Why Economies Grow
Economic Freedom Offers Hope to Countries Struggling with Poverty
NOVEMBER 01, 2001 by AARON SCHAVEY
Filed Under : Free Trade, Regulation, Property Rights, Poverty, Taxation, Interventionism, Rule of Law
Aaron Schavey is a policy analyst in the Center for International Trade and Economics (CITE) at the Heritage Foundation.
One of the consequences of living in an affluent society such as the United States is that the poverty of the majority of the world is often overlooked. For instance, a recent report from the Organization of Economic Cooperation and Development (OECD) noted that the income of the average African in 1995 was roughly equal to the average income of someone living in Western Europe in 1820!1 A more recent report by the World Bank revealed that approximately 2.8 billion people—nearly half the world’s population—live on less than $2 a day.2 On a global scale, poverty is rampant.
Behind these statistics are the people who don’t know where their next meal is coming from, suffer from diseases induced from widespread poverty, or spend 15 hours or more a day working just to earn a few dollars. In contrast, most people in the United States take for granted the luxuries a rich economy affords them, and many assume that the rest of the world resembles the United States.
To illustrate the misconception many Americans have about the poverty of the developing world, consider the outrage expressed over “sweatshops” in these countries. If Americans truly grasped the poverty of these nations, would they have such a negative reaction to reports on the working conditions there? Or would they realize that sweatshop conditions are the best conditions—horrific as they are—that developing countries can provide? If Americans truly understood global poverty they would realize that most people who work in the sweatshops prefer their current employment over the alternative of not working.3 When an employee in a textile factory loses his job the opportunities for finding another job are low or nonexistent. Simply put, citizens in developing countries prefer “sweating” over starving.
But before working conditions can improve and enough food can be produced, the developing countries must grow. They must implement policies that encourage economic growth rather than the stagnant or even declining growth rates many poor countries experienced throughout the twentieth century.
The experience of countries such as Hong Kong, South Korea, and Singapore should give hope to a number of developing countries today. A half-century ago these countries were as poor as—if not poorer than—many developing countries today. Now these countries are some of the wealthiest in the world. Real GDP in Hong Kong in 1998 was 15 times larger than it was in 1960, while Korea was 16 times larger and Singapore 22 times larger. In contrast, real GDP in sub-Saharan Africa increased only 3 times over this same time period (see chart 1).
How did they do it? The answer is economic freedom. These countries restructured their economies by creating institutions that allowed citizens to make economic decisions without government interference. By creating an environment where economic freedom flourishes, these countries experienced rapid growth and were able to lift themselves out of poverty.
Institutions of Freedom
What are the institutions that promote economic freedom? To answer this question, it is useful to look at the Heritage Foundation’s Index of Economic Freedom, which measures the level of economic freedom in 161 countries. The Heritage Foundation looks at ten factors assessing the institutions under which a society operates. The Index demonstrates that if a government establishes institutions that respect and facilitate economic freedom, economic growth will follow.
The ten factors that the Heritage Foundation examines are:
Trade policy. When individuals are free to engage in trade with people in other nations, economic growth is promoted, since the buyers can acquire goods and services more cheaply abroad than they can produce at home. For developing countries, open trade is essential for acquiring products and technologies unavailable at home. Moreover, open trade encourages developing countries to specialize in the things they are best at producing, which helps them finance needed imports.
Fiscal burden of government. If governments keep taxes low, it gives people an extra incentive to work. Clearly, society benefits when the incentive to work more hours increases. Besides, the less a government taxes its citizens, the more money they have to pursue their own goals.
Government intervention in the economy. A government that operates a hotel, restaurant, or any other business crowds out private investment. Besides, government enterprises are often inefficient and act as a drag on the economy. Financing these enterprises further erodes economic freedom by reducing the amount of resources and opportunities available for the private sector.
Monetary policy. A modern-day economy needs a sound currency that can be used for exchange and storing value and as a unit of account to allow comparisons across goods and services. If the government debauches the currency, the country will suffer from the problems of inflation. Under inflation, economic freedom is eroded because the ability of individuals to make long-term contracts is sharply curtailed, the incentive to save diminishes, and prices are distorted. Even John Maynard Keynes warned of the evils of inflation: “by a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”4
Capital flows and foreign investment. Governments that recognize Wal-Mart’s right to open a store or Honda’s right to open a factory increase the level of economic freedom in their countries. If foreigners are free to invest in a country, its citizens’ economic choices are expanded. If Wal-Mart opens a store in China, it creates employment for the local residents, but it also creates other business opportunities for local distribution companies, local clothing and toy manufacturers, and so on. However, foreigners will invest in a country only if they believe they will be able to get their money out of the country. Therefore, it is essential that countries allow capital to flow freely.
