Category Archives: Economics

Does Heritage’s EFW index correlate with GDP/capita?

The Heritage Foundation has published an “Index of Economic Freedom” in some form or another since 1992. (Or, at least that’s how far back their dataset goes.)

The EFW index grades the following 10 characteristics:

  • Business Freedom (low regulatory burden on business)
  • Trade Freedom (free trade)
  • Fiscal Freedom (low taxes)
  • Government Spending (low gov spending / GDP ratio)
  • Monetary Freedom (price stability, low price controls)
  • Investment Freedom (low restrictions on capital flow)
  • Financial Freedom (low financial services regulation)
  • Property Rights
  • Freedom from Corruption
  • Labor Freedom  (essentially, a lack of strong unionization)

Each of the above is scored 0-100, and then those scores are averaged for each country to yield an overall score. (You can read more about the methodology on the Heritage page if you’re interested.)

The first thing I did was to pull the data into Mathematica and append a column of GDP/capita using the CountryData[] function. Then, I filtered the data so that all the entries remaining in the array contained valid scores/numbers for each column, so that I wouldn’t end up with random zeros in the data. The only four years with totally complete data were 2005-2008, so those were the only years I studied. GDP was normalized in adjusted USD via the exchange rate as of last Friday (1/20/11, when I tabulated the data).

And, yes, I’m aware that GDP/capita does not necessarily equate to the “wealth” of a nation, per se, but it is most widely available/published metric that suits this purpose.

So, first, a log-plot of EFW score and GDP/capita (in 2008):

GDP/capita against overall EFW score. Correlation of 0.68 and a slope of .095 (on a log axis).

The plots for 2007-2005 look very similar. But, in case you’re not convinced, here are the ANOVA tables for 2005 and 2006:

ANOVA for 2005

ANOVA for 2006

ANOVA for 2007

ANOVA for 2008

I would like to point out the outrageously small P-values for the linear fits of these datasets. If we can conclude anything, it is that economic freedom MATTERS. We can go back and forth all day about whether or not there are too many extrinsic correlations between wealth and freedom for us to interpret the data appropriately, but these numbers suggest that Heritage’s index is a good predictor of the wealth of a country, causal relationships notwithstanding.

I’m still working on interpreting the relationships between the EFW sub-categories and wealth; it would appear that most of the subcategories do not correlate as well with wealth than the overall index does. (Property Rights and Freedom from Corruption correlate better than anything else, with values of .724 and .799, respectively, in 2008.) Additionally, I would like to look at whether or not adjustments in EFW over time affect GDP/capita, because it would help establish (or disprove) a causal relationship between the two. I’m also open to suggestions about picking a new measure of “wealth” via publicly available econometric data, if anyone has suggestions. GDP/capita looks sort of like productivity, except it does not take into account how much of the population is working. Perhaps GDP/working population or just raw productivity would be more accurate. (Since government spending is part of GDP and is a negative factor in EFW, it creates noise as a consequence of it being a factor in the EFW score. It doesn’t help, either, that deficit spending will have the effect of making those countries look wealthier.)

The raw data (without econometric data) is available for download on the Heritage site. Contact me personally if you want my filtered sets with econometric data.

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Opposing views on 2012

Bearish or Bullish?

I’m inclined to lean bearish. Maybe that’s just because being bearish over the last few years has been the right thing to be, but I can’t help but feel like we’re in this for the long haul. If this recession really is a deleveraging, then it’s going to be a while before things get going again economically. Here are a couple of my concerns:

  • Public Debt: We will eventually run out of money. I simply cannot feel optimistic about our long-term financial stability as a nation given the apathy of the political establishment on both sides to do anything meaningful about our deficit. We cannot expect to borrow at 2% yields forever (see: Europe.) We will be in very serious trouble if we find ourselves, all of a sudden, unable to manipulate interest rates.
  • Artificially Low Lending Rates: Something that Keynesians refuse to acknowledge, by and large, is that there is risk associated with providing easy access to capital. Low rates make it easier for banks to create enormous amounts of leverage, which is what gets us into liquidity traps in the first place. Really low lending rates reduce the incentive for borrowers to find something worthwhile to do with the money that they have borrowed; additionally, low rates create an incentive to lever up your investments, which leads to increased risk.
  • No Incentive for Policy Change: The two issues above work with one another in a positive-feedback loop. The Fed has created an environment that makes it easy for our government to borrow money, so policy makers have a disincentive to restrain money supply growth. Additionally, reversing course to market interest rates would create some economic hurting and probably some disinflation, but it has to happen eventually. These problems won’t simply go away if we ignore them.
  • More Deleveraging: Households have deleveraged a fair bit (we’re down to 1993 household debt levels), but we may continue to do so until we reach, say, 1980 levels. If deleveraging is part of a 50- or 60-year macrocycle, then we should expect the credit cycle reversal to take us back to levels before the credit cycle. As evidence that we’re still very much in the midst of deleveraging, I would point to extremely low interest rates in virtually every market. No one wants to take on debt.
  • Homes: In spite of massive government interventions, the negative equity problem in home mortgages persists. We’re forcing the market to clear much slower than it would otherwise, so  I would expect that we have at least another year of cleaning up to do. (On the policy front, I think that rather than forcing rates even lower, we should just create incentives for banks to lower the principal on the mortgages that they issued. Otherwise the negative equity problem will persists, and the principal of these loans as reflected on bank balance sheets will not reflect the value of the underlying asset.)

I’m not that worried about Europe, because we don’t have a tremendous amount of direct exposure, relatively speaking. (As James Altucher points out, the top 5 US banks are 8% exposed to European debt. In 1981, we were 260% exposed to South American debt.) Granted, though, their crisis will still have the effect of devaluing the dollar through increased US SDR holdings, among other things, but we could be much worse off in terms of exposure.

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