMIN)

Where Vij represents the value of country i indicator at year j and VMAX and VMIN, its maximum and minimum values

Alternatively, when the value of the indicator is directly related to the value of economic freedom, it is the following expression the one used,

Iij = 10 (VIJVMIN) / (VMAXVMIN)

Thus, in either case the resulting index of economic freedom ranges between 0 (minimum) and 10 (maximum).

The period considered is that of the spread of modern capitalism, namely, the epoch covering from the emergence of free trade and laissez faire in the mid-nineteenth century to the eve of the current recession.

Legal structure and security of property rights

The rule of law, security of property rights, judicial independence, and impartial courts are major components of a legal structure consistent with economic liberty.

Two indicators that aim at capturing the legal framework and the protection of property rights from a long-run perspective can be employed.

  • The first one is ‘Constraint on the Executive’, that is, the extent of institutional constraints on the decision-making powers of the chief executive. The executive branch is typically constrained by the legislative and judicial branches of government.
  • The second indicator is ‘Contract Intensive Money’ (CIM), that designates the percentage of deposits in money supply, and is proposed as a way of measuring compliance with contracts and the security of property rights.

CIM = (M2C) / M2

Where C is currency outside banks and M2 is money supply, including currency outside banks, current and term deposits.

The rationale that lies beneath this indicator is that when economic agents trust that contracts will be respected and operate in an assumed safe environment, they hold a larger proportion of their money as deposits -as it is not risky and provides a more attractive option than cash-, so CIM tends to increase. CIM, hence, provides an indicator of the security of property rights.

An index of legal structure and security of property rights has been obtained as the unweighted arithmetic average of these two indices.

Value of money

A reliable and efficient monetary system is essential to protect economic freedom and its main contribution is to provide a regime of stable prices. Inflation erodes the value of property held in monetary instruments. Furthermore, high and volatile inflation rates distort relative prices and alter long-term contracts, making difficult for individuals to plan for the future.

The measures that aim at assessing the consistency of monetary policy and institutions with long-term price stability include:

Imagen_LPE2Leandro Prados de la Escosura

Leandro Prados-de-la-Escosura (Spain, 1951), D. Phil. (Oxford University) and Ph.D. (Universidad Complutense, Madrid), Professor of Economic History and Researcher at the Figuerola Institute at Universidad Carlos III, Madrid. He is also a Research Fellow at the Centre for Economic Policy Research (CEPR), a Research Associate at the Centre for Competitive Advantage in the Global Economy (CAGE), and Corresponding Fellow of Spain’s Royal Academy of History.

He has taught at Georgetown University (Prince of Asturias Professor) and the University of California, San Diego. He has been a Visiting Fellow at All Souls College, Oxford and the London School of Economics, and a Jean Monnet Fellow at the European University Institute. During the academic year 2013-14 he was Leverhulme Professor at the London School of Economics. He has been appointed Honorary Maddison Chair at the University of Groningen (2015-2019).

He served as President of the European Historical Economics Society [EHES] (2001-2003) and as Trustee of the Cliometric Society (1990-1993) and EHES (1991-1995). He belonged to the Executive Committee of the International Economic History Association, 2006-2012. He is currently in the Membership Committee of the Economic History Association.

He is currently an Editorial Board member of Explorations in Economic History, Cliometrica, and Histoire Economique Quantitative, and served at the European Review of Economic History (1997-2010). He is a member of the Scientific Advisory Committees of theEuropean Review of Economic History and the Scandinavian Economic History Review. He is a former editor of Revista de Historia Económica/ Journal of Iberian and Latin American Economic History (1991-1994) and a former member of its Board of Trustees (1995-2000, 2005-2012).

He has contributed to the main journals in economic history and published and edited books on long-run growth and retardation in Spain, the economic consequences of Latin American independence, the costs and benefits of European imperialism, and British exceptionalism at the time of the Industrial Revolution.

