Liberty and Disparity A Constitutional Economics Perspective

1. Liberty and Disparity A Constitutional Economics Perspective

2. Liberty and DisparityA Constitutional Economics Perspective • Introduction • The Perspective of Constitutional Economics • Liberty, Disparity and Constitutional Choice • Liberty and Prosperity • A Trade-Off Between Liberty and Equality? • Globalization and Inequality • Conclusion

3. 1. Introduction • Liberty: An attribute of a society’s legal-institutional framework. The more scope it provides for protected individual rights to choose the more liberty (‘private autonomy’) citizens enjoy. • Disparity: An attribute of the socio-economic outcome patterns that result within a given legal-institutional framework. • In its more general interpretation, disparity means differences in socio-economic, cultural and other attributes between persons in a society. • In its more specific interpretation, disparity means inequality, in particular income inequality. • The issue to be addressed: What are the effects of liberty, specifically economic liberty, on disparity, specifically on income inequality? • The perspective from which this issue will be approached: The research program of constitutional economics.

4. 2. The Perspective of Constitutional Economics • Constitutional economics (Brennan and Buchanan 1985; Buchanan 1990) as the ‘economics of rules’ studies • how a society’s rules, i.e. its legal-institutional framework, affect the resulting socio-economic outcome pattern, or, • how the ‘order of rules’ affects the resulting ‘order of actions’ (Hayek 1969), or, • in terms of the game metaphor, how the ‘rules of the game’ affect the ‘playing of the game.’ • As applied science constitutional economics inquires into • how by choosing ‘better’ laws and institutions a polity can improve the socio-economic outcome patterns for its citizens, or, • how by improving the ‘order of rules’ the ‘order of actions’ can be improved, or, • in terms of the game metaphor, how by adopting better ‘rules of the game’ citizens can come to play a ‘better game.’

5. 2. The Perspective of Constitutional Economics • As applied science constitutional economics uses theoretical and empirical knowledge about the working properties of alternative rule-regimes to provide advice for the prudential choice of rules. • The advice of applied sciences is always directed at addressees whose interests are supposedly served by the advice. • In a democratic polity “as a cooperative venture for mutual advantage” (Rawls 1971: 84) the ultimate addressees of constitutional advice are the principals-citizens. Constitutional recommendations must, therefore, be based on reasons why citizens should prefer the recommended rule-regime over feasible alternative regimes. • In this sense constitutional economics seeks to identify legal-institutional reforms that promise to serve citizens’ common constitutional interests (Vanberg 2005; 2007).

6. 3. Liberty, Disparity and Constitutional Choice • Society and economy are complex adaptive systems in which outcomes emerge from the strategic interactions of the individuals involved. • In such systems, outcomes cannot be chosen directly by political agencies. Outcomes can only be affected indirectly by the choice of rules-institutions or by specific interventions that are expected to result in desired outcome patterns. • Liberty as an attribute of a society’s legal-institutional framework is subject to constitutional choice. Through the political process citizens can choose to adopt rule-regimes that give more or less room to individual liberty. • Disparity as an attribute of socio-economic outcome patterns is not directly subject to political choice. Citizens can only seek to indirectly affect disparity either through changes in the ‘rules of the game’ or by interventionist measures, including redistribution.

7. 3. Liberty, Disparity and Constitutional Choice • A central tenet of constitutional economics is that improving the ‘rules of the game’ – by contrast to specific interventions – is the only sustainable strategy for systematically improving the ‘performance’ of complex socio-economic systems. • Applied to the issue of ‘liberty and disparity’: • As politically organized communities citizens can seek to choose rules and institutions that give more or less room for individual liberty with the aim of ‘playing a better game.’ • Such choice should be prudently informed by the expected working properties of these rules, i.e. by the outcome patterns they can be predicted to produce, including their effects on disparity. • Constitutional economics can assist citizens in making such choice by providing information on the kinds of outcome patterns that alternative rule-regimes can be expected to produce.

