India was recently ranked 115 out of 157 countries in the 2008 Index of Economic Freedom (IEF), produced by the Heritage Foundation and The Wall Street Journal. It is “mostly unfree.” According to Mary Anastasia O’Grady, one of the index’s co-editors, “freedom and prosperity are highly correlated” and “economic liberty matters to human progress.” Further, she says, “the evidence is piling up that neither government nor multilateral spending on education and infrastructure are key to development.” But beyond the polemic against politicians, government and multilaterals, as well as the typical confusion of correlation and causality, some interesting facts emerge from the exercise.
First, to give IEF its due, it is constructed relatively objectively. An attempt is made to neutrally measure each component (business freedom, trade freedom, labour freedom, and so on). Much of the measurement relies on sources with less of an axe to grind, or at least different axes (the World Bank, Transparency International, et al). Biases in the methodology are transparent—for example, smaller government means more economic freedom—and can be corrected in alternative constructions, since the data is also made available. All to the good, but the overall IEF is less interesting than its underpinnings.
One thing stood out for me—China does worse than India on IEF, but has grown consistently faster, and is much richer. So there must be something deeper than the correlation between IEF and prosperity. Comparing India and China, in fact, the places where China does significantly better (setting aside government size, though there may be other reasons to question India’s performance on that score) are trade freedom and “monetary freedom”, the latter including both inflation and price distortions. There may be a lesson here—India might benefit from liberalizing its international trade further. For that matter, internal trade barriers, not captured in the index, are also high in India.
If China alone is not the best comparator, then use averages for the whole set of countries. Again, India does worst on trade freedom, followed by financial freedom, business freedom, investment freedom and freedom from corruption. It does relatively well on property rights, fiscal freedom (essentially tax burdens) and even labour freedom. One might conjecture from this, even without accepting the ideology of IEF’s producers, that a bit more ease in starting, running and growing businesses might be just the right thing.
That conjecture is still subject to the criticism that there is no evidence of causality. Stephen Parente, in a carefully crafted contribution to the IEF report, does provide a more solid analysis. Marshalling historical experience, he traces the process of catching up by the late starters in the world economy, and suggests that inefficiencies in using existing knowledge explain much of the gap between the rich and poor. Examples from India include small-scale industry reservations, low-productivity state-owned enterprises, and barriers to the adoption of best-practice technologies. If one accepts the international evidence, then India’s policymakers might serve the cause of development best by removing inflexibilities and transaction costs wherever possible, rather than just throwing government money around freely.
Two challenges remain. First, how does one overcome resistance from groups that will be hurt by greater flexibility in the economy? Creative solutions to compensate the losers from reform have yet to emerge in Indian policy debates. Second, the process of growth also enhances relative deprivation, as some groups are left behind. The current government has tried to remedy this problem with several welfare programmes and rural investment schemes, but without putting its own house in order, so that such spending remains as inefficient as ever. Economic freedom requires better government, not smaller government.
Finally, in discussing the link between economic freedom and prosperity, another index comes to mind. The UN’s Human Development Index (HDI) uses life expectancy, literacy and education measures along with per capita incomes. India ranks 128 out of 177 countries on that measure. Unsurprisingly, perhaps, HDI and IEF are strongly positively correlated. Strikingly, however, China does much better on HDI, ranking 81st. Setting aside China’s income advantage, the biggest difference in components comes in life expectancy and literacy, more so than education.
Ultimately, the numbers suggest a very simple story. Before anything else, pay attention to the most basic needs of the people, and get that role of government right, rather than try to fine tune so much else. And even in the more sophisticated parts of the economy, whether it is finance, manufacturing or infrastructure, focus on why resources are used so inefficiently. Where government policies are responsible, come up with politically feasible ways to change those policies. The remarkable lesson of China is that just a few shifts in policy orientation (international trade and investment, in China’s case) can have a major impact. Perhaps India needs to be free of some old ideas.
Nirvikar Singh is professor of economics at the University of California, Santa Cruz. Your comments are welcome at firstname.lastname@example.org