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Ethical Foundations
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Lecture-speech delivered at the 1st International Conference-Workshop "Ethical Foundations
of Economy" , Krakow Oct. 14, 03


Ethics, Corruption and Economic Freedom

by Ana Isabel Eiras, Senior Policy Analyst for International Economics
in the Center for International Trade and Economics
at The Heritage Foundation


The subject of "ethics" has increasingly been present in economic analysis, 1 although not without considerable debate. Some economists believe that the importance of economics is purely technical. Others believe that moral considerations in economic analysis provide a more accurate picture of possible outcomes, since it takes into consideration the "human" aspect of economic actors-that is, people. I confess that, as an economist, it makes me nervous to insert subjective measures as "morality" and "ethics" when I do my own analysis, both because my conclusions may be applicable to a few cases, and because morality and ethics are hard to measure. But since economics is the study of choice, human behavior cannot be ignored from economic analysis, if we want to have a meaningful insight on people's economic life.

Ethics, according to the English dictionary Merriam-Webster's, is "the discipline dealing with what is good and bad..." 2 In general, we call "unethical" to those actions for which there is a social consensus that is a "bad" thing. Corruption has several meanings, depending on whether it takes place in the public or private sector; however, for most people "corruption" is something "unethical", something considered a "wrongdoing". A closer look at human behavior in economic life suggests that, in some instances, corruption does not reflect so much a lack of ethics, as it reflects a lack of economic freedom.

Economic Freedom and Corruption

To better understand the link between corruption and economic freedom, let me first describe economic freedom and then explain how its absence fosters corruption. I will examine the relationship between economic freedom and both corruption in the form of informal economic activity and in the public sector bureaucracy.

According to The Heritage Foundation /Wall Street Journal annual Index of Economic Freedom, economic freedom is "…the absence of government constrain or coercion on the production, distribution or consumption of goods and services, beyond the extent necessary for citizens to protect and maintain liberty itself." 3 The Index measures the level of economic freedom in 161 countries in the world. To measure economic freedom, it focus the study in 10 different factors, including:

  • Trade policy
  • Fiscal Burden
  • Government Intervention
  • Monetary Policy
  • Banking and Finance
  • Capital Flows and Foreign Investment
  • Wages and Prices
  • Property Rights
  • Regulations
  • Informal Market
The Index provides a framework for understanding how open countries are to competition, the degree of state intervention in the economy-whether through taxation, spending or overregulation-and the strength and independence of a countries' judiciary to enforce rules and protect private property. The 10 factors of the Index allow anyone to see how much or little economic freedom a country has. Some countries may have freedom in all factors; others may have freedom in just a few. One of the most important findings of the Index is that, as Frederick von Hayek foresaw more than 60 years ago, economic freedom is required in all aspects of economic life-that is, in all of the 10 factors-in order for countries to improve their economic efficiency and, consequently, the living standards of their people.

Chart 1

The Index shows that corruption not always reflects inherent unethical behavior. This is particularly the case of those who are forced out of the formal economy into the informal economy, through burdensome regulations, taxation and weak property rights. Chart 1 and 2 illustrate the relationship between economic freedom and the size of the informal economy, as a percentage of GDP in OECD countries and 22 transition economies. Chart 1 shows a positive correlation between these two factors. As economic freedom vanishes, the informal economy takes a larger share of GDP.

Chart 2

On average, as shown in Chart 2, the size of the informal economy in economically unfree and repressed economies is almost 3 times the size of the informal economy in free economies, and almost double the size of the informal economy in mostly free economies.

These charts illustrate the perverse effect of economic repression on the ethics of ordinary people and on the perpetration of their poverty conditions. For example, in most developed countries, people have a better standard of living thanks to credit access. In the United States, for example, without credit, I would not have a house, or a car, or a TV, or a vacation, or many of the products that add comfort and convenience to my life. Credit makes it possible for me, an ordinary middle class person, to improve my standard of living in many ways.

To have access to credit, however, I need to prove that I have an income or a property. To prove that I have income, I need a "formal" job and to prove that I have property I need a property title. The amount of available "formal" jobs depend, of course, on how easy/difficult it is for people to invest, whether in a small retail shop to sell groceries or in a big factory. The friendlier the business environment, the more likely "formal" jobs will be available. According to the Index of Economic Freedom, however, in most low to middle income countries, it is extremely difficult for small and medium investors-which are the largest source of jobs-to operate, both because of the regulatory environment and the lack of a strong rule of law.