8. 3. Liberty, Disparity and Constitutional Choice • The issue to be discussed: • What advice – in light of our theoretical and empirical knowledge about the working properties of alternative legal-institutional regimes – can constitutional economics provide to citizens who are to decide on the extent of individual liberty, specifically economic freedom, that their socio-economic constitution is to provide for? • Or, in the terminology of constitutional economics: What rules pertaining to the extent of economic liberty can reasonably (i.e. on theoretical and empirical grounds) be assumed to serve the common constitutional interests of all members of the citizenry?

9. 4. Liberty and Prosperity • Apart from the intrinsic value of liberty, a primary argument in favor of a ‘constitution of liberty’ is that economic liberty is the principal wellspring of prosperity. • There is a growing consensus in economics that differences in economic institutions are “the most important explanation of the differences in income across countries” (Olson 1996: 7) and, in particular, • that institutions “that enforce contracts and protect property rights” (ibid.: 6) are essential ingredients to the production of wealth, and • that, in general, institutions that protect and support individuals’ freedom to engage in economic activities and in voluntary transactions with others are conducive to the production of wealth.

10. 4. Liberty and Prosperity • An essential theoretical argument for the intrinsic link between liberty and prosperity has been provided by F.A. Hayek: • It is because of the freedom of choice that individuals enjoy in markets that “more knowledge” is utilized for solving economic problems than under alternative regimes. • The use and creation of knowledge as sources of prosperity: • “The order of the market serves our ends … by … an effective utilization of the knowledge and skills of the several members” of society (Hayek 1976: 107). • The competition that comes with economic liberty creates “general conditions which are most likely to lead to the discovery of the largest number of opportunities” (Hayek 1979: 68). • The failure of the socialist systems of central planning had its principal reason in their inferior capacity to ‘use the knowledge’ dispersed in society’ and to benefit from competition as a ‘discovery procedure.’

11. 4. Liberty and Prosperity • There is ample historical evidence for the connection between economic liberty and prosperity. • This evidence has more recently been supplemented by systematic empirical research based on comparative data on economic freedom across the world. • The Fraser Institute’s Economic Freedom Index comparing 141 countries (Gwartney et al. 2007). • The Heritage Foundation’s Index of Economic Freedom comparing 154 countries (Heritage Foundation 2007). • Freedom House’s Economic Freedom Indicators (Messik 1996). • The World Bank’s “Doing Business” Report comparing regulation in 178 economies (World Bank 2007). • Despite their differences in purpose and methodology the resulting rankings have very much in common.

12. 4. Liberty and Prosperity • Freedom House’s “World Survey of Economic Freedom: 1995-1996” summarizes: • “The survey thus joins a handful of recent studies in showing that economic freedom is the surest path to growth and development” (Messick 1996: 9). • Comparing the Frazer Institute, Heritage Foundation and Freedom House data, Hanke and Walters (1997: 140) conclude: • The differences between the studies “do not alter a finding which is of crucial importance: Economic freedom and economic wealth are inextricably linked. All signs point in the same direction: those who would like people to enjoy greater prosperity must work to assure greater economic liberty.” • Most recent data from the Fraser Institute and Heritage Foundation publications confirm this finding.

13. 4. Liberty and Prosperity

14. Per Capita Income and Economic Freedom Quartile Least Free …………… Most Free Sources: The Fraser Institute; The World Bank, World Development Indicators CD-ROM, 2007.

15. Income (per person) of the Bottom Ten Sources: The Fraser Institute; The World Bank, World Development Indicators CD-ROM, 2007.

16. Income (per person) of the Top 10 Sources: The Fraser Institute; The World Bank, World Development Indicators CD-ROM, 2007.

17. 4. Liberty and Prosperity Empirical studies, based on the research on economic freedom indices, show not only the essential link between liberty and prosperity but also the “apparent ability of economic freedoms to promote non-material measures of well-being in society” (Stroup 2006: 63).

18. Human Development Index and Economic Freedom Quartiles Least Free ……………. Most Free Sources: The Fraser Institute; United Nations Development Program, Human Development Indicators 2006, available at http://hdr.undp.org/.

