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Does economic freedom equal growth?
Our correspondent
Published: 06-NOV-06

Drive through the low highway viaducttoward Victoria Island in the bustling city of Lagos, Nigeria, and you will see the shantytown of Makoko, home to an estimated 50 000 people, swirling out into the black waters below. Wooden huts on stilts stretch out into the lagoon; young men punt and women paddle dug-out canoes down into narrow canals weaving between the raised homes.

It is possibly the last place on earth you would expect to witness an educational revolution, but that is precisely what’s happening. In Makoko — as in other poor communities around the developing world — parents are abandoning public education en masse, disturbed by its low quality, and educational entrepreneurs are setting up private schools to cater for demand.

The private schools, it turns out, whatever their appearances might suggest, are of the highest quality at a fraction of the cost of public education. This example of the benefits of free enterprise, cited in the latest Heritage Foundation-Wall Street Journal 12th Economic Freedom Index, is held up as a “neat grassroots solution to the problem that so confounds development experts: how to achieve universal basic education — the UN’s Millennium Summit development goal of ‘education for