Economic and Political Freedom Drive Prosperity

Since the fall of the Berlin Wall 20 years ago, promotion of the market economy has been a powerful economic theme of much of Western politics. But capitalism has come under attack with the economic crisis, the looming threat of climate change and a broader concern, most recently driven by French President Nicolas Sarkozy, that growth alone isn't the same as prosperity.

And at first glance, the Legatum Prosperity Index, published in October 2009, might seem to provide evidence that capitalism is in trouble. This is the third year Legatum has published an index which aims to be a holistic measure of societal well-being. Legatum finds that the five most prosperous countries are social democracies of Northern Europe. In order, they are Finland, Switzerland, Sweden, Denmark and Norway. With the partial exception of Switzerland all are well known as high-tax, social welfare countries. And while the USA and UK rank 9th and 12th, respectively, France, Germany and Spain are not far behind; indeed, 14 of the top 20 countries are European. So does Legatum's Index demonstrate that capitalism needs to be reined in, as many of its critics consider? Not necessarily.

The Wall Street Journal (WSJ)/Heritage Foundation Index of Economic Freedom measures the key aspects of political and economic freedom, such as the strength of democratic checks and balances, protection of property rights, enforcement of contracts, ease of starting a business and of hiring and firing staff. The Legatum Prosperity Index measures broadly the same factors in three of its nine sub-indices. It also measures six other sub-indices under the headings, governance, education, health, social capital, security and personal freedom, some of which rely on quite personal evaluations of subjective well-being. In all, there are 79 variables selected by Legatum's academic advisory panel.

Does Legatum's Index demonstrate that capitalism needs to be reined in, as many of its critics consider? Not necessarily.

The addition of the wider subjective evaluations and social variables means the top performers are not the same in each index. Hong Kong and Singapore score very highly in the WSJ Index due to their strongly capitalist systems but their lower personal freedoms and social capital scores drag them down to 18th and 23rd, respectively, in the Legatum Index. Similarly, the Legatum top performers of Northern Europe do less well on the WSJ Index because of their economic fundamentals.

Interestingly, Legatum specifically calls the economic and democracy indices the drivers of wealth, and implicitly prosperity; most adherents of the WSJ index think of wealth as the basis of health and happiness too. In other words, that market economies with good economic fundamentals drive us to more prosperous lives. But is this true?

There is a way of establishing the explanatory power of the more established Wall Street Journal/Heritage Foundation Index on the more subjective indicators compiled by Legatum. If one strips out the three economic/democracy sub-indicators from Legatum, one can compile a ranking from the six remaining, and primarily more subjective, sub-indices. Using econometric techniques one can test how much of the WSJ Index explains, in a statistical sense, the subjective well-being as established by Legatum's revised index.

For the latest data Legatum has, the relationship is statistically significant, with just under two-thirds of the subjective well-being found by Legatum explained by economic and political freedom. This is a significant finding, and while obviously leaving a lot of room for other explanations too, demonstrates the strong association and almost certainly vital importance of both freedoms for prosperity.

Indeed, when one looks at the Northern European states at the top of the Legatum Index, with the exception of punitive tax rates, most do encourage entrepreneurs, practise free trade and have stable monetary policies. These indices are not the final answer, but they are however a useful response to
President Sarkozy. For while economic and political liberty do not equate with wider prosperity, they are vital as the engine of much of what makes life worthwhile.

Roger Bate is the Legatum Fellow in Global Prosperity at AEI.

Photo Credit: iStockphoto/eva serrabassa

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