The causal relationship between economic freedom and prosperity

The full title of Adam Smith’s 1776 magnum opus is An Inquiry into the Nature and Causes of the Wealth of Nations and economists have been asking about the sources of long-run economic growth ever since. Even Robert Lucas, a Nobel Laureate who won the prize in economics for work on short-run business cycles, eventually turned his research efforts toward the long-run questions. In doing so he frankly stated: “The consequences for human welfare involved in questions like these are simply staggering. Once one starts to think about them, it is hard to think about anything else.”¹ Despite nearly 250 years of economic thinking on the topic since The Wealth of Nations was published, we think Adam Smith had much of the story right when he observed that “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things.”² In other words, little else is required than to provide individuals with economic freedom.

Over the last thirty years multiple indexes have been created that measure economic freedom in a way that approximates the ideal outlined by Adam Smith. During that time, hundreds of studies have been published linking economic freedom to higher income levels and growth, as well as many other desirable outcomes (e.g., life expectancy).³

The Atlantic Council has now constructed a new country-level index of economic freedom. In this chapter, we explain how theory suggests that greater economic freedom will make a country more prosperous. We then use the Atlantic Council’s Index to illustrate, first, a positive correlation between economic freedom and prosperity. Then, second, we use a modern empirical technique to further illustrate that the relationship is causal. This is precisely what Adam Smith and subsequent economic theory indicates we should expect.

Theory: Why economic freedom promotes prosperity

All societies confront the same fundamental economic problem: how to organize their scarce resources to satisfy individuals’ most important desires out of the infinite array of possibilities. Societies that solve this problem well, and repeatedly re-solve the problem as circumstances evolve, are prosperous and grow. Those that do not are poor and stagnant.

A market economy solves the economic problem by allowing decentralized competition between entrepreneurs to discover, and continually rediscover, the solution. But the quality of the institutional and policy environment is crucial for how well entrepreneurs perform this task. The institutional and policy environment provides entrepreneurs with the incentives and information that guide their actions. When that environment provides more economic freedom, it channels their efforts in ways that promote prosperity.⁴

Economic freedom is characterized by: well-defined and enforced property rights; the ability of those holding property rights to freely trade them with others, including individuals from other countries; and, lastly, the ability of individuals to invest their property in ways they find most profitable. Why do we expect economic freedom, as here characterized, to be important for prosperity?

To begin with, property rights are the bedrock of any market economy. Without rights of ownership, individuals cannot engage in market exchange that moves resources from less- to more-valued uses. And in thinking about this, we must note that property rights can be more or less complete; also more or less secure. In general, any property right can be defined in terms of (a) the right to use something, (b) the right to exclude others from using that something, and/or (c) the right to transfer that property to someone else. A more complete property right is defined to a greater extent in terms of (a), (b), and (c); a more secure property right is one where there is a greater expectation that definitions in terms of (a), (b), or (c) will be enforced.

The definition and enforcement of property rights are complementary. (The former without the latter is moot; the latter without the former is trivial.) The greater the extent to which you have both together, the more that owners can use their property—and profit from using it—themselves or via exchange with others. As such, well-defined and enforced property rights provide incentives to use that property in ways that are most valuable to society (within the hands of the owner or by the owner knowing when it is better to transfer the property into the use of others).

Alternatively, if property rights are incomplete or insecure, it will decrease the incentive to use them efficiently. For example, in the United States, we have property rights in our own bodies, but these property rights are incomplete. For example, we can use our kidneys; we can certainly exclude others from using them; but our rights to transfer them are severely proscribed. We can give (donate) them away, but we are not allowed to sell them. In this case, the property right to our kidneys is incomplete. An implication is that individuals with two good kidneys are not incentivized to trade one of them to someone else who values it more highly. This fact is evidenced by people who wait for years on (donor-based) transplant lists or—tragically—die while they had the means to bid a competitive price.

Similarly, even if one does have complete property rights, if those rights are not secure, owners may not have the incentive to put the property to its highest valued use. Imagine being given formal legal title to a factory in Haiti. If you do not believe your property will be secure from criminal gangs or future government nationalization, you would have no incentive to invest for the long run.

