Institutions matter. Economists of the classical period knew that well. In recent years, economists have increasingly included institutional variables in their 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, Heritage Foundation, 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, in fact, more prosperous and dynamic than those that are less free. However, not all aspects of economic freedom turn out to be equally important. In earlier posts, 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 those that focus on price stability—the Fraser “Sound Money” component and the Heritage “Monetary Freedom” component.

I find that these price stability components add little to our understanding of economic freedom. Furthermore, because they incorporate an exaggerated fear of even moderate inflation, an attempt to achieve maximum price stability, as defined by these indicators, would be less likely to bring prosperity than to undermine it.

Is price stability an institution or a policy outcome?

The first problem with the Fraser and Heritage price stability indicators is that they do not really measure economic freedom in the sense that it underlies 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—“not 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-quarters of the data that go into the Fraser Sound Money indicator and four-fifths of the Heritage Monetary 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 conceptually, good central banking and economic freedom are different things.

Instead, it seems to me that 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. If I were to try to build a better measure of monetary freedom, I would begin by including both of those, but I would not stop there.

Why not, for example, include a measure of central bank independence, much as both the Fraser and Heritage indexes include measures of judicial independence in evaluating the quality of legal institutions? 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, it might make sense to rate central banks on their use of policy rules. Many economists have argued that using policy rules to constrain or even fully replace central bank discretion can improve price stability. (A recent conference sponsored by the Boston Fed provides a detailed airing of the case for policy rules and contained discretion.)