19. 5. A Trade-Off Between Liberty and Equality? • While the positive effect of economic freedom on prosperity is rarely disputed (and in fact undisputable), what remains disputed is the effect of liberty on equality. • With regard to the issue of ‘equality’ we must distinguish between • equality before the law (equal treatment), and • equality of outcomes. • While equality before the law (i.e. absence of privileges and discri-mination) is an essential ingredient of a ‘constitution of liberty,’ equality of outcomes is incompatible with liberty. • Hayek (1960: 87): “From the fact that people are very different it follows that, if we treat them equally, the result must be inequality in their actual position, and that the only way to place them in an equal position would be to treat them differently. Equality before the law and material equality are therefore not only different but are in conflict with each other.”

20. 5. A Trade-Off Between Liberty and Equality? • Liberty means freedom to be different, to do things differently, to experiment with alternative practices. • The very combination of liberty and differences in talents and interests between people is a principal source of productivity. • It provides opportunities for mutual gains from specialization and trade. • With regard to redistributive policies that aim at equalizing out-comes short-term and long-term effects must be distinguished: • Hayek (1960: 48f.): “At any given moment we could improve the position of the poorest by giving them what we took from the wealthy. But … it would, before long, slow down the movement of the whole and in the long run hold back those in the rear.” • Barro (2000: 32): “Although the direct effects on income distribution may be desirable (because they are equalizing), these programs tend to compromise property rights and reduce the incentives of people to work and invest.”

21. 5. A Trade-Off Between Liberty and Equality? • The citizens of a democratic polity should not only consider the negative long-term effects of redistributive policies. Because of the likely negative effects of great inequalities on social cohesion and peaceful integration they may also have prudential reasons to be concerned about income inequality. • In regard to such inequalities a critical difference exists between • income inequalities that result from privileges granted to particular groups (i.e. from inequalities in rights), and • income inequalities that result from the fact that people exercise their economic liberties within a competitive market economy under the rule of law. • A ‘constitution of liberty’ is incompatible with privileges and requires their elimination (Hayek 1960: 153f.). • Hayek (ibid.: 49): “Of course, a society in which only the politically privileged were allowed to rise … would be no better than an egalitarian society.”

22. 5. A Trade-Off Between Liberty and Equality? • Does the empirical evidence show that income inequality is greater in societies with greater economic liberty? • N. Berggren (1999: 217) concludes from his analysis using Fraser Institute data: “The results point in a clear direction: that economic freedom – as a dynamic concept – appears to go together not only with general wealth and growth, but also with equality.” • G. Scully (2002: 90) summarizes the findings of his data analysis: “In this study, it is found that the amount of economic freedom across nations has the attribute of increasing the rate of economic progress and improving the distribution of market income. That economic freedom is a positive and significant determinant of economic growth is not a controversial finding. The empirical evidence here indicates that economic freedom reduces inequality (i.e., lowers the Gini).” – And he concludes: “Nations can move to a less restrictive rights regime and increase economic efficiency, economic growth, and equity” (Scully 1992: 197).

23. 5. A Trade-Off Between Liberty and Equality? • A qualification must be noted: • While the empirical evidence suggests that overall economic liberty has an equalizing effect on income distribution, • “there is a positive but relatively small trade-off betweengrowth and income inequality” (Scully 2002: 77). • Since economic freedom promotes economic growth its equalizing effect on income distribution appears to be the combined result of two effects: • In the shorter term with economic growth comes an increase in income equality. • In the longer term economic liberty reduces income inequality through the forces of competition that tend to erode positions of economic power.

24. 5. A Trade-Off Between Liberty and Equality? • While the evidence does not support the presumption that economic liberty leads to increased inequality but rather indicates that it has an overall and in the longer run it has an equalizing effect on income distribution, • what should perhaps be considered more important than its effects on income equality is the unambiguously positive effect of economic liberty on the reduction of poverty.

25. Per Capita Income of Poorest 10% and Economic Freedom Least Free …….. Most Free Sources: The Fraser Institute; The World Bank, World Development Indicators CD-ROM, 2007.

26. 5. A Trade-Off Between Liberty and Equality? Source: Sala-I-Martin, X.: The World Distribution of Income: Falling Poverty and … Convergence, Period, in: The Quarterly Journal of Economics, Vol. 71 (2006), 363.

27. 5. A Trade-Off Between Liberty and Equality? Source: Sala-I-Martin, X.: The World Distribution of Income: Falling Poverty and … Convergence, Period, in: The Quarterly Journal of Economics, Vol. 71 (2006), 363.