Banking and finance. Certain economic activities, such as building homes, opening factories, and acquiring capital goods, require financing through a bank. Governments that regulate the allocation of credit through interest-rate controls or subsidies artificially affect the level of economic activity. For instance, interest-rate caps reduce the amount of credit available by preventing banks from making loans to individuals willing to undertake especially risky activity. Similarly, governments that subsidize banks or make loan guarantees encourage individuals to engage in risky economic activities that would otherwise not take place. (These ventures often result in losses in the long run.) When governments abstain from interfering in the financial sector, economies tend to be most efficient at providing the needed financing of the economic activity.
Wages and prices. Wages and prices play a crucial role in a market economy by providing signals to producers and consumers. An entrepreneur wanting to expand production can attract more workers by offering a higher wage. Similarly, prices communicate information to entrepreneurs that assist them in identifying changes in demand for and supply of their product. If the demand for a good increases, this will be reflected in the price of the product, and the new price will be a signal to producers to increase production. When governments allow prices to be freely determined, the efficiency of the market increases dramatically.
Property rights. A government that provides a secure rule of law, an efficient court system, and an independent judiciary creates an environment that encourages exchange, innovation, and investment. When property rights are secure, citizens know that if they take a risk and the undertaking proves successful, they will receive the rewards. They do not have to worry about someone stealing their profits. Nor do they have to invest scarce resources trying to simulate what property rights would achieve, such as paying protection money to a gang.
Regulation. In a market economy entrepreneurs transform scarce resources such as capital and labor into goods and services demanded by the public. The public benefits, while the entrepreneurs are rewarded with profits. Governments that make it difficult for entrepreneurs to start up businesses prevent them from engaging in this activity. Similarly, if governments impose burdensome environmental or health and safety regulations, the cost of doing business will go up and may discourage entrepreneurs from producing.
Black market. A black market indicates that some government obstacle prevents individuals from acting in the legal market. Black markets provide a valuable service by allowing economic activity to take place that is prohibited. But they are usually attended by undesirable features, such as the violent settling of disputes. Legalizing the prohibited activity would end the violence and restore economic freedom.
Growth Follows Freedom
These factors represent ten key elements in an economy that affect an individual’s incentive to engage in an economic activity. In those countries where economic freedom is maintained and individuals pursue their economic goals without government interference, economic growth follows. This can be seen in Chart 2, which shows the level of per capita wealth according to level of economic freedom.
The chart shows little difference between “repressed” and “mostly unfree” countries in terms of per capita income, but once an economy moves from the “mostly unfree” category, per capita income increases nearly four times. The chart also shows that income per capita among “free” economies is, on average, nearly twice as high as income per capita among “mostly free” economies.
Developing countries seeking to lift themselves out of poverty should take seriously the lesson that people in free countries tend to accumulate more wealth on average than in less free countries. People whose countries move from the “mostly unfree” to the “mostly free” category will see their incomes rise. Along with economic growth come improved working conditions, reduced incidence of diseases, and the gradual elimination of the other hardships that poverty brings to a nation.
Approximately half the world’s population lives in poverty in countries whose economies are either “repressed” or “mostly unfree.” At the same time, the living standards of the average American eclipse that of a millionaire living in the 1890s.5
Clearly, poverty in the developing world needs to be addressed. Countless examples have proven over and over that economic freedom is the way to address it. Freedom is the key to economic growth. For developing countries struggling with poverty and despair, economic freedom offers hope.
- Angus Madison, “Monitoring the World Economy: 1820–1992,” Organization of Economic Cooperation and Development, 1996, p. 22.
- World Bank, “World Development Report 2000/2001: Attacking Poverty,” Oxford University Press, September 2000, p. 3.
- The United States has brought a lawsuit against a factory in Nicaragua over the poor working conditions. The 1,000 employees of the factory are asking that the lawsuit be dropped, because they fear that the lawsuit will cause them more harm than good. See Andrew Bounds, “Nicaraguan ‘Sweatshop’ Workers Want Lawsuit Dropped,” Financial Times, February 5, 2001, p. 12.
- John Maynard Keynes, The Economic Consequences of the Peace(London: Macmillan and Co. Ltd., 1919), pp. 102–103.
- In the nineteenth century a millionaire didn’t have a number of goods and services that are taken for granted today such as a refrigerator, an automobile, air travel, television, common medicines such as aspirin, or health care such as open-heart surgery, to name a few items. W. Michael Cox and Richard Alm, Myths of the Rich and Poor: Why We’re Better Off Than We Think (New York: Basic Books, 1999), p. 23.