Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
and economic freedom

Democracy: Impossible without economic freedom

Until the 1970s, Venezuela was regarded as a relatively well functioning democracy with relatively well-developed market economy. For decades, Venezuela took the top spot in Latin America regarding wealth. Today the country is governed by a dictator and is on the brink of economic collapse. How did that happen? Over the past decades the Venezuelan state intervened more and more in the economy of the country. High taxes, high government expenditures, inflation, and systematic violation of property rights were the means for creating the “socialist paradise”. However, economic repressions were followed by political repressions. This is of no surprise. There is no country in which democracy persisted without being accompanied by a relatively free market economy.

Friedman: Democracy and lack of economic freedom are incompatible
To those that do not believe that a decentralised organisation of the economy can reliably satisfy the people’s needs, but who still favour a democratic decision making process, the combination of political freedom and a state-controlled economy seems to be attractive. This combination, however, is not stable in the long-run according to Milton Friedman. According to the Friedman-Hypothesis, a society whose members enjoy a high level of political freedom also has to provide a high level of economic freedom.

A possible explanation for the Friedman-Hypothesis is delivered by Friedrich August von Hayek. In a world with limited resources, a mechanism is needed for deciding which goods are used for what purpose. If the usage of resources is not decentrally organised through markets, in a democracy the voters have to agree with the principals of a centralised allocation of the resources which is decided upon by political decision-makers.However, those political representatives who are further empowered by the control over economic resources, tend to secure the seeming consent of their voters through political control and propaganda. The lack of economic freedom undermines political freedom through the concentration of political and economic power in the hands of few political dignitaries.

Data: No Countries politically free and substantially economically unfree
Evidence for Friedman’s hypothesis that a free political system cannot survive without economic freedom can be found in the data for 155 countries. Almost all countries, categorised as politically free based on the data provided by Freedom House, are also categorised as relatively economically free according to data from the Heritage Foundation.

A bit more than half of the countries (84) can be found in the quadrant “politically free/economically free”. Out of the politically free countries, New Zealand offers the highest degree of economic freedom.

The politically as well as economically least free country among the examined countries is North Korea. Luckily, apart from Venezuela, only few countries are found in the company of North Korea and are categorised as politically and economically unfree. However, it has to be noted that countries for which there is no data available are also located here, i.e. Libya, Somalia or Sudan.

The quadrant “politically free/economically unfree” is almost empty. The few countries which are located in this quadrant are on the edge of being economically relatively free countries, i.e. Bolivia.

In many countries, on the other hand, people are enjoying considerable economic freedom, however, they are politically unfree, i.e. in Singapore. These cases do not contradict the Friedman-Hypothesis, though. While Friedman regards a lack of economic freedom as incompatible with political freedom, he assumed economic freedom to be a necessary but not a sufficient condition for political freedom. Friedman assumed a combination of a lack of political freedom with economic freedom to be possible in the long-run, even though he obviously regarded a politically and economically free society as desirable.

A Welcome Development
Not only static evidence supports Friedman’s Hypothesis: Politically free and economically unfree countries did not persist for long, historically. After some time they either were not democratic any more or they were no longer economically unfree. For example, in the year 1980 twelve countries were politically free but economically unfree and therefore violated the Friedman-Hypothesis. But in 1990 already, this was the case for only one country (Barbados). Ten out of the twelve countries moved towards free markets while only one country moved out of the quadrant as it became politically unfree: Venezuela.

Democracy and Market Economy: Two Sides of the same Coin
Democracy and a lack of economic freedom are incompatible. Democracy and an open market economy, on the other hand, are not just compatible but strengthen one another. Both are mechanisms for limiting power. Firstly, they reduce the influence of direct competitors. The competition among politicians and parties counteracts a concentration of political power. Private ownership of factors of production and the decentralised decision on the use of resources by households and companies, which are in competition with each other, limit the economic power of individual market participants. Secondly, the representatives of the political and economic spheres are limiting one another. The private control over the factors of production limits the abuse of those factors by political officials, while the legal framework of economic activities is set by politics.

Democrats for Market Economy
Democracy is a model of success. It is a political system, however, that does not survive in the long-run without an open market economy. Convinced democrats should promote the market economy. Recently, one should be warned by the developments in Venezuela. Just ten years ago, German politicians still cheered the economic repression introduced by Hugo Chávez. When a democratic society weakens its market order too much, it endangers the democracy – with unintended consequences and an uncertain outcome.

This article is a translation of an original piece published on our German site and available at ...

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