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Economic Freedom and Corruption

A. Chaffed and Eugenia Gunman “Either force or corruption has been the principle of every modern government, unless the Dutch perhaps be excepted, and I am not well enough informed to except them absolutely. ” ?Thomas Jefferson The effects of corruption on economic freedom have been debated intensely by economists and political scientists for many years, fueled by each new allegation of bribery, extortion, or fraud involving public officials. We began to consider this issue seriously during an ongoing debate on patents in Argentina in 1996.

At that time, Argentina’s president, who had championed several free-market reforms, was trying to bring the country’s intellectual property rights laws in line with those of the free world, but his efforts were being stymied by special-interest groups, such as the powerful local pharmaceutical industry that had been exempt from respecting patents since 1864. The ability of these groups to prevent such a change in law received wide press coverage in Argentina and prompted letters of protest from the governments of the United States and the European Union.

Indeed, it led to our hypothesis that corruption could prove to be a ajar stumbling block to economic reform. Cases of allegedly corrupt practices in countries implementing market-oriented

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reforms heighten criticisms that free- market policies and a so-called neo-liberalism merely fuel greed and encourage corruption. If such criticisms are correct, then the historical record should show that, as economic freedom in a country increases, so does corruption. If economic freedom and corruption prove to be inversely related, then the criticisms have little merit.

To understand the relationship between economic freedom and corruption, and to test our hypothesis, we analyzed data compiled in previous editions of The Heritage Foundation’s Index of Economic Freedom, the Fraser Institute’s Economic Freedom of the World 1975-1995,1 Freedom House’s World Survey of Economic Freedom 1995- 1996,2 and the less rigorous Transparency International index on the perception of corruption. 3 The findings of our first analysis were published in 1997 by the Center of Public Studies in Santiago, Chile, in a paper entitled “The State and Corruption. 4 Since then, we have continued to update and analyze the data, and the findings intention to show not only that economic freedom is not responsible for corruption, but also that?more important? economic freedom is a major deterrent of corruption. Economic freedom, however, does not produce automatic effects, and where corruption is entrenched, many institutions of civil society must become involved to deter and eliminate it. Chapter 3: Economic Freedom and Corruption 51 A PERVASIVE PHENOMENON absence of government coercion or constraint on the production, distribution, or consumption of goods and services. 5 For our purposes, economic freedom is the eight of individuals to try to do what they want with what they earn, build, create, or own. What they own is what they have acquired voluntarily within the limits of Just laws. Corruption, on the other hand, is using to one’s own advantage, and outside a just rule of law, what one does not have the right to own or control. For the sake of this discussion, the authors are concerned only with corruption that takes place within the scope of goods and services handled by the authorities entrusted by the government of a civil society.

Judging by today’s headlines, corruption among overspent officials is fast becoming a major growth industry, perhaps rivaling even the growth of the Internet. A recent news article, for example, reported that, according to senior U. S. , British, and Russian law enforcement officials, “Russian organized crime figures laundered at least $1 5 billion through two New York banks at the direction of President Boris Yuletide’s government…. [T]he money includes at least $10 billion in International Monetary Fund loans. “6 The U. S. Investigation is continuing. Meanwhile, in early October 1999, it was reported that a “Federal grand our in Manhattan indicted three Russian immigrants and three of their companies. ” The grand Jury’s action marked “the first criminal charges to come out of the investigation” led by the Federal Bureau of Investigation. 7 Even a former Deputy Director of the Russian KGB, General Nikolas Lennox, has acknowledged the high level of corruption among government officials in Russia. In his words: Everyone violates the law. Law has been totally undermined….

Corruption, theft are everywhere: the cancerous metastasis of corruption has practically penetrated the country. This is recognized by the United States of America; we even recognize it. It is not a secret. It is painful to speak in this way about one’s own country, but we must find a solution to our evils. 8 52 Similar reports of corruption, though perhaps of smaller magnitude, have involved officials in Bulgaria, France, Mexico, Nigeria, Pakistan, South Korea, and the United States. The effect of such corruption on an economy is not lost on economists.