28. 6. Globalization and Inequality • A controversially discussed issue of particular recent interest concerns the effects of globalization on income inequality in the world. • In its World Development Report for 2000/01 the World Bank (2001) claims: “The average income in the richest twenty countries is thirty-seven times the average in the poorest twenty – a gap that has doubled in the past fourty years.” • In its The Inequality Predicament. Report on the World Situation 2005 the United Nations‘ Department of Economic and Social Affairs affirms that “the income gap between the richest and the poorest countries has widened in recent decades” (p. 44).

29. 5. A Trade-Off Between Liberty and Equality? United Nations 2005: The Inequality Predicament, p. 45

30. 6. Globalization and Inequality • The United Nations’ Report on the World Situation 2005 identifies “the combined challenges of globalization and market reforms” as causes of the ‘The Inequality Predicament’: • “Structural adjustment programmes and market reforms (along with, V.V.) … financial and trade liberalization have generally had a negative impact on the welfare of individuals, groups and communities worldwide” (United Nations 2005: 105). • “Foremost among the global dynamics that help explain the root causes of persistent inequality trends are the liberalization policies implemented in many countries during the past two decades. These reforms have … had a major adverse impact on inequality trends” (ibid.: 108). • “The liberalization and adjustment policies implemented over the past two decades have contributed to the rise in inequality …. These processes have been an important cause of the increased poverty rates and inequalities in income distribution documented by various studies” (ibid.: 109/110).

31. 6. Globalization and Inequality • Economists S. Bhalla (2002), Deepak Lal (2006: 127ff.) and X. Sala-i-Martin (2006; 2007) have critically analyzed these claims. • Bhalla, after correcting for statistical and data flaws in the figures provided by the World Bank, concludes: “I find the opposite to be true, not only has inequality not increased, it has actually fallen, and by the end of 2000 was at its lowest level in 50 years” (Bhalla 2002: 1). • Bhalla and Sala-i-Martin argue that the change in the world distribution of income looks quite different from the World Bank and United Nations figures if a number of corrections are made: • First: Instead of comparing the twenty poorest with the twenty richest nations in 1960 and in 2000 a more informative picture emerges if one looks at the change in the relative position for the same set of countries between 1960 and 2000.

32. 5. A Trade-Off Between Liberty and Equality?

33. 6. Globalization and Inequality • The corrections in the World Bank and United Nations figures that Bhalla and Sala-i-Martin suggest include further: • Second: Since countries differ significantly in population size, simply comparing per capita income across nations provides a misleading picture if one is interested in how income inequality between individuals has changed. Therefore, population-weighted per capita income figures should be used. • Third: In order to provide a meaningful picture of world income inequality between individuals both within-country dispersion of income and inequality between countries have to be accounted for.

34. 6. Globalization and Inequality • Sala-i-Martin (2006: 382): The United Nations argument “that global income inequality has risen (is) based on the following logic: • Claim 1: ‘Income inequalities within countries have increased.’ • Claim 2: ‘Income inequalities across countries have increased.’ • Conclusion: ‘Global income inequalities have also increased.’ Although it is true that within-country inequalities are increasing on average, and it is also true that income per capita across countries have been diverging, the conclusion that global income inequality has risen does not follow logically from these premises.”

35. 6. Globalization and Inequality • As Bhalla and Sala-i-Martin show, with population-weighted per capita income figures the net effect of changes in income inequalities between and within countries over the past two decades has been a significant decrease in world-wide income inequality between individuals. • Sala-i-Martin (2006: 383, 386): “The problem for the UNDP is that population-weighted measures of income inequality show a downward trend over the past twenty years. … If rather than considering GDP per capita across countries, we analyze the incomes of individual citizens, the last two decades have witnessed an unambiguous process of ‘convergence, period!’” • A most significant part of this development have been the growth rates of China and India since they adopted market-oriented reforms.

36. 6. Globalization and Inequality

37. 6. Globalization and Inequality

38. 6. Globalization and Inequality

39. 6. Globalization and Inequality Source: Sala-I-Martin, X.: The World Distribution of Income: Falling Poverty and … Convergence, Period, in: The Quarterly Journal of Economics, Vol. 71 (2006), 385.

