[Regrettably, we are unable to publish the graphs (Figure 1-3) referenced in Dr. Grubel's article, below. Data on which the graphs are based appears below Dr. Grubel's article.]
The conventional wisdom until recently has been that more highly regulated economies are more productive, have lower unemployment and better social development than economies relying more on unregulated, free markets. The higher productivity of the more regulated economies was believed to have come from their ability to direct massive amounts of investment into most productive uses, to escape the unemployment and other effects of business cycles and to invest much to promote social development.
Henry Wallich was a prominent German-born US economist who in 1960 published an influential book with the title The Cost of Freedom. In this book he made the case for this conventional wisdom and showed its validity with data from the 1930s and the immediate postwar years. Since the publication of his book and the late 1980s Communism in the Soviet Block officially continued to generate high and stable growth rates with no unemployment. At one point Krushchev predicted that the Soviet Union would soon “bury” the United States with its economic success. The only shortcoming of the planned and highly regulated economies was, as the title of Wallich’s book implies, the Loss of Freedom of its citizens.
With the collapse of the Soviet empire in the 1980s came revelations about the false statistics on which this conventional wisdom was based. The prolonged economic troubles of Sweden have raised doubts about the longer run success of heavy economic and social engineering. But many people, to this day, cling to the notion that economic regulation results in higher economic growth, lower unemployment and better social development. These people attribute the dismal record of the Soviet-style economies to totalitarianism, not regulation and planning. They blame Sweden’s problems on temporary problems.
A recent study shows just how wrong are these unrepentant defenders of planning and regulation. This study Economic Freedom of the World 1997 was co-authored by Professor James Gwartney and Robert Lawson and published by The Fraser Institute in Canada and a number of economic research institutes around the world. Central to the study is the index of economic freedom for 115 countries. The index reflects government policies which affect inflation and the value of money, the private disposition of income, the opportunity to deal with the rest of the world and the regulation of domestic production and consumption. It is important to note that the index reflects policies which reduce economic freedom but which should increase economic and social performance in the light of theories which see government as a powerful promoter of such developments.
Countries in the study were ranked according to their Economic Freedom Index, which ranged from a low of 1.9 out of 10 for Algeria to the high of 9.3 for Hong Kong. The 115 ranked countries were divided into equal sized groups and Figure 1 shows the average real per capita income of the countries in each of these quintiles. The evidence is dramatic and clear: Economic freedom and real income per capita go together. There is no Cost of Freedom, there are only economic benefits.
Still there are many vocal defenders of government intervention. They no longer promise that it will produce greater material well-being . Now they insist that regulation and the implicit Loss of Freedom are necessary for the creation of stable employment and social development. They argue that
minimum wages are needed to assure a decent income for all members of society. Unemployed workers need generous unemployment insurance benefits to live on while they look for work. Workers must be protected from unemployment through laws which force employers to pay them a large sum before they can lay them off work. Handicapped workers must be helped to find work by mandating that they represent a specified percentage of firms’ entire work force. Unions must be made strong through appropriate legislation so that they can balance the power of employers and bargain fair wages for their members.
All of the goals of the preceding labour market regulations are noble. If they could be achieved, the Loss of Freedom may well be worth it. But in the light of the unexpected relationship between income and economic freedom shown in Figure 1it is important to consider such a possibility for labour market freedom. Economists have for a long time produced reasoning consistent with such an outcome.
Minimum wages prevent the hiring of workers with low productivity. Most affected by minimum wages are the young and others entering the labour market for the first time. Generous unemployment insurance programs encourage workers to take longer to find new jobs and have more spells of unemployment. The unemployment insurance benefits also represent an implicit subsidy to seasonal industries like construction, because they have to pay their workers less to keep them attached to the industry. As a result seasonal industries are larger and during certain times of the year generate more unemployment than they would have without the subsidy.