For example, Papas Phonographic, an economist at Clangorous University in Bangkok, remarked last year that “It would not be wrong to say that corruption is the single most important reason for our economic meltdown. 9 One of the side effects of corruption is a loss of public confidence in government. This has been well illustrated by the findings of a recent survey conducted in Latin America by The Wall Street Journal Americas. A stunning 69 percent of respondents said that corruption is a “very serious” problem in their countries; “moreover, an overwhelming number?88% ?said corruption has gotten worse in the last few years. In Venezuela, that perception was shared by an almost unanimous 96%” of respondents. 10 The current political turmoil in Venezuela?which could delay marionettes reforms for cascades?is not unrelated to this widespread perception of corruption. Not long ago, Michel Campuses, managing director of the International Monetary Fund (MIFF), wrote that “governments must demonstrate that they have no tolerance for corruption…. [T]hey must establish a simple and transparent regulatory framework of the Judiciary. 11 One might expect from such a statement that the MIFF (and organizations such as the World Bank) would have zero tolerance for corruption among recipients of its economic assistance packages. Yet these organizations repeatedly make loans to countries that are plagued by corruption. Indeed, in Russian’s case, it is clear that “the Central Intelligence Agency uncovered what its analysts believed to be conclusive evidence of [Russian Prime Minister Victor] Churchwarden’s personal corruption in 1995,”12 long before another $4. Billion in MIFF credits was approved last July. It is likely that a study of the majority of the recipients of MIFF and World Bank grants and loans would show a positive correlation with corruption. 13 Corruption is anything but a new phenomenon. For centuries, corruption has been associated with government’s excessive involvement in the economy. In 17th century Spain, for example, 2000 Index of Economic Freedom Pedro Fernando De Inveterate wrote that monarchs often lose their kingdoms through excessive governmental expenditures.

People who dispense government funds with largesse “easily fall prey to the temptations of bribery, thievery and other bad actions that violate the laws of Justice. When expenditures exceed the possibilities of the treasury, there is no guarantee of honesty, incorruptible ministers or fair Judges. “14 Corruption holds no monopoly on a period of history, a culture, or a particular country. Even democracies are susceptible. Two centuries ago, Thomas Jefferson wrote that Alexander Hamilton “was indeed a singular character. Of acute understanding, disinterested, honest, and honorable in all private transactions… Lully valuing virtue in private life, yet so bewitched and perverted by the British example, as to be under thro’ conviction that corruption was essential to the government of a nation. “1 5 The importance of limiting the effects of corruption led the Founding Fathers to enumerate carefully the powers of the government. The Merits of an Economic Analysis of Corruption Ludwig von Misses wrote in Human Action: A Treatise n Economics that “An analysis of interventionism would be incomplete if it were not to refer to the phenomenon of corruption. 16 Our study reviewed all the relevant economic literature of the past three decades. Scholars of the Chicago School,17 the Virginia School,18 and various other traditions in economics have analyzed the interaction of political agents, the demand for regulation, and the effects of corrupt and opportunistic conduct on an economy. These analyses show a lack of incentive for voters’ control of government activities. Gordon Outlook, for example, has written hat “in strict cost benefit terms, he [the voter] is rational to be ignorant…. T]he influence his individual vote has on almost any election is so small that even very modest information costs swamp expected net benefits from informed voting. “20 In general, the economic literature emphasizes that the structural characteristic of political markets?in which there is little incentive for control by the voters and strong incentives for self-serving politicians to cater to interest groups?is a principal factor in corruption.

These scholarly contributions have resulted in a robust and insistent Chapter 3: Economic Freedom and Corruption analytical framework which shows that overextended and overvaluation of privileges. As our analysis shows, corruption is pervasive in areas that lack economic freedom. On one hand, corruption is the cost of obtaining privileges that only the state can “legally’ grant, such as favoritism in taxation, tariffs, subsidies, loans, government contracting, and regulation. On the other, corruption is the result of attempts to avoid the restrictions that accompany the use of privileges, taxes, and barriers to free trade.

The 1999 Index of Economic Freedom included corruption as a variable in three of the factors used in its measurements: Corruption within the judiciary influences respect for property rights; corruption within the bureaucracy affects regulation; and the existence of black markets is also an indicator of corruption. Indeed, economic history over the past few decades provides ample evidence of interventionist policies that lead to corruption. These policies include: Access to loans at below-market rates. Many government-owned banks were created with the excuse that they would provide credit to the poor.

Soon they were giving credits at subsidized rates to individuals, companies, or sectors that had high political importance. In some countries, privileged favors went to the industrial sector; in others, they went to the agricultural sector. Mortgages at negative interest rates were given to party members or figureheads. In 1996, a local banker in Bulgaria described the pervasive corruption in his country this way: You’ve got a corrupt system that enabled a group of people to steal other people’s savings….