40. 6. Globalization and Inequality • While globally individual income inequality declined since 1980, there is regional variation: • For 2002 Bhalla (2002: 205) reports: “Industrialized countries have witnessed no change, Asia has recorded more than a 10 percent increase (in the Gini coefficient, V.V.), and the post-communist structural changes in Eastern Europe have not been good for growth or for inequality. … Inequality has increased by an unprecedented amount – from an average Gini level of 32 before the 1990s to an average of almost 50 today.” • Sala-i-Martin (2006: 388f.): “Over 71 percent of income inequality across individuals in the world is accounted for by differences across countries and only 29 percent is accounted for by within-country differences. … The decline in across-country inequality has been larger than the increase in within-country inequality so that the sum goes down.”

41. 6. Globalization and Inequality • Even more pronounced than the reduction in world-wide income inequality is the reduction in absolute poverty in the world. • Sala-i-Martin’s (2007: 20f.) calculations show that: • “Using the original World Bank definition ($495 annual income), the poverty rate declined from 15.4 percent of the world population in 1970 to 5.7 percent in 2000.” • “With the 2$-a-day definition ($730 a year), the poverty rate was close to 30 percent in 1970 and a little below 11 percent in 2000.” • “Finally, using the $3-a-day definition ($1,140 a year), the poverty rate was 47 percent in 1970 and 21 percent in 2000.”

42. 6. Globalization and Inequality Source: Sala-I-Martin, X.: The World Distribution of Income: Falling Poverty and … Convergence, Period, in: The Quarterly Journal of Economics, Vol. 71 (2006), 373.

43. 6. Globalization and Inequality • While global poverty rates declined overall, there is significant regional variation. In particular, the Asian success contrasts with the development in Sub-Saharan Africa. • Sala-i-Martin (2007: 21): “Overall, poverty rates (in Sub-Saharan Africa, V.V.) in 1970 were similar to those in South Asia and East Asia at 35 percent. By 2000, poverty rates in Africa had reached close to 50 percent, while those in Asia had declined to less than 3 percent.” • “Africa accounted for only 14.5 percent of the world’s poor in 1970. Today, despite the fact that Africa accounts for only 10 percent of the world’s population, it accounts for 67.8 percent of the world’s poor” (ibid.).

44. 6. Globalization and Inequality • The differences in economic performance are systematically connected to countries’ institutional characteristics. • Deepak Lal (2006: 132): “Africa – which has not integrated into the world economy and faces serious problems of governance – is the only region where poverty has risen.” • In the World Trade Organization’s study on Trade, Income Disparity and Poverty(World Trade Organization 1999) D. Ben-David (1999: 37) concludes: “Countries that formally enacted trade liberalization policies exhibited a convergence in income gaps once they implemented trade reforms.”

45. 6. Globalization and Inequality Source: Sala-I-Martin, X.: The World Distribution of Income: Falling Poverty and … Convergence, Period, in: The Quarterly Journal of Economics, Vol. 71 (2006), 380.

46. 7. Conclusion • The purpose of the preceding inquiry has been, • to look at the relation between liberty and disparity and, more specifically, at the relation between economic freedom and income inequality from a constitutional economics perspective, and • to clarify what advise constitutional economics can provide, in light of our theoretical and empirical knowledge about the working properties of a ‘constitution of liberty,’ to citizens who are to choose the economic constitution for their polity. • Our theoretical knowledge and the empirical evidence • not only support the insight that economic freedom and the rule of law are the wellspring of prosperity, • they also suggest that there is much less of a trade-off between economic liberty and equality than is often presumed, but that, • on the contrary, the rule of law, economic liberty and the forces of market competition have an overall equalizing effect.

47. 7. Conclusion • Citizens have reasons to be much more concerned about inequalities that are founded on privileges than on inequalities that result from the exercise of economic liberty within a competitive market under the rule of law. • Citizens’ concerns about adverse effects of competition in a global economy are better accounted for • by mutual insurance regimes that protect everybody from falling below a minimum level of income and that assist individuals in adapting to new conditions, • than by redistributive policies that erode the productive dynamics of a market economy. • The globalization experience supports Milton Friedman’s claim: • “A society that puts equality before freedom will get neither. A society that puts freedom before equality will get a high degree of both.”