When property rights are relatively complete and secure, they provide incentives for entrepreneurs to channel resources to their highest-valued uses. Of course, the process still requires entrepreneurs to be able to know what the highest-valued uses are. Furthermore, the process requires that they know how the highest-valued uses are changing over time (with, for example, technological changes or the changing preferences of individuals). That is where prices come in. Market prices provide the information about the relative scarcity of resources in alternative uses. When the price of any resource increases, it signals that the resource is now valued more highly somewhere else in the economy. Owners of the resource then have an incentive to sell it off into the hands of others. (Importantly, those sellers do not need to know where or why the resource is more urgently needed elsewhere. They need only see the price change.)

As the Nobel Laureate Friedrich Hayek notes: “The marvel is that in a case like [this], without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people . . . are made to use the material or its products more sparingly; i.e., they move in the right direction.”⁵ Changes in market prices give entrepreneurs incentives to move resources towards more highly valued uses, doing so by conveying the minimum of information necessary for them to do so. In a world where knowledge of market conditions and people’s preferences are in continual flux, the price system’s economization of information is invaluable.

All of the above requires that entrepreneurs are able to freely trade their property with others. Those others not only include individuals within their own country, but also individuals across the globe. For domestic entrepreneurs, exports can greatly increase the scope of the demand for their product, allowing them to increase production. Similarly, imports serve as important components and raw materials in their production process. Shutting off international trade would deny entrepreneurs many mutually beneficial opportunities for exchange. Put differently, restrictions on international trade mean that individuals in any given country have severely circumscribed property rights.

Furthermore, part of being able to exercise one’s property rights is to be forward-looking in terms of how one employs resources (or decides to transfer those resources). Indeed, the world is dynamic and decisions involving capital—that is, resources which are devoted now in search of future profits—are critical as to whether countries experience long-run growth. Therefore, whether the institutional and policy environment allows entrepreneurs to invest their capital both within their country and across its borders is key. When their capital is restricted from seeking the best opportunities for future profits, property rights are, again, circumscribed in ways that are detrimental to prosperity.

Measurement: The Atlantic Council’s Economic Freedom Index

The Atlantic Council publishes an overall index of freedom, which accounts for legal, political, and economic dimensions. While these different dimensions are not mutually exclusive, they can meaningfully be considered separately. Here we are concerned with the Atlantic Council’s Economic Freedom sub-index. This sub-index reflects many aspects of what we have just described. In particular, it is constructed based on four separate indicators: (a) property rights, (b) trade freedom, (c) investment freedom, and (d) women’s economic freedom.

The property rights indicator is perhaps the most straightforward. It measures “the extent to which a country’s legal framework allows individuals to acquire, hold, and utilize private property, secured by clear laws that the government enforces. Its component parts are protection of property rights and risk of expropriation.”⁶ It is clearly a measure indicative of both the completeness and security of property rights, as we have described above.

The trade freedom indicator measures “a wide variety of trade restrictions: tariffs, quotas, hidden administrative restraints, and controls on exchange rates and the movement of capital.”⁷ In terms of our description above, this can be interpreted as a measure of how well prices reflect real international scarcities. In countries that score higher on this measure their prices better reflect the availability of resources around the globe because entrepreneurs have more complete property rights to exchange to a greater extent with foreigners.

The investment freedom indicator measures “the ability of individuals and firms to move capital within and across a country’s border without restrictions.”⁸ This indicator can be thought of as a proxy for how freely the entrepreneurial process can move capital in response to the incentives and information provided by property rights and prices. If entrepreneurs have better access to capital, they can more quickly and efficiently reallocate resources to promote prosperity.

Finally, the women’s economic freedom indicator measures “inequality in legislation between men and women as it relates to economic activity.”⁹ This was not something that was explicitly discussed in the “Theory” section above. However, roughly half of the global population consists of women. As such, any country is circumscribing the property rights of roughly half of its citizens if it discriminates against women. In other words, roughly half of the market’s discovery process is impeded if women do not have the same economic rights as men. There is no evidence to suggest that the inherent entrepreneurial potential of women is less than that of men. And even if it was less by any plausible amount, it remains clear that circumscribing the rights of the entire female population is detrimental to a country’s overall prospects for prosperity. Thus, this measure helps to capture how widespread the formal property rights and economic freedoms are within a country.

Existing empirical research using the Atlantic Council’s measure of economic freedom shows statistical correlation between freedom and measures of prosperity. As every introductory statistics student is taught, correlation is not causation. However, even absent more compelling statistical techniques, we believe that economic theory, as briefly summarized above, gives us good reason to believe that these statistical correlations are illustrating an underlying causal relationship. Below we examine this empirical relationship with greater scrutiny.

