SA’s Rating in the Economic Freedom of the World 2010 Annual Report

The Economic Freedom of the World: 2010 Annual Report places a timely focus on three issues that are of particularly pressing importance to SA. Unemployment is an intensely draining personal experience and a loss to all others in the community who might have benefited from the opportunity to form either a working or a trade relationship. Crime, particularly violent crime, is a violation of person and property that steals from the spirit of the community and imposes a burden of waste and uncertainty on the whole of society. Macroeconomic volatility, which can be seen in the industrial and financial fluctuations that change the directions of lives and livelihoods, is a phenomenon that seems not to be caused by any one person, yet affects simultaneously everyone and every business in an economy.

These three problems very often occur together, and they characterise some countries more than others. SA’s unemployment rate is over 25 percent, which means that a quarter of the workforce is not producing, not trading, and not serving others in any open economic relationship. SA is also known for high crime rates. A Business Day article in September 2010 reported a decrease in the murder rate but noted, “that still puts SA at the top of the murder rate list in the world” and that it “retains its position as one of the most dangerous countries outside a war zone.” SA did not experience economic recession during the post-transition decade and a half. But it was nevertheless a time of macroeconomic worries related to labour unrest, the conduct and burden of government enterprises, price and financial fluctuations, and the effects of restrictions on international capital flows.

Economic Freedom Reduces Unemployment
To be counted as “unemployed,” one is assumed to be actively looking for work. We know that there are plenty of needs and wants that are not being served, and that there is an endless list of desired improvements that could be made in this world. Why, then, are so many people unable to find formal employment? Horst Feldmann demonstrates the existence of a clear relationship between the overall level of economic freedom and employment. Economically free countries tend to have significantly lower rates of unemployment.

South African analysts and policymakers who are looking for solutions to the unemployment crisis will find clear guiding signs in the detailed components of the Economic Freedom of the World (EFW) index. Area 5 of the index, “Regulation of Credit, Labour and Business,” contains a section (B) on Labour Market Regulations. This section contains three of SA’s lowest economic-freedom scores.

Economists have long known that strong government interference in labour markets will make employment relationships more costly, more uncertain, and more adversarial. This all tends to discourage hiring and makes other countries look relatively more attractive for investment.

The trends in SA labour regulation, as shown in EFW components 5.B (i)-(iii), suggest strongly that the government is increasingly over-prescriptive in industrial relations matters. Unemployment is one result. The ever-present, and much-used, threat of strike action by the various trade unions also results in periodic losses of production and income. This is really just a form of periodic unemployment that punctuates the chronic misallocation of productive resources that results from the politicisation of work relationships.

A freer, more flexible labour market would allow workers and employers to seek out and compete for each other’s services. This is really the only way that people will find their most-valued places in the working world. The current collectivised structures are clearly preventing this and, unless reformed, will condemn the next generation to lives of restricted opportunity. Such situations are neither economically nor politically sustainable.

Economic Freedom Reduces Crime
It is clear that the politicisation of labour relations, by reducing the choices open to the groups and individuals involved, tends to increase conflict, not reduce it. The politicisation of economic life in general is also associated with increasing levels of societal conflict, as is shown in the crime statistics.

Edward Peter Stringham and John Levendis present strong evidence that homicide rates are significantly lower in countries that have greater economic freedom. They illustrate the dangers associated with the loss of economic freedom through the recent example of Venezuela. Twenty to thirty years ago, Venezuela had an EFW rating that was slightly better than that of SA. The most recent EFW ratings (using 2008 data) place Venezuela at a rank of 138 out of 141 countries. Its rating of 4.33 (out of 10) shows that Venezuela has become one of the least economically free countries in the world.

Consistent with our predictions, as its residents lost their economic freedom, Venezuela’s economic performance deteriorated drastically. But the pertinent point here is summed up by Stringham and Levendis: “By 2006, Venezuela had become the world’s most violent country.”

Venezuela is an extreme example of what not to do. But Stringham and Levendis show that the inverse relationship between economic freedom and homicide rates is also significant in a comparison of two OECD countries. Their suggestion as to one of the best ways to reduce homicide rates is, “move towards laissez-faire.”

Economic Freedom Reduces Volatility
Restrictions on economic freedom tend to reduce the abilities of people and their businesses to adapt to the various resource challenges that face us all. The realisation of creative ideas and better modes of co-operation are made more difficult by excessive regulation and the shifting of resources away from productive enterprises through taxation and inflation. Those countries with lower EFW ratings tend also to have lower long-term economic growth rates. But as their freedom ratings rise, they can achieve better than average growth rates.

John W. Dawson shows that a lower freedom rating is associated with higher volatility in economic growth rates. Consistent with this, four of the five components of the EFW freedom index show significant negative correlations with macroeconomic volatility. The exception is Area 1, the “Size of Government” component, which has a positive correlation. Interestingly, Area 1 is SA’s weakest component. This is due to high government consumption and investment levels as well as high marginal income and payroll tax rates. These factors might serve to help dampen volatility, but at the sacrifice of long-term growth potential.

Monetary Policy is Sound but Exchange Controls Should GO
SA’s highest freedom score is in Area 3, “Access to Sound Money.” This score still could be much improved when South Africans gain greater freedom to own foreign currency. Similarly, the score for Area 4, the “Freedom to Trade Internationally,” is also pulled down by international capital and exchange controls.

SA’s EFW Rating has Declined
SA’s overall EFW rating in this year’s report (using 2008 data) is 6.65 for a ranking of 82nd in the world. This is SA’s lowest rating in over 10 years, and suggests a downward trend from the peak in the 2002 data.

The threat of a retreat from economic freedom in SA is not a call to panic, but a call to action. The details provided by the EFW component ratings give guidance as to which areas of governance are most in need of improvement. As Christopher Coyne and Russell Sobel suggest, improvements in one area of freedom and governance often require simultaneous improvements in other institutional components in order to achieve permanence.

Components that Need to be Improved
All components below a score of 10 deserve attention, but those under 5 are the weakest links. These are the areas of priority action:

a) Limit government spending.
b) Reduce government ownership and control of property and businesses.
c) Reduce marginal tax rates.
d) Reduce the cost and uncertainty of enforcing contracts.
e) Simplify and reduce the tariff structure on international trade.
f) Remove all international capital and exchange controls.
g) Restore freedom of choice to individuals and businesses in employment relationships.
h) Reduce the bureaucratic costs of doing business.

Author: Richard J Grant is Professor of Finance & Economics, Lipscomb University, Nashville, Tennessee and Publications Editor of the Free Market Foundation. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author's and are not necessarily shared by the members of the Foundation.

FMF Feature Article / 21 September 2010