48. References • Barro, Robert J. 2000: “Rule of Law, Democracy, and Economic Performance,” in: 2000 Index of Economic Freedom, Washington D.C. and New York: The Heritage Foundation and The Wall Street Journal, 31-49. • Ben-David, Dan 1999: “Trade, Growth and Disparity Among Nations,” in: Trade, Income Disparity and Poverty, by. D. Ben-David, H. Nordström, L.A. Winters, Special Studies 5, Geneva: World Trade Organization, 11-42. • Berggren, Niclas 1999: “Economic freedom and equality: Friends or foes,” Public Choice 100, 203-223. • Bhalla, Surjit 2002: Imagine There’s No Country: Poverty, Inequality and Growth in the Age of Globalization, Washington D.C.: Institute of International Economics. • Brennan, Geoffrey and James M. Buchanan 1985: The reason of rules: Constitutional political economy, Cambridge et al.: Cambridge University Press. • Buchanan, James M. 1990: “The Domain of Constitutional Economics,” Constitutional Political Economy 1, 1-18. • Gwartney, James et al. 2007: Economic Freedom of the World: 2007 Annual Report, Vancouver: Fraser Institute. • Hanke, Steven H. and Stephen J.K. Walters 1997: “Economic Freedom, Prosperity, and Equality,” The Cato Journal 17, 117-146.

49. References • Hayek, F.A. 1960: The Constitution of Liberty, Chicago: The University of Chicago Press. • Hayek, F.A. 1969: “Rechtsordnung und Handelnsordnung”, in F.A. Hayek, Freiburger Studien, Tübingen: J.C.B. Mohr (Paul Siebeck), 161-198. • Hayek, F.A. 1976. The Mirage of Social Justice. Law, Legislation and Liberty,Vol. 2. London and Henley: Routledge and Kegan Paul. • Hayek, F.A. 1979. The Political Order of a Free People. Law, Legislation and Liberty, Vol. 3. London and Henley: Routledge and Kegan Paul. • Heritage Foundation 2007: 2007 Index of Economic Freedom, Washington D.C. and New York: The Heritage Foundation and The Wall Street Journal. • Lal, Deepak 2006: Reviving the Invisible Hand. The Case for Classical Liberalism in the Twenty-First Century, Princeton and Oxford: Princeton University Press. • Messick, Richard 1996: World Survey of Economic Freedom, 1995-1996, New Brunswick, N.J.: Freedom House and Transaction Publishers. • Olson, Mancur 1996: “Big Bills Left on the Sidewalk: Why Some Nations are Rich, and Others Poor,” Journal of Economic Perspectives 10, 3-24. • Rawls, John 1971: A Theory of Justice, Cambridge, Mass.: Harvard University Press.

50. References • Sala-i-Martin, Xavier 2006: “The World Distribution of Income: Falling Poverty and … Convergence, Period,” The Quarterly Journal of Economics CXXI, 351-397. • Sala-i-Martin, Xavier 2007: “Global Inequality Fades as the Global Economy Grows,” in: 2007 Index of Economic Freedom, Washington D.C. and New York: The Heritage Foundation and The Wall Street Journal, 15-25. • Scully, Gerald 1992: Constitutional Environments and Economic Growth, Princeton N.J.: Princeton University Press. • Scully, Gerald 2002: “Economic Freedom, Government Policy and the Trade-Off Between Equity and Economic Growth,” Public Choice 113, 77-96. • Stroup, Michael D. 2006: “Economic Freedom, Democracy, and the Quality of Life,” World Development 35, 52-66. • United Nations, Department of Economic and Social Affairs 2005: The Inequality Predicament. Report on the World Situation 2005, New York: United Nations. • Vanberg, Viktor J. 2005: “Market and state: the perspective of constitutional political economy,” Journal of Institutional Economics 1, 23-49. • Vanberg, Viktor J. 2007: “Democracy, citizen sovereignty and constitutional economics,“ in: José Casas Pardo, Pedro Schwartz (eds.), Public Choice and the Challenges of Democracy, Cheltenham: Edward Elgar, 101-120.