The requirements to pay large sums to workers upon separation and hiring quotas for the handicapped result in higher total costs of labour for firms. If labour productivity is less than the cost of labour inflated by these social measures, firms reduce employment and move production abroad. The announced goals of unions are to raise wages and help the less fortunate in their ranks. If the productivity of labour does not keep up with the cost-increasing demands of unions, firms employ fewer workers and shift production abroad.
So, what is the evidence on economic freedom and the performance of the labour market? Have countries with many restrictions on freedom have more or less unemployment than those with fewer restrictions? Unfortunately, unemployment rates are published consistently only for 20 OECD countries rather than the 115 found in the Fraser Institute study. Following the method described above, I ranked these 20 countries according to their economic freedom index, divided them into quintiles and calculated for each group the average rates of unemployment for the period 1993-96. The results are found in Figure 2 and are very strong: Greater economic freedom brings lower, not higher unemployment.
The results are not as strong as those for per capita income. There is little difference in the rates between countries in the third and fourth quintiles. On the other hand, the results of Figure 2 are surprisingly good because the sample size and variations in the Freedom Index are relatively small for the kind of analysis they are used for. There are only 20 countries and a variation which has the lowest index for Italy at 5.5 and the highest for New Zealand at 8.0.
It should be noted that unemployment is not the only measure of the success of labour market regulations. Another important measure is the distribution of income as reflected in the share of total income going to those at the top and bottom quintiles of all income earners. The ratio of the top over the bottom quintiles in the United States is 3.8, in Germany 3.4 and Sweden 2.8. Sweden’s unfree labour markets have produced a more equal distribution of income than the somewhat freer German markets and the much freer US markets. However, these benefits are achieved not only at the cost of higher unemployment, as Figure 2 shows. They also have resulted in costs of relatively lower material living standards for the entire population. In 1960 Sweden’s per capita income was the fourth highest among the OECD countries. By 1995 it had fallen to 16th place. Over the same period the United States remained in second place. Germany rose from 12th to 10th place.
There are measures of well-being other than per capita income and unemployment. What is the relationship between economic freedom and such measures? The United Nations Development Program (UNDP) publishes annually the Human Development Index based on life expectancy at birth, adult literacy rate, school enrolment levels and real GDP per capita in individual countries. This UNDP index was developed in response to strong criticism of dollar income as a measure of welfare either through time or across countries. It is highly regarded because it is produced by an independent UN agency dedicated to social development and with enough resources to produce reliable statistics for nearly all countries of the world.
I found the UNDP index for 110 countries in the Fraser Institute study, grouped them in quintiles in ascending order of economic freedom and calculated the average Human Development Index for each group of countries. The results are found in Figure 3 and again are strong: Human Development is higher the greater is Economic Freedom. The exception is the fourth quintile, which contains no Western industrial countries but does include China and India. Further research is needed to explain this anomaly.
The preceding results support Milton Friedman’s long standing, fundamental proposition that Economic Freedom is not only a good in its own right but that it also promotes economic and social development. However, the results are also relevant to the much narrower and specific recent discussions over labour market policies and unemployment in Europe. These discussions tend to focus on the merit of many, wide-ranging national policies and institutions created over a long period of time. There is a strong similarity with the discussions about industrial and social policies which in the postwar years resulted in the conventional wisdom described above.
The trouble with such historic and narrowly focussed approaches is that they tend to lose sight of the forest by concentrating on trees. They miss the ever growing evidence that free markets produce superior economic and social outcomes. Such evidence is ignored only at great cost, payable by the unemployed, not the policy makers unwilling to take it seriously.
Herbert Grubel, PhD
Professor of Economics, Simon Fraser University
Senior Fellow, The Fraser Institute, Canada
The numbers for the three bar graphs are as follows. Column 1 gives the 5 quintiles, grouping countries according to the value of their Economic Freedom Index. Column 2 gives the average per capita incomes, column 3 the average rates of unemployment and column four the average values of the UNDP Development Index.
Data for Figures 1-3
Quintile Income UnEmp Dev.Index
5 2541 11.785 0.543
4 3057 9.46875 0.489
3 6385 9.54375 0.767
2 12369 7.558333 0.823
1 14829 6.585417 0.858