Empirical analysis: Does economic freedom cause prosperity?

Data and approach

The Atlantic Council’s Freedom Index is a valuable tool that can be used to study the relationship between freedom and prosperity. However, there are some limitations with this data that dictate our empirical approach to examining the relationship. This section first reviews this new index and describes our empirical approach before proceeding with our empirical analysis.

The new Freedom Index is composed of three main indicator areas: economic freedom, political freedom, and legal freedom. The Index was released with 2021 data as well as data for three earlier years, each five years apart: 2016, 2011, and 2006. We believe each of these areas of freedom are important but focus our analysis on the relationship between the economic freedom indicator and prosperity. This is in part driven by our need to observe changes in Index values to study causal relationships. Political and legal freedoms tend to change too gradually for a short fifteen-year time span to be useful in our analysis. Also, the theoretical causal link between freedom and prosperity is stronger for economic freedom than for the other two areas.

We first focus on economic freedom’s effect on a simple measure of prosperity: GDP per capita. This is a standard measure of the average standard of living within a country and has expansive country/time coverage. Our measure of GDP per capita is derived from the Penn World Tables (PWT), Version 10.0.¹⁰ A difficulty with the GDP per capita data is that it is not (yet) available past 2019 in the PWT. Though, given the economic consequences of the COVID-19 pandemic, 2020 data may yield a misleading impression of world prosperity.

We also use a separate index constructed by the Atlantic Council as an alternative measure of prosperity: the Prosperity Index. This Index is a broader measure of prosperity than simple GDP per capita but this broader scope also limits its usefulness in empirical analyses over a relatively short time period. The Prosperity Index is an equally weighted index of: income, measured as gross national income (GNI) per capita; health, measured by life expectancy; the environment, as measured by water quality; minority rights, as measured by acceptance of religious minorities; and happiness (subjectively evaluated well-being), as measured by survey data in the UN World Happiness Report. Although these measures are important for understanding long-run prosperity, and although most are highly correlated with the level of GDP per capita, by their very nature, most change very slowly. Larger changes in the growth rates of GDP per capita can be observed over shorter periods and it is thus better suited for our empirical analysis that is confined to fifteen years of data availability.

Our empirical strategy is to first illustrate that levels of economic freedom are highly correlated with both the Prosperity Index and GDP per capita using a simple regression analysis. (When using GDP per capita we take the natural logarithm of the measure, which allows us to interpret a change in that measure as a percentage change.) Then, when we move on to studying the causal relationship, which requires us to examine how five-year changes in economic freedom impact subsequent five-year changes in outcomes, we restrict our analysis to the relationship between economic freedom and GDP per capita. In this latter approach, we identify countries that experienced meaningful increases in economic freedom and then match them to similar countries that did not experience such reform. We then compare subsequent changes in prosperity across the two groups.

Countries differ across many important dimensions. While political systems are slow to change, they are drastically different across countries. Some of these differences are important to consider when estimating the effect of economic freedom or changes in economic freedom on prosperity. For example, it may well be the case that authoritarian-run countries are less willing to implement economic reforms conducive to freedom. These authoritarian countries are also likely to be less prosperous in general. If we compare prosperity levels (or growth outcomes) of these countries with those of more democratic countries, which tend to have more economic freedom, we are unlikely to get a reliable estimate of economic freedom’s effect on prosperity.

A better juxtaposition would be to compare prosperity in countries with similar political structures, but different levels of economic freedom. In a regression analysis, this is done by including control variables for political institutions, along with other factors that could correlate with both economic freedom and prosperity. For matching, this is done by pairing countries that experienced meaningful increases in economic freedom with countries that are similar except for not having experienced the economic freedom increase. (Assume, for example, that in 2011 countries A and B are both democracies; they have similar income levels; they also start from similar levels of economic freedom. But A experiences a subsequent increase in economic freedom while B does not. We want to use countries like B to create a “counterfactual” by which to evaluate the effect of increased economic freedom on A’s prosperity.) In other words, we want to compare prosperity (in regression) or changes in prosperity (in matching) across countries that differ in economic freedom but are otherwise similar.

Our analysis considers a set of indicators that is standard in the literature—an index of human capital, investment share of GDP, government expenditure share of GDP, export share of GDP, an index of democracy, and inflation. More specifically, we follow the recent analysis of Grier and Grier,¹¹ who analyzed the impact on growth of economic freedom reform as measured by the Economic Freedom of the World Index.¹² These indicators are intended to capture many of the important characteristics of a country that may influence both economic freedom and prosperity. Summary statistics and sources for these variables, and our outcomes of interest, are given in Table 1.

