What Makes Economies Grow
April 1 1998 by Kim R. Holmes
While economists butt heads over a number of central issues, few debates matter as much to everyone or subsume as many other contentious economic issues as the question, “What causes economic growth?”
One entry into this seemingly ageless controversy was a critique of the Heritage Foundation/Wall Journal 1997 Index of Economic Freedom, written by
We come in on the other side of this controversy, arguing instead that one could trace the roots of economic growth to the specialization and entrepreneurship that thrive in an institutional setting favorable to growth. We contend that if the political, judicial, and cultural institutions work together to protect property rights, advance the rule of law, and limit government spending and taxes, then the millions of economic decisions made by private individuals would yield rates of long-term economic growth far superior to the hundreds made by central planners. Not only are growth rates superior, but long-term economic growth may not be possible at all if public decision-making significantly substitutes for private initiatives.
We illustrated in the 1997 Index of Economic Freedom, and again in the 1998 version, that the institutional setting apparently makes a significant difference in the level of long-term economic growth. In fact, the association between country Index scores and economic growth strikingly reflects the research findings of the New Economic Growth theorists. While Scott, and others in his corner, are correct in arguing that mature economies are more likely than less mature ones to enjoy economic freedoms and experience more stable growth, it- does not follow that economies must first be mature before they can secure signficant economic freedoms. In fact, it just may be essential for sustained growth that institutional parameters identified in the Index be in place before long-term improvement to economic well-being and the distribution of income can occur.
The Heritage Foundation has been examining the effects of economic freedom on economic growth since the mid-’80s; this led to the publication of the first. Index of Economic Freedom in 1994-a comprehensive analysis of the economic policies of most of the world’s countries The Index is now published annually b The Heritage Foundation and the Wall Street Journal.
To reach their conclusions, Heritage economists evaluated the level of economic freedom in 150 countries by scoring them in the following categories: trade policy, tax policy, government consumption of economic output, monetary policy, restrictions on foreign investment, wage and price controls, property rights, regulation, and the size and pervasiveness of the black market. More than 50 independent components are then used to determine the scores in the individual categories.
While the Index was originally envisioned and developed as a public policy tool that would demonstrate the benefits of free-market principles to politicians, we believe its objective nature and its evaluation of a large number of countries have made it an effective tool for the international business community. The Index is designed to help executives cross the vast divide between recognizing a potential for a return on investment and successfully choosing when, where, and how to take advantage of that potential.
Having a comprehensive understanding of economic freedom around the world can help businesses assess and hedge against risk; know which countries are likely to buy more
ASSESSING AND HEDGING AGAINST RISK
The dramatic increase in
Businesses consider many different options in an attempt to maximize their ROI in capital and technology. Exploring these options requires risk assessments and advice from experienced experts and large consulting firms specializing in such analyses. But because these assessments and advice can be prohibitively expensive, smaller companies may tend to narrow their options prior to contracting the assessments to cut down on expense, and that, in turn, narrows their considerations and increases the potential for missed opportunities.
The essence of risk analysis is information about the economic and political environments in target countries: The more information available on these characteristics, the more reliable the analysis. Not coincidentally, the amount of reliable information available on a certain country goes hand in hand with the level of economic and political freedom in the country. By definition, open economies have fewer restrictions on the flow of economic resources and information than do closed economies, a characteristic that makes both the country and the investor better able to adapt to economic changes. As a result, countries that embrace economic freedom are more stable and less risky.
However, a closer look reveals that foreign investment in
OPEN MARKETS MAKE GOOD INVESTMENTS
Lowering trade barriers around the world facilitates trade as businesses face lower costs of doing business in foreign countries. The primary conduit for this reduction in expenses is through free trade agreements. Agreements such as the North American Free Trade Agreement (NAFTA) are tantamount to a trillion-dollar tax break for
There are numerous examples of how open markets benefit
This increase in
Given the evidence, there is no denying that the export and foreign investment sectors of the
The Index also clearly identifies those countries that have successfully achieved sustained economic growth. Further, it indicates which policies are likely to lead to economic growth. A study contained in the 1997 Index looked at the growth rates of real GDP per capita between 1980 and 1993 for 138 countries. The study proves that a country’s level of economic freedom-more than any other single factor-is the determinant for significant economic growth. For example, countries ranked “economically free” experienced an average annual per capita GDP growth rate of 2.88 percent, while countries classified as “economically repressed” saw a growth rate of -1.44 percent.
THE BOTTOM LINE
Increases in per capita wealth clearly correspond to increases in economic freedom. And countries that embrace free market principles will experience greater and more stable economic growth than those that discourage free markets. The factors that contribute to economic freedom lead to higher levels of household income and increase the possibility of domestic consumption for products generated from investment and likely improve the rate of return.
Business’s chief goal is to achieve the highest levels of profitability while increasing the net present value of its investments. As the world’s economies increase their interaction, businesses increasingly look to foreign countries as both markets for goods and services and profitable destinations for investment.
However, these businesses are faced with deciding which countries offer the most promise and least risk, with little prior direct experience in these potential markets. It’s a daunting and expensive task, and knowing which economies are destined for freedom can undoubtedly make it easier.
Dr. Kim R. Holmes is vice president of the Kathryn B. and Shelby Cullom Davis International Studies Center at The Heritage Foundation, based in Washington, D.C. Brett D. Schaefer is the Jay Kingham Fellow in International Regulatory Affairs at The Heritage Foundation.