Consider labor regulations in Argentina. In this country, an employer must grant, by law, several employee benefits, including holidays, vacations, sick leave, health insurance, paid overtime, an annual bonus and some paid months before laying off an employee. The immediate problem with this kind of legislation is that it assumes that all employees are equally good, equally responsible and equally productive, which is not true. If the employee arrives late, treats customers poorly, and makes the employer lose money, the law grants that employee the same benefits that it grants to a good employee. Perhaps large businesses, like a multinational factory, can afford to comply with these regulations because of the size of the business and its diversification around the world. But the burden of these regulations destroys small and medium entrepreneurs, who may put their entire savings at stake in their investment. As a result, small and medium business choose to do businesses and create jobs in the informal sector, where these benefits are negotiable and tied to performance, and not forced by law.

If they do not have a job, people can still access to credit if they have a property title to use a collateral. According to Peruvian economist Hernando de Soto, many of the poor in the developing world have property but the bureaucracy they have to go through in order to get a property title is, at best, huge. 4 For example, in Perú, "to obtain legal authorization to build a house on state-owned land took six years and eleven months, requiring 207 administrative steps in 52 government offices…To obtain a legal title for that piece of land took 728 steps." 5 It is just as bad in other countries, such as Egypt, where it takes 77 steps, in 31 government offices (anywhere from 6 to 14 years); or the Philippines, where it takes 168 steps through 53 offices (anywhere from 13 to 25 years.) The poor own many things that they could use as collateral, but it is bureaucratically impossible for them validate their property rights. As a result, they are unable to convert what they own into capital and, therefore, raise their standard of living.

Informality responds to economic repression, not to something inherently unethical in those who circumvent legislations. What is most unethical about informality is the condition in which the government forces the poor to live in. Informally employed people are condemned to a standard of living that is significantly lower than that of formally employed people, who have credit access. Also, informality creates a culture of despise for the law and fosters corruption and bribery in the public sector, as a necessary means to navigate the bureaucracy.

Chart 3

Chart 3 and 4 illustrate the relationship between economic freedom and the level of corruption in 95 countries around the world 6. Chart 3 shows a strong correlation between these two factors. As economic freedom vanishes, corruption flourishes. On average, as shown in Chart 4, the level of perceived morality-as a contrast to corruption-in economically free countries is almost 4 times the level of perceived morality in the public sector in mostly unfree or repressed economies, and almost 60 percent grater than in mostly free economies.

Chart 4

Having a weak rule of law significantly adds to level of corruption both in the public sector as well as the amount of informal activity. A weak judiciary is a "blind eye" on anything done outside the law. With a weak judiciary, corruption goes unpunished and informality flourishes. This is one of the most serious problems we find in the world today. Of 161 countries evaluated in the 2003 Index of Economic Freedom, 108 receive bad scores in both "regulations" and "property rights, undermining any effort to improve the living standards of the poorest in those 108 countries.

Concluding remarks

To be sure, there are cases of corruption that respond to the unethical nature of the corrupt individual. But for the most part, the unethical behavior stems from the environment in which individuals must interact. Convoluted regulations and weak rule of law foster a culture of corruption and informality both in the private and public sector. In the public sector, convoluted regulations and weak rule of law provide ample opportunities for public officials to excerpt bribes without punishment. In the private sector, those two factors push some people to do business informally, as a means to survive, and others to profit far more than what they would if the possibility of bribery did not exist. The result is an increasingly unequal society, in terms of the opportunity to create wealth and improve living standards.

To fight corruption and informality, it is essential to understand that corruption is a symptom-of overregulation, lack of rule of law, a large public sector-not the root of the problem. Countries must advance economic freedom in all possible areas of the economy, with particular emphasis to regulations affecting small and medium business, in order for corruption and informality to decrease. The Index of Economic Freedom is an excellent guide to identify what is obstructing economic activity and, therefore, perpetrating poverty. Countries must also preserve the independence and effectiveness of the Judiciary to punish corrupt actions. Economic freedom with a strong rule of law will foster a culture of investment, job creation and institutional respect, all essential factors to massively improve the living standards of ordinary people.

Ana Isabel Eiras

1 See Daniel Hausmann and Michael McPherson, "Taking Ethics Seriously: Economics and Contemporary Moral Philosophy." Journal of Economic Literature, Vol XXXI (June 1993), pp 671-731. Also, Leonard Silk, "Ethics in Economics", American Economic Review, Volume 67, Number 1, February 1977.
2 Merriam-Webster's Collegiate Dictionary. Tenth Edition. 2002.
3 Gerald P. O'Driscoll, Jr., Edwin J. Feulner, and Mary Anastasia O'Grady, 2003 Index of Economic Freedom (Washington, D.C.: The Heritage Foundation and Dow Jones & Company, Inc., 2003) p.50.
4 Hernando de Soto. The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New York: Basic Books, 2000).
5 Idem.
6 The TI Corruption Perceptions Index (CPI) ranks countries in terms of the degree to which corruption is perceived to exist among public officials and politicians. The CPI focuses on corruption in the public sector and defines corruption as the abuse of public office for private gain. The lower the score, the more the corruption. For details about how the CPI is done, visit www.transparency.org




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