Economic Freedom Improves Air Quality – Study

A new study by the Fraser Institute in Canada finds that economic freedom is an important cause of air quality improvement.

The study compares average airborne concentrations of particulate matter and economic freedom in 105 countries around the world. The authors, Joel Wood and Ian Herzog, find that in 2010, the 20 countries that were most economically free had average concentrations of particulate matter that were nearly 40% lower than the 20 least-free countries.

Of course, correlation does not prove causation, and other variables often associated with economic liberty, namely wealth and democracy, also foster air quality improvement. Nonetheless, the authors find a “robust” relationship between economic freedom and air quality after controlling for other factors:

After controlling for the effects of income, political freedom, and other confounding variables, we find that a permanent one-point increase in the Economic Freedom of the World index results in a 7.15% decrease in concentrations of fine particulate matter in the long-run, holding all else equal. This effect is robust to many different model specifications and is statistically significant. This effect is in addition to a general 36% decrease over time due to unidentified factors.

The study is based on urban concentrations of airborne particulate matter smaller than 10 microns in diameter (PM10) from the World Bank’s World Development Indicators and on the Fraser Institute’s Economic Freedom of the World (EFW), which in turn is largely based on data from the International Monetary Fund, World Bank, and World Economic Forum. The EFW index “reflects the size of government; the quality of the legal system and strength of property rights; soundness of money; freedom to trade; and burden of regulation.”

So why does economic freedom promote air quality improvement?

• Property rights defined and secured through a strong justice system enable people to protect themselves and their property from pollution.
• In contrast, government regulations that preempt private, court-enforced “negotiations between those benefiting from and those being hurt by a polluting activity” prevent “an efficient distribution of the right to the environmental resource” and “cause inefficient levels of pollution.”
• Freedom to trade “is key to ensuring that new, cleaner technologies can be adopted across borders.”
• “Bureaucratic inefficiency, the influence of special-interest groups, and the prevalence of state-owned enterprises can all hinder the ability of a government to improve the environment effectively.”
• State-run firms shielded from market discipline are wasteful resource consumers.

The last point is more important than generally realized. In this connection, I’m pleased to post Hoover Institution scholar Mikhail S. Bernstam’s splendid out-of-print book, The Wealth of Nations and the Environment. Published in 1990, the book is something a post mortem on the Soviet Union. The Soviet empire collapsed largely because it went bankrupt. Economic decline however did not mean less pollution but more. Our worst ecological nightmares were daily realities of people living in the USSR and other eastern bloc countries. Why is that?

Bernstam’s analysis is both elegant (simple) and compelling. Market economies are “cost minimization” systems, socialist economies are “input maximization” systems. In the former, competition continually pushes firms to become more efficient resource users — to do more with less. In the latter, the state guarantees monopoly-enterprises a reasonable rate of return based on costs, so firms have an incentive to increase costs (consume more inputs) to increase profits:

At least in the last few decades, supply prices of most outputs are cost-based and enterprise profits are proportional to costs. . . .In order to maximize profits, producers maximize inputs. It pays to maximize costs and wastes over the production cycle.

The result, writes Bernstam, was an “amazing bifurcation” in the “trend in resource use and pollution within the industrialized world” during the 1970s and 1980s:

The amounts of throughput of major resources and the ensuing discharges of air, water, and soil pollution began to decline rapidly across nations with competitive market economies. This is despite, or rather because of, further economic growth in the Western market countries. During the same two decades, throughput of resources and environmental disruption were rapidly increasing in the USSR and European socialist countries despite an economic slowdown and subsequent stagnation . . . .

The perverse incentive at the heart of the Soviet system was such that state enterprises consumed more and more resources to produce fewer and fewer final household goods. Economic collapse and environmental ruin went hand in hand.

Soviet energy production, for example, was unsustainable both economically and environmentally. In the passage below, Bernstam explicates a table presenting Soviet estimates of how much energy will have to be consumed to produce energy during the period 1975-2035:

In 1975, energy inputs (including energy used to produce equipment for energy extraction) constituted about 22% of energy output of natural gas. This fraction grew to 28% in 1980 and 32% in 1985 and 1990, and it is projected to increase to 46% in 1995, 58% in 2000 and so on, until it reaches 100% in 2030 and exceeds 100% thereafter.

In contrast, in market economies, firms are guided — as if by an “Invisible Environmental Hand” — to reduce their impacts on air, water, and soil:

Competitive firms in trying to maximize their profits have to, among other things, minimize their costs. They increase productivity via the use of capital stock and energy at early industrial stages when these both substitute for, and complement to, labor. However, resources involved in energy conversion, materials processing, and the employment of machinery represent costs. All these costs continue to be minimized. . . . Environmental disruption slows down after the initial rise and then declines at an increasing rate. The result was not the design of participants of open competitive markets. They were driven by profit motives to eventual environmental ends with no intention of their own.

Marx opined that capitalism “contained the seeds of its own destruction.” It was actually the Soviet experiment to replace Adam Smith’s invisible hand with centralized planning that was doomed to fail. In the USSR, Bernstam writes:

Inputs have grown faster than output, and this pattern applies to most economic activities. Inputs have grown faster than output at an increasing rate. Eventually, the relationship becomes backward-bending, that is, inputs continue to grow while output declines.