His current research interests are economic freedom and wellbeing in historical perspective; growth, distribution, and welfare in Latin America since independence; and economic change and inequality in pre-industrial Spain. He has been Team Leader at Carlos III University of the CEPR/ European Commission FP7 Collaborative Project “Historical Patterns of Development and Underdevelopment: Origins and Persistence of the Great Divergence”.

leandro.prados.delaescosura@uc3m.es

https://uc3m.academia.edu/LPradosdelaEscosura

Research papers at: https://ideas.repec.org/e/ppr58.html

  • The ‘differential money growth’ –that is, the difference between the average annual growth of the money supply in the last five years and the average annual growth of real GDP in the last ten years–. Its rationale is that high rates of monetary growth lead to inflation,
  • The inflation rate,
  • And the standard deviation of inflation (as a measure of volatility).

An index of value of money has been obtained as the unweighted arithmetic average of these three indices.

Freedom to trade internationally

Free trade represents a key dimension of economic liberty as it provides individuals with the widest possible choice of goods and services and facilitates specialisation along comparative advantage. By not interfering with the freedom to enter and compete in international factor and commodity markets, governments promote economic freedom.

In order to assess economic freedom in international trade a variety of restraints need to be considered including tariffs, quotas, and exchange rate and capital controls. From a historical perspective, a distinction between pre- and post-Second World War periods needs to be made, as differences in restrictions and data availability require different indicators. Thus, weighted nominal protection (WNP) –the ratio of total tariff revenue to the value of total imports- and capital mobility provide indices for the entire period, while for the post-1950 era indices of current account restrictions and the ‘black market premium’ (BMP) -the difference (in logs) between the parallel, market-determined and official exchange rates-, are also included.

An index of international trade has been obtained as the unweighted arithmetic average of the first two indices for 1850-1950, and of the four indices for the period from 1950 onwards.

Regulation

Regulation of economic activities can restrict market freedom entry by interfering with individuals’ decision to engage in voluntary exchange.

Credit market regulation

The following historical indicators have been constructed,

  • The risk of crowding out provides a proxy of the regulation of the private sector credit. It is approximated by the ratio of the budget balance to GDP.
  • Interest rate control, approximated in the long run by real short-term interest rates (that, is nominal short-term interest rate less inflation).

An index of credit market regulation has been obtained as the unweighted arithmetic average of these two indices.

Labour market regulation

An important facet of regulation of economic activity is, at least since mid-twentieth century, that of the labour market.

Laws and regulations affecting wages and working conditions may restrict negative economic liberty by reducing//constraining labour market flexibility. An index of employment protection legislation (EPL) has been employed to proxy the regulation in the labour market.

Due to lack of data, the coverage of the index of freedom from labour market regulation is restricted to the post-1950 era, which actually is the most relevant from the point of view of constraints on economic freedom.

The final index of freedom from regulation corresponds to the index of credit regulation between 1850 and 1950 and, from 1950 onwards, has been derived as an unweighted arithmetic average of the indices of credit and labour market regulation.

Table 1: Dimensions of the Historical Index of Economic Liberty (HIEL) and their Components

Legal Structure and Property Rights Value of Money International Trade Regulation
Contract-Intensive Money Inflation Rate Nominal Weighted Protection Budget Balance
(% GDP)
Constraints on the Executive Inflation Variability Capital Mobility Real Interest Rate
Money growth Current Account Restrictions, 1950-2007 Employment Protection Legislation, 1950-2007
Black Market Premium, 1950-2007

An Aggregate Index of Economic Liberty

Then, the indices for each dimension (namely, property rights, money, international trade, and regulation) are combined as an unweighted average into a historical index of economic liberty (HIEL), which ranges between 0 and 10. Thus,

HIEL = (ILE derechos de propiedad + ILE dinero + ILE comercio + ILE regulación) / 4

References

Gwartney, J.D., R.A. Lawson, and J.H. Hall (2014), Economic Freedom of the World: 2014 Annual Report, Vancouver: Fraser Institute.

Prados de la Escosura, L. (2016), “Economic Freedom in the Long Run: Evidence from OECD Countries (1850-2007)”, Economic History Review 69 (2016) DOI: 10.1111/ehr.12130
https://onlinelibrary.wiley.com/resolve/doi?DOI=10.1111%2Fehr.12130#.VfmVGW0QG4k.twitter.

[1] The Historical Index of Economic Liberty (HIEL) is inspired in and adapts from a long run perspective The Fraser Institute’s Economic Freedom of the World Index (EFW) (See Gwartney, Lawson, and Hall, 2014). A detailed explanation of the concept, computation procedures, and analysis of the results is provided in Prados de la Escosura (2016).