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Economic Freedom, Institutions, and Sound Money

How to measure central bank performance

Institutions matter. Economists of the classical period knew that well, and in recent years, economists have increasingly included institutional variables in empirical work. The economic freedom indexes from the Fraser Institute and the Heritage Foundation have been among the most widely used institutional indicators.

The purpose of an economic freedom index, according to Heritage, is to “document the positive relationship between economic freedom and a variety of positive social and economic goals.” Many studies support that claim, finding that countries with high economic freedom scores are more prosperous and dynamic than those rated as less free. However, not all aspects of economic freedom are equally important.

I have been critical of the components of the economic freedom indexes that focus on the size of government and regulation. Here, I take on the those that focus on price stability — the Fraser “Sound Money” component and the Heritage “Monetary Freedom” component. I find they add little to our understanding of economic freedom, and should be used with caution. At the same time, I offer some suggestions about how the quality of monetary institutions might more usefully be measured.

Is Price Stability an Institution or a Policy Outcome?

The fundamental problem with the Fraser and Heritage price stability indicators is that they do not measure economic freedom the same way as other components of the indexes.

Robert Lawson, a senior member of the team that publishes Fraser’s Economic Freedom of the World reports, once wrote that an economic freedom index is, or should be, only that, rather than “an index of economic growth policies, efficient government provision of public goods, macroeconomic stabilization policies, or ideal income distribution policies.” If so, then the sound money indicators, as indexes of the success of monetary policy, are just what an economic freedom index should not be.

Measures of inflation and money growth account for three-fourths of the data that go into the Fraser Sound Money indicator and four-fifths of the Heritage Economic Freedom indicator. Rather than measuring the freedom of individuals to work, produce, consume and invest as they see fit, they measure the performance of central banks. To be sure, if we are going to have central banks, we want them to do a good job, but good central banking and economic freedom are different things.

Instead, the natural meaning of economic freedom, as applied to monetary matters, ought to be the freedom to use and exchange whatever kind of money one wants for whatever purpose.

To their credit, neither Fraser nor Heritage entirely neglects that notion of monetary freedom. Fraser’s Sound Money includes a subcomponent, weighted at 25 percent, that measures the extent of restrictions on ownership of foreign currency bank accounts. The Heritage Monetary Freedom indicator gives a weight of up to 20 percent to a measure of the extent of price controls. Both of those indicators point to real institutional limits to economic freedom, in the sense of the right to enter into voluntary transactions without coercive intervention by government.

Toward a Better Measure of Monetary Freedom

If I were to try to build a better measure of monetary freedom, I would begin by including both restrictions on ownership of foreign currency and price controls, but I would not stop there. Why not, for example, include a measure of central bank independence? Both the Fraser and Heritage freedom indexes include measures of judicial independence in their components that focus on legal systems and property rights.

Central bank independence serves a similar role in insulating a key government function from arbitrary political interference. There is a large literature linking central bank independence to the desired policy outcome of price stability. (This IMF working paper discusses measurement issues and provides links to previous literature.)

In a similar vein, if we want to show that good institutions produce good economic performance, we could rate central banks on their use of policy rules. Participants in a recent conference sponsored by the Boston Fed argued that policy rules and constraints on discretion resulted in greater price stability in the long run.

Another indicator for possible inclusion in a monetary freedom index would be the presence or absence of black markets for foreign currency, and, where black markets exist, the spread between the official and black-market exchange rates. (Fraser does include a measure of black market exchange rates, but as a subcomponent of the Freedom of Trade category rather than of Sound Money.) The multiple official exchange rates for different types of transactions that some countries maintain also represent limitations on freedom. It could even be argued that fixed exchange rates of any kind as restrain economic freedom, although perhaps not egregiously, when unlimited transactions are allowed at the official rate.

Finally, we might try to measure the degree to which a country’s monetary system is open to competing forms of money — a subject that Larry White, among others, has written about at length. An up-to-date treatment would want to cover regulatory limits on the use of cryptocurrencies.

A greater emphasis on these and other institutional variables, and less on the rate of inflation itself, would make the monetary components of the Fraser and Heritage indicators more consistent with the conceptual framework that underlies their other components.

The Bottom Line

The idea of measuring economic freedom in the first place is motivated by the hypothesis that good institutions produce good outcomes. Explorations of that hypothesis are best conducted using economic freedom indicators that focus on institutional quality. Including indicators of policy outcomes, such as inflation rates, only confuses matters.

Researchers should treat the price stability components of the Fraser and Heritage indexes with caution. When exploring the relationship between macroeconomic performance and the quality of monetary institutions, they should consider augmenting the Fraser and Heritage data with additional institutional indicators, such as measures of central bank independence, the use of monetary policy rules, freedom to use competing forms of money, and exchange rate regimes.

When measuring policy outcomes, they should consider using widely available price stability data, such as those from the IMF, rather than the Fraser and Heritage indicators, which mix indicators of policy performance with indicators of institutional quality that does more to obscure than to illuminate the underlying issues.

This article is based in part on material previously posted at the Niskanen Center.

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