Notes: ^aDan Negrea and Matthew Kroenig, “Do Countries Need Freedom to Achieve Prosperity? Introducing the Atlantic Council Freedom and Prosperity Indexes,” Atlantic Council, https://www.atlanticcouncil.org/in-depth-research-reports/report/do-countries-need-freedom-to-achieve-prosperity. ^b University of Groningen, https://www.rug.nl/ggdc. ^cKevin B. Grier and Robin M. Grier, “The Washington Consensus Works: Causal Effects of Reform, 1970-2015,” Journal of Comparative Economics 49, no. 1 (March 2021), 59–72. ^dMonty G. Marshall, Ted Robert Gurr, and Keith Jaggers, Polity IV Project: Political Regime Characteristics and Transitions, 1800-2015. Dataset Users’ Manual, Center for Systemic Peace, 2017. ^e www.worldbank.org/data.

Regression

We first present simple regression results, showing the contemporaneous relationship between the Atlantic Council’s Economic Freedom Index and prosperity (as measured by the Prosperity Index or GDP per capita). Recall the Economic Freedom Index is only available in five-year increments from 2006 through 2021. We also include all control variables discussed above, however these controls are included as five-year lags. Ideally, we want to compare the effect of economic freedom in two countries that begin with similar characteristics. Controlling for the initial levels for each control variable allows us to focus on this comparison. Lastly, we include control variables for each year (i.e., 2011, 2016, and 2021). These control variables help capture events that are common across countries in any given year (e.g., the effects of the COVID-19 pandemic).

The simple regression results are summarized in Table 2. Column (1) reports the relationship between economic freedom and the Atlantic Council’s Prosperity Index; column (2) presents the results with GDP per capita as the measure of prosperity. In both cases, economic freedom is strongly related to prosperity, with statistical significance at the 99 percent confidence level. These effects are also large in magnitude. As shown in Table 1, the Economic Freedom Index varies drastically across countries, with a standard deviation change of approximately 17 points in the Index. A 17-point increase in economic freedom would increase a country’s GDP per capita by 17 × 1.9 percent, or approximately 32 percent. This is an enormous increase in a country’s standard of living. Of course, a 17-point change in economic freedom for any given country is improbable over a short time frame. As also shown in Table 1, the average five-year change in economic freedom within any given country is 1.53. Even with this more modest increase, economic freedom reform is associated with a nearly 3 percent increase in GDP per capita.

Statistical significance: * 10 percent; ** 5 percent; *** 1 percent.

Although we control for many important characteristics, linear regression does not establish a causal relationship between the variables without additional, and often unwarranted, assumptions. Regressions include all countries of the world in their estimates. This can result in extreme extrapolation and yield comparisons that are not intuitive. For example, the United States may be compared to the Republic of the Congo. A related concern with the linearity assumption is that a regression treats a change in the Economic Freedom Index from 0 to 10 the same as a change from 90 to 100, even though the former is likely more influential. We address these concerns with a matching analysis in the following section.

Matching analysis

In this section, we focus on how five-year changes in economic freedom influence subsequent changes in prosperity in the five years that follow. By focusing on changes in prosperity—that is, growth—we are analyzing within-country changes in our outcome of interest. GDP per capita substantially varies over a five-year time span with an average growth of 11 percent. In comparison, the Prosperity Index only increased by approximately 0.43 points, on average. A 0.431 increase is extremely small, given that the Index is constructed on a 0–100 scale. In addition, and as discussed above, given the components of this Index, we do not expect the Prosperity Index measure to vary much through short time periods. Our focus here is therefore on GDP per capita alone.

We also focus only on significant changes in economic freedom. By “significant,” we mean an increase in the Economic Freedom Index of at least 3.5 points. On average, economic freedom increases by 1.53 points within a five-year period, with a nearly 4-point standard deviation. An increase of 3.5 points, then, is larger than the average but not quite an outlier. This yields 91 potential instances of economic freedom reform of this magnitude to study. We also double this cutoff to 7 points, although the number of instances in which countries experience such drastic change is small, with only 29 potential cases.

To analyze the effect of these increases in economic freedom on changes in subsequent prosperity, we utilize a matching method called Mahalanobis Distance Matching (MDM). Essentially, this matching procedure minimizes the difference in relevant characteristics of the country that increased economic freedom and otherwise similar countries that did not experience positive reforms in economic freedom. The relevant characteristics in our case are the same (lagged) controls as in our regression analysis.

