What Is The Relationship Between Economic Freedom and Prosperity?
Why are some countries rich but others remain poor? This is a question that has been investigated for a long time, and was also one tackled by Adam Smith in his famous book, The Wealth of Nations.
The field of development economics mainly came into being in the early 20th century, and the preoccupation in the early years revolved around central planning and socialism, i.e. the way in which the government could engineer growth through rational planning of the economy. That has generally given way to a more market-oriented paradigm in the later half of the 20th century following the collapse of the Soviet Union, which exposed the failures of central planning. Accordingly, this piece aims to outline the free-market libertarian perspective on economic development and how it is achieved.
In short, free-market libertarians emphasise that a country becomes rich when it adopts a free market system. But what does that mean specifically? To answer this question, we need to turn to the study of institutions in development economics.
New Institutional Economics has arisen as a field over the last few decades with the banner “institutions matter”. Institutions can be understood simply as rules of the game, i.e. the formal laws and basic framework of social and economic organisation. They can also include other softer, more informal aspects like values, norms and cultural beliefs. What institutionalists argue is that institutions structure the incentives of economic actors and affect the mechanisms employed to transmit information. People respond to incentives and information given by the institutional context, and thus, the institutional environment can determine if people engage in productive, unproductive, or destructive behaviour. If the institutional environment rewards productive behaviour, economic development results.
But what are the institutions that contribute to long run economic development? The free-market economists emphasise market institutions, most importantly, the security of private property rights, the rule of law, and contract enforcement. These are the basic rules of the game supplied by the legal framework that enables economic development to occur spontaneously in the market-place. Thus, free-marketeers do see a role for government, but it is limited only to the provision and strengthening of this crucial legal framework that markets depend on.The history of North and South Koreas illustrate the importance of market institutions well. Even though both enjoy the same cultural heritage and geographical conditions, they diverged after WW2 in their choice of institutions. The South instituted a set of market institutions like property rights and the rule of law, while the North chose the path of socialism, where property rights were abolished. This natural historical experiment points us to the main cause of development: favourable institutions.
Aside from having the right institutions, countries also need to have the right policies. Free marketeers believe that the right policies are those that minimise price distortions, promote competition, open up the country to foreign investment and trade, ensure basic macro-economic stability in the country. Taxes should be kept low, and regulations, minimal. Having market institutions and market-based policies contribute to a country’s economic freedom.
Multiple attempts have been made to rank countries in terms of the strength of their economic freedom, and research reveal indeed that the degree of economic freedom a country enjoys, the more prosperous it is. For instance, the Index of Economic Freedom by Heritage Foundation and Wall Street Journal, as well as the Economic Freedom of the World Report by the Fraser Institute, find significant positive relationships between economic freedom and various indicators of human welfare (including non-material ones like gender equality, life expectancy, and quality of healthcare).
Looking deeper, the Fraser report measures the extent to which countries achieve these four principles: 1) personal choice rather than collective choice, 2) voluntary exchange coordinated by markets rather than allocation via the political process, 3) freedom to enter and compete in markets and also, 4) protection of persons and their property from aggression by others. These four criteria are consistent with the institutionalist literature since it looks into the legal framework, but also goes beyond that to look at specific government policies and whether they stifle or promote economic freedom. In practice, it measures directly these aspects:
- Size of Government: Expenditures, Taxes, and Enterprises
- Legal Structure and Security of Property Rights
- Access to Sound Money
- Freedom to Trade Internationally
- Regulation of Credit, Labor, and Business
Economic freedom (measured by the Fraser report) has been shown to correlate strongly with:
- Higher average income per person (Countries with more economic freedom have substantially higher per capita incomes) and higher economic growth (Countries with more economic freedom have higher growth rates)
- Higher income of the poorest 10% (The amount of income earned by the poorest 10% of the population is much greater in nations with the most economic freedom than it is in those with the least. However, the share of income earned by the poorest 10% of the population is unrelated to the degree of economic freedom in a nation). In fact, seeking a correlation between Economic Freedom and the Gini Coefficient, it is found that economically free nations have a better income distribution and less inequality overall.
- Higher life expectancy (Life expectancy is over 20 years longer in countries with the most economic freedom than it is in those with the least)
- Higher literacy (Adult literacy increases with economic freedom)
- Lower infant mortality (Infant mortality is much lower in countries with high economic freedom)
- Better child labour conditions (The incidence of child labour declines as economic freedom increases)
- Higher access to water sources (Access to improved (treated) water increases with economic freedom)
- Less corruption (With fewer regulations, taxes, and tariﬀs, economic freedom reduces the opportunities for corruption on the part of public oﬃcials)
- Better political rights and civil liberties (Political rights (e.g., free and fair elections) and civil liberties (e.g., freedom of speech) go hand in hand with economic freedom)
Not only are economic institutions and market policies important, some political economists have also done research on political institutions as well. An important recent book is Why Nations Fail, by Daron Acemoglu and James Robinson. Here, the authors argue that a country’s success is determined by whether it has inclusive institutions, rather than extractive ones. Inclusive institutions include the market institutions mentioned above, as well as a political system that allows many people to have a say in decision-making, as opposed to cases where a small group of people control political institutions and are unwilling to change. They argue that a functioning democratic and pluralistic state guarantees the rule of law.
The Power of Liberal Ideas
Institutions are important, and this has been a key historical reason that made countries rich. However, what’s the basis for these institutions in the first place? The economic historian, Deirdre McCloskey, argued that in the West, it was the rise of liberal-bourgeois ideas that first swept the continent, and only then did market institutions arise later on.
She summarised her case in an op-ed on Nytimes, explaining what she terms as the “Great Enrichment”, which was the sudden and tremendous increase in living standards in Western Europe in the 1700-1800s:
“Not exploitation of the poor, not investment, not existing institutions, but a mere idea, which the philosopher and economist Adam Smith called “the liberal plan of equality, liberty and justice.” In a word, it was liberalism, in the free-market European sense. Give masses of ordinary people equality before the law and equality of social dignity, and leave them alone, and it turns out that they become extraordinarily creative and energetic.”
For her, ideas are even more foundational than institutions. The deeper implication here is that countries that frown upon wealth accumulation, commerce and entrepreneurship will have problems developing. What this also means is that anyone who cares about human well-being should look into the history of liberalism, understand its ideas, and make that case today.