What's wrong with economic freedom in Guatemala?

by Russ McCullough

I am excited to be traveling to Guatemala with my wife and son in August! My wife helps run a non-profit called Education and More there where the organization contracts with local indigenous women to produce products that use the hand-woven fabric that has been made for centuries there. Generational poverty is an issue there where subsistence living is the norm. The proceeds from sales in the United States and donations fund a fair wage to the women in addition to private schooling for their children through high school and even college for those who go. It is a fabulous organization and please visit https://www.educationandmore.org/ to learn more and donate if you want to support what they do.

The Gwartney Institute investigates reasons why some countries are poor and others are rich. It turns out that Economic Freedom is highly negatively correlated with poverty. Countries with a high degree of economic freedom have less poverty. The Fraser Institute publishes the Economic Freedom of the World (EFW) Index each year, its lead author is Dr. Jim Gwartney for which our Institute was named. I was shocked to learn that the most recent ranking of Guatemala was 23rd in the world for economic freedom, tied with Finland! Income per person adjusted for purchasing power parity in Finland was $43,700 in Finland during this time while it was only $8,000 in Guatemala (it was $57,900 in the USA). The average income for countries in the top 25% of the EFW index is $42,500 and the average for the bottom 25% was $6,500.
 
This did not make sense to me, so I began to investigate why Guatemala is so poor relative to its high EFW ranking. I found a plausible reason for the discrepancy by diving deeper into the way the EFW index value is calculated and then reconciling it with Guatemala’s area scores. There are five primary areas of the EFW index; 1) size of government, 2) legal system and property rights, 3) sound money, 4) freedom to trade internationally, and 5) regulation. Within each of these five areas, data is collected from many objective external sources and then each area receives a score out of 10. A simple average is used to compute the overall score (click here for details). The beauty of this formula is that a single number now objectively reflects the compilation of 42 variables for every country with data available. However, this is precisely what causes some countries to be ranked higher than what seems they should.

A country that is weak in ‘Area 2 -legal system and property rights’ may not be very free at all. Is anarchy true freedom? No, freedom is not the absence of government. Individual freedom can only be achieved with proper constraints on other people’s behavior to do no harm to others. Indeed, “do whatever you want as long as you don’t hurt someone else” is a philosophy that contributes to individual freedom. While the simple average of the areas gives us a transparent way to calculate the overall EFW, I would argue that Guatemala presents a case that shows how important Area 2 is for low income countries. It shows how the EFW index can be used to determine policy recommendations to raise people out of poverty.

The other area of the index that makes Guatemala rank higher than it should is ‘Area 1 -size of government’. The index suggests to me that the government sector is too small, specifically the sub-areas of Government Consumption and Transfers and Subsidies are too low relative to other countries in the top 25%. As a free-market economist, I find this a bit difficult to write.

However, I think it makes sense given that Guatemala has the best score for both of those sub-areas of all countries in the top 25% which means they spend the least amount of money relative to country income. Those sub-areas simply look at the fraction of government spending to Gross Domestic Product. It looks to me that Guatemalan government needs to do more work on ‘legal system and property rights’ and this likely means more government spending in that area. There is an optimal level of government spending to maintain a healthy rule of law. If spending is too low, vital functions of the government are underfunded. By looking at the outcomes in Guatemala, they are apparently not doing enough to get the wealth-creating engine of capitalism going strongly.

I did a little modification to the sub-areas to see where Guatemala would rank if it was doing the average level of government spending done by countries in the top 25%. By replacing just these two numbers, Guatemala’s EFW overall score falls to 7.28 which drops its ranking to 54 (the 2nd quartile) which is sandwiched between the Slovak Republic and Italy. Since the average income in the 2nd quartile is $20,200, I am not sure it has dropped enough. The average income in the 3rd quartile is $14,300! 

That’s enough of the numbers, I don’t want your head to spin. The measurement of economic freedom is a complex topic but the general results we find from research using the EFW index paints a clear picture that economic freedom is key to getting the social outcomes we all desire. Where economic freedom is strongest, there is less poverty, better access to drinking water, longer life expectancy, lower infant mortality, better gender equity –the list goes on and on and is compelling. I hope that my visit to Guatemala will further inform me of other policy recommendations that can lead to more human flourishing there.

Dr. Russ McCullough is the Founder & Director of the Gwartney Institute and the Wayne Angell Chair in Economics at Ottawa University