What is an Index of Economic Freedom?
An index of economic freedom measures jurisdictions against each other in terms of trade freedom, tax burden, judicial effectiveness, and so on. These factors may be weighted according to their influence on economic freedom and compiled into a single score that allows for a ranking. The ranking can be done on a country basis or can look at wider regions or smaller sub-national units like states.
- An index of economic freedom scores and ranks countries according to criteria that the creators of the index judge as being relevant. Not all economists will agree on the criteria, of course.
- Indexes of economic freedom score free-market economies at the high end of the spectrum.
- There is a strong correlation between the index of economic freedom ranking of a country and the income their citizens enjoy.
- Investors can use the index of economic freedom as a quick way to monitor the changes in economies they have or want exposure to.
The most widely referenced index of economic freedom is produced by the Heritage Foundation, a conservative American think tank. The Fraser Institute, a Canadian think tank, also publishes a well-known index of economic freedom.
Understanding the Index of Economic Freedom
The Heritage Foundation's Index of Economic Freedom scores countries based on twelve factors:
- Property rights
- Judicial effectiveness
- Government integrity
- Tax burden
- Government spending
- Fiscal health
- Business freedom
- Labor freedom
- Monetary freedom
- Trade freedom
- Investment freedom
- Financial freedom
A country's scores in each area are then compiled into a single score, according to which countries are ranked from most (highest score) to least free. It should be noted that some of these categories are ideologically loaded: what appeals to a laissez-faire economist as a high degree of labor freedom might strike a liberal economist as a lack of worker protection, for example.
The Heritage Foundation's Index of Economic Freedom has pointed out some important correlations that should encourage nations to try to improve their scores over time. The most important is the observation that people living in countries categorized as free or mostly free enjoy higher incomes than those living in lower scoring nations. The disparity between the best and worst nations is more than six times, meaning someone in an economically free nation makes six times more than someone in an economically repressed nation. Related to this income gap, there is also a correlation between economic freedom and GDP growth, as well as higher standard of living and a general rule of law for citizens.
Recent Index of Economic Freedom Rankings
In recent years, the top countries for economic freedom has been fairly consistent. Hong Kong ranked number one in 2019 with an overall score of 90.2. It was followed by Singapore (89.4), New Zealand (84.4), Switzerland (81.9), Australia (80.9), and Ireland (80.5) to round out the economies rated as free. The United States ranked 12th with an overall score of 76.8, hurt mostly by government spending and fiscal health. This actually marked a significant improvement over previous years where the U.S. has been as low 17th.
Countries on the opposite end of the freedom spectrum include North Korea (5.9), Venezuela (25.9), Cuba (27.8), Eritrea (38.9), and the Republic of Congo (39.7). As mentioned, the higher the score in the economic freedom index, the higher the income and vice versa. The free countries in 2019 had an average GDP per capita of $63,588, while the repressed countries sat at just $7,716. There is also a regional phenomenon where similarly ranking countries can be clustered. In 2019, Sub-Saharan Africa scored below the world average of 60.8 with its regional score of 54.2. Europe scored above the world average as a region with 68.6. Of course, there are outliers in every region. North Korea, with the overall worst score of 5.9, is in the Asia Pacific region with two of the highest scorers in New Zealand and Australia.
How the Index of Economic Freedom is Used for Investing
The Heritage Foundation's Index of Economic Freedom website features a heat map that allows you to view the changes in the world over time. In addition to being academically interesting, the change to economic freedom over time can be a significant data source for investors, particularly those interested in emerging markets. The index of economic freedom can provide a guide on whether the potential for hot emerging market picks like the BRIC nations are actually seeing the policy changes necessary for that growth to benefit international investors. On the opposite end, negative changes in the index can be a signal to investors to trim their direct and indirect exposure to nations that are experiencing a decline.