Take our measure of democracy (the Polity 2 Index) as an illustrative example.¹³ Suppose a reforming country has a Polity score of 8, implying it is highly democratic. MDM will match this country to other countries with similar levels of democracy but not the same large improvement in economic freedom. Given that we have a range of characteristics we are concerned about and that we try to best match against all of them, and that these characteristics themselves are highly variable, our matches will not be perfect across all margins. However, focusing only on these best matches minimizes the need to extrapolate and reduces the risk of making poor comparisons as happens in regressions. We consider comparing each reforming country to its closest match on all these other characteristics and then subsequently compare it to an average of its two, three, and four closest matches. For simplicity, we refer to these matches as their “nearest neighbor” (or “two neighbors,” etc.).

Similar to the regression analysis, we match each of the characteristics using their value prior to the change in economic freedom. This allows us to compare the effect of changes in economic freedom across two countries (and averages of two, three, and four countries) that were otherwise identical prior to this change in freedom. In this same spirit, then, we also include lagged economic freedom scores and lagged GDP per capita as additional characteristics to match upon to better estimate the effect of a change in economic freedom.

Our matching results are presented in Table 3 for the 3.5-point threshold and Table 4 for the 7-point threshold. In both cases, economic freedom reform is associated with higher GDP per capita growth over the subsequent five years. These numbers are comparable to our regression estimates. A 3.5-point increase in economic freedom is associated with an increase in GDP over five years of approximately 6 to 8 percentage points. A 7-point increase in economic freedom corresponds to even larger increases in GDP over five years: nearly 10 to nearly 15 percentage points. Both represent considerable increases in the average income of a country’s citizenry.

Statistical significance: * 10 percent; ** 5 percent; *** 1 percent.
Note: Matching covariates include: lags of economic freedom, investment, government spending, exports, Polity score, and inflation at time T−5. The lag of the dependent variable (at T−5) is also included in each specification.

Statistical significance: * 10 percent; ** 5 percent; *** 1 percent.
Note: Matching covariates include: lags of economic freedom, investment, government spending, exports, Polity score, and inflation. The lag of the dependent variable is also included in each specification.

Conclusion

Back in 1776, Adam Smith recognized that the wealth of nations is rooted in the economic freedom of their citizens. Without discounting the nearly two-and-a-half subsequent centuries of scholarship, Smith’s fundamental insight remains consistent with both theory and evidence.

In line with its mission to engage international affairs and advance them toward meeting global challenges, the Atlantic Council has constructed a country-level index of economic freedom that covers the last decade and a half. This paper has reviewed the theory suggesting that economic freedom should be associated with prosperity; second, it has provided evidence, based on the Atlantic Council Index, that economic freedom not only correlates with prosperity but, indeed, is an important cause of prosperity.

Regarding the latter aim, we have analyzed the Economic Freedom Index in relation to both the Atlantic Council’s Prosperity Index, as well as the straightforward measure of country-level GDP per capita. Our evidence suggests that economic freedom remains an important correlate of both GDP per capita and the Atlantic Council’s broader measure of prosperity, while controlling for a number of other factors. Furthermore, GDP data changes enough over the fifteen-year period covered by the Atlantic Council’s Economic Freedom Index for us to employ “matching methods,” a more sophisticated approach to establishing causal statistical relationships. Based on this approach, we find that a meaningful increase in economic freedom leads to large increases in GDP per capita over a five-year time horizon. For example, a 3.5-point increase in a country’s economic freedom score is associated with a five-year increase in GDP per capita between 6 and 8 percentage points.

This chapter indicates that both theory and evidence support Adam Smith’s prescription of “peace, easy taxes, and a tolerable administration of justice.” The recipe for greater prosperity across the globe is increased economic freedom.

Jamie Bologna Pavlik is a research fellow at the Free Market Institute at Texas Tech University.

Benjamin Powell is the executive director of the Free Market Institute at Texas Tech University.

Andrew Young is the director of graduate students and a research fellow at the Free Market Institute at Texas Tech University.

Image: Li Qiang, 40, owner of a small shop selling coconuts and other convenience items, speaks with a man outside his store at a beach during the Spring Festival and Lunar New Year holiday in Sanya, Hainan province, China January 23, 2023. REUTERS/Alessandro Diviggiano

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