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Economic freedom helps cut unemployment, study shows

A smaller government sector and a stronger rule of law can help to reduce unemployment, particularly among women and young people, suggests a study of 87 countries.

The new research, published in the July issue of the Southern Economic Journal, is the first to analyse how economic freedom affects unemployment.

Based on data from the period 1980-2003, the findings suggest that if Italy had enjoyed the same extent of economic freedom as the United States, its unemployment rate would have been 2.4 percentage points lower among women and 4.2 percentage points lower among young people.

Dr Horst Feldmann from the University of Bath, who carried out the research, used the Economic Freedom of the World index that has been constructed by a worldwide network of economists.

“Economic freedom has already been shown to have a favourable effect on gross domestic product (GDP) per capita, but nobody has analysed its effect on unemployment before,” said Dr Feldmann.

“The study clearly shows that restrictions on economic freedom are likely to involve substantial costs in terms of higher unemployment.”

The study establishes not only the effect on overall unemployment but also the extent to which economic freedom affects unemployment amongst women and young people – two groups that typically have above-average unemployment rates.

Dr Feldmann also analysed how different economic freedoms – which include a small government sector, a strong rule of law, ‘sound’ money, free trade, and a light regulatory burden – influence unemployment, both in the short and long term.

One of the key findings from the study is that a small government sector has beneficial effects on unemployment.

“If Italy’s government sector had been as small as in the United States, its overall unemployment rate would have been 2.3 percentage points lower,” said Dr Feldmann from the University’s Department of Economics & International Development.

“This corroborates theories that suggest that a large government sector crowds out the private sector, reducing the international competitiveness of the relevant economy.

“In addition, high taxes, which are an unavoidable implication of a large government sector, reduce the profitability of private investment.”

One surprising finding to emerge from the research is the link between a strong rule of law and unemployment.

“If Italy had enjoyed the same strength in the rule of law as the United States, its overall unemployment rate would have been 1.4 percentage points lower,” said Dr Feldmann.

“Under the rule of law, people have a strong incentive to be gainfully employed because the income they earn is legally secured.

“Also, businesses have a strong incentive to hire staff because the proceeds resulting from employment are legally secured.

“By contrast, a weak rule of law undermines both people’s incentive to take up gainful employment and enterprises’ incentive to hire workers and innovate.”

Additionally, the research shows that freedom to trade internationally in the longer term results in a fall in unemployment over several years.

Similarly, flexible regulations governing credit, labour and product markets help reduce unemployment over longer periods of time.

Andrew McLaughlin | alfa
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