Banks took people’s savings and continued to lend to state-owned enterprises that were making shoes and to private enterprises?none of which had any intention of repaying. The enterprises could only stay in business if the Government or banks kept them afloat. So-called entrepreneurs clustered in “economic groups”? made up of former senior Commune insist and security officials with links to the Government?were given loans by banks to buy raw materials. These were sold to enterprises that were in turn propped up by the Government or banks.

The end products, usually chemicals or steel, were then sold at large mark-ups abroad. 21 In Chile, it has been estimated that between 1940 and 1973, government banks awarded $4. Billion in direct subsidies through “soft” loans. 22 Receiving loans at subsidized interest rates when inflation is over 100 percent a month is a sure way to become rich. Foreign trade restrictions. In several countries, officials who had the authority to grant import or export permits, determine preferential exchange rates, fix import and export duties, or waive internal taxes used their powers to become rich or make others rich. 3 A clear example occurred in Venezuela with the creation in 1983 of a system of differential exchange rates (R©gene De Cambiums Differentials, or ARCADE). One of the most widely used textbooks on economics in that country acknowledges that “ARCADE turned into one of the largest sources of corruption in the history of Venezuela. “24 Government procurement. So-called public works projects are also opportunities for corruption. From New York City to Titter del Fugue, cases can be found in which government officials abused their authority to grant building and maintenance contracts by giving them to political allies. Ђ Price controls and regulation. Price controls, key facilitators of corruption throughout the history of civilization, have been practically eliminated almost unchallenged. Many projects today cannot proceed without health, safety, environmental, and other licenses and permits. Not granting a permit or delaying a permit can tip the balance in favor of the government’s friends. Facilitating bids may channel immense financial resources to a bureaucrat or his friends and allies. The mere access to information or to a 54 friendly official could give the overwhelming competitive advantage to one bidder over another.

Government representatives from countries that have important influence in institutions like the World Bank, Investment Development Bank, MIFF, or Export-Import Bank have even proffered the enticement of their “pull” with these organizations in exchange for such contracts. Corrupt officials point to the economic development or Jobs generated by such acts of favoritism as a source of national pride and “good government. ” State ownership of utilities and natural resources. Government control of water, electricity, communications, and oil and gas companies creates ample opportunities for corruption.

The governments of Argentina and Mexico, for example, have controlled hundreds of companies, and this has made irrupt activities in procurement, foreign trade, credit markets, and even advertising markets possible given the size of their budgets. In analyzing Indian’s state-run irrigation system, Professor Sham Kamala of California State University at Hayward wrote: Public-sector irrigation systems everywhere are typically plagued with cost and time overruns, endemic inefficiency, chronic excess demands, and widespread corruption and reinserting.

In India, government functionaries and system operators ?who control the allocation of water supplies?routinely extort high rents from farmers. 25 Secret or discretionary funds. Governments that establish reserved or secret discretionary funds enable corrupt officials to use those funds to supplement the salaries of congressmen and technocrats or for personal benefit. Consider the case of South Korea.

In 1996, shortly after two former presidents of that country were convicted of corruption, several heads of international businesses were convicted primarily for contributing to a $620 million political slush fund: 2000 Index of Economic Freedom The scene was unthinkable in the old South Korea: nine of the country’s wealthiest and most influential business leaders facing a Judge one rainy day in August to be intended as criminals, payers of bribes totaling hundreds of millions of dollars. One after the other, the heads of Deadwood, Samsung and other global Korean companies got prison terms or suspended sentences.

Coming Just hours after two former South Korean presidents were convicted of sedition and corruption, the Judge’s action was welcomed here as another blow…. 26 meet or central bank purchases of bad debt at prices higher than currently available on the market also open the door to corruption. Cases in which owners of private banks, especially those who favor the overspent, received the equivalent of hundreds of millions of dollars through such from Russia through international banks should also provoke investigations of similar international bailouts and huge transfers of money because of the likelihood of corruption.

Examples of these types of corruption would be easy to document in almost any country. Because they involve people working under very different political and economic systems, it is tempting to blame human nature. However, a careful review of various recently published studies measuring corruption and economic freedom permits us to analyze the direct correlation between corruption ND the level of economic freedom. Credit bailouts. Bank bailouts and govern- ices in the data in order to select or discard alternative hypotheses.

Thus, while the correlations presented in this chapter are important to an understanding of the effects of corruption on economic freedom, they are not the ultimate proof of the validity of our theory. The statistical information presented here is relevant; it corroborates the logical analysis that incentives created by government intervention in an economy, coupled with the weaknesses of human nature, create opportunities for corruption. Measurements of Corruption. Transparency International (T’) publishes an annual corruption index that is an average of several surveys.

Its 1996 index, for example, was the result of 10 different surveys. 27 From a methodological point of view, TLS index has limitations. It evaluates the level of corruption as it is perceived by executives of multinational organizations and the impact they feel this corruption is having on social life and commercial activity. Such a subjective measurement of perceptions can diverge from reality. The TTL figures are at least an approximation of the level of corruption. Nevertheless, using “objective information” eased on, say, the number of Judicial sentences or litigated complaints also has drawbacks.

The different degrees of efficiency among Judicial systems in detecting cases of corruption make international comparisons almost impossible. The original TTL index gave a zero rating to the most corrupt country and a 10 to the “cleanest. ” For our studies, these grades have been converted to a percentile scale that enables us to construct clearer correlations with the indexes of economic freedom, where zero equals the least amount of corruption and 100 represents the most amount of corruption. Measurements of Economic Freedom.

Three independent organizations produced the data on economic freedom that we used in our initial 1997 study. In addition to The Heritage Foundation’s 1996 Index of Economic Freedom, we used the Fraser Institute’s Economic Freedom of the World 1975-1995 and Freedom House’s 1995 Survey of Economic Freedom. There was a difference in the countries and the number of countries they analyzed. That 55 THE CORRELATION BETWEEN ECONOMIC FREEDOM AND CORRUPTION All measurements, by definition, are subject to error. Indexes such as those we used for data in our original 1997 analysis can never give exact measurements of the abject being studied.

But they do make it easier to grasp trends and tenderhearted 3: Economic Freedom and Corruption Chart 3. 1 Most Corruption 100 90 70 6050 40 20 Corruption Score, 1996 RE=O. 71 Least Corruption 10102030405060708090100 Lowest Economic Freedom 1995 Economic Freedom Average Score (Heritage, Fraser, Freedom House) Highest Economic Freedom Note: *Economic Freedom score represents a simple average of the non-corruption related economic freedom scores of The Heritage Foundation, the Fraser Institute’s “LSI” Index, and Freedom House. Sources: Economic Freedom score based on 1996

Index of Economic Freedom, The Heritage Foundation; Fraser Institute, Economic Freedom in the World, 1975-1995; Freedom House, World Survey of Economic Freedom 1995-1996; Corruption Index score based on 1996 data from Transparency International Web site. Year, of the 140 countries analyzed by The Heritage Foundation, 95 appeared in Framer’s index and 69 in Freedom House’s index. 28 Despite all the methodological and philosophical difficulties the authors of these studies encountered in measuring economic freedom, choosing indicators, and gathering reliable information, the three indexes reached remarkably similar results.

There is, in fact, a high degree of correlation among their rankings. In our 1997 study, we found that the correlation between the Fraser Institute and Heritage Foundation indexes was 0. 87, and that the correlations between these two and the 1995 Freedom House index were 0. 84 and 0. 79, respectively. These correlations are not only high, but also significant. 56 For our original study, we chose to use a Fraser index that had a higher association with the indexes of The Heritage Foundation and Freedom House. 9 We followed the same methodology we used to convert the TTL index and changed the country scores o their comparable score on a scale of 1 to 100, with 100 signifying the highest degree of economic freedom. To give more validity to the estimation, we averaged the different index scores, which should have improved the predictive capacity of the regression. Because both Freedom House and Heritage included corruption in some measuring corruption would give the regression analysis. 30 We therefore 2000 Index of Economic Freedom Table 3. 1 Economic Freedom with Justice, 1998 Top 10 Countries 1. 2. 3. 4. 5. 6. . 8. 9. 10. Singapore New Zealand Hong Kong Switzerland Denmark Finland Canada Netherlands United Kingdom Luxembourg 91. 33 87. 97 85. 53 85. 47 84. 03 83. 42 82. 11 81 . 81 81. 69 81. 69 10. 9. 8. 7. 6. 5. 4. 3. 2. 1. Bottom 10 Countries Honduras China Tanzania Russia Nigeria India Venezuela Ukraine Cameroon Vietnam 32. 81 32. 78 32. 42 32. 14 31 . 72 31 . 17 30. 94 29. 28 26. 44 18. 06 Source: Authors’ calculations, based on 1998 data in the 1999 Index of Economic Freedom and on Transparency International data. Eliminated scores for factors that included corruption and adjusted the indexes accordingly.

The resulting correlations did not suffer great variation. Empirical Results. All the indexes of economic freedom showed a high negative, or inverse, correlation with the index of corruption. Using the average of the three index scores, we found a slightly higher correlation and lower unexplained variances. All correlations clearly showed that the higher the index of economic freedom, the lower the level of corruption. (See Chart 3. 1 . ) Although the correlation between the index of corruption and the index of economic freedom is high, it does not allow us to see how the components of these indexes relate to each other.

For example, a country that unilaterally reduces its import tariffs to zero and sells all state-owned companies will be economically freer. A country that eliminated an income tax or De-monopolized the money supply would also have a freer economy. As a result, the reader should carefully consider each particular case before making a conclusion about the impact of economic policy changes on corruption within specific countries. Measuring Economic Freedom with Justice True economic freedom is possible only under a system of limited government with a strong rule Chapter 3: Economic Freedom and Corruption of law.

Economic freedom has little value if corruption in government means that only a few will enjoy it. Therefore, the rule of law, under limited government, is the essence of a Just society?one in which the rights of persons are respected and individuals are free to improve their personal and social lives through their own efforts and according to Just laws, unencumbered by corrupt government actions. To see how countries fared in this regard, we ranked them according to their level of “economic freedom with Justice. (In this case, the term “Justice” does not imply the redistribution of wealth. In order to rank the countries, we used 1998 data from the converted the scores in these indexes by assigning 100 to the best score on countries with the most economic freedom and the least amount of corruption. Table 3. 1 shows the rankings for the 10 best-performing and 10 worst-performing countries. The best countries are those in which the current laws and recent economic performance show a high degree of economic freedom and where businessmen perceive low levels of corruption.

Singapore ranking is the only one we found questionable. In Singapore Authoritarian Capitalism,32 Christopher Ling, a visiting associate roofless of economics at Case Western Reserve University, argues that because of corruption, 57 Chart 3. 2 Higher Heritage Economic Freedom Scores Are Highly Correlated with Lower Corruption Scores Most Corruption Transparency International Index of Corruption, 1998 RE=O. 519 10 20 50 70 Heritage Index of Economic Freedom, 1998 Note: Economic Freedom score represents the non-corruption related economic freedom score.

Sources: Economic Freedom score based on 1999 Index of Economic Freedom, The Heritage Foundation and The Wall Street Journal; Corruption Index core based on data from Transparency International Web site, www. Transparency. De/documents/ICP/index. HTML. Singapore should not receive a high mark for economic freedom. However, if businessmen in Singapore who have been surveyed by Transparency International were aware of the type of bureaucratic harassment that Ling encountered, then perhaps an element of cautious fear encouraged them to respond favorably to TLS questions.

We used the data provided by TTL in our analysis because, despite its problems, the TTL index is still the most respected index measuring corruption available today. The correlation between economic freedom and corruption shown in Chart 3. 2, using the above data (Heritage’s 1999 Index of Economic Freedom and Transparency Internationally 1998 index), confirmed the results of our original study. 58 The correlation coefficients of this comparison are high and significant. The coefficient of determination (RE) is high, showing that 51 percent of the variance is explained by the level of economic freedom.

Statistical analysis would note that a 1. 0 percent increase in the economic freedom index produces a decrease of more than 1. 0 percent in the level of corruption. This high association between these measurements suggests that critics would find it hard to prove that any perceived surges in corruption were in fact caused by increases in economic freedom. 33 Additional Concerns. Our analysis of “economic freedom with Justice” does not allow us to answer all the questions that arise in discussions 2000 Index of Economic Freedom about corruption.

For example, we were not able to test: Whether there is a greater possibility of corruption in government operations requiring major transfers of money to one major contractor, such as public works, than in transfer agencies homeless; For any special effect of a policy, such as discretionary, differential exchange rates; Whether the increase in the need to reallocate resources (such as when a country suddenly opens its borders or demolishes its socialist structure) combined with Judicial insecurity would facilitate greater corruption; or What effect illegal drug trafficking and the drug war have on economic freedom and corruption. Among the factors that could lead to a deficiency in the corruption measurement is the difficulty in capturing the effects of certain regulations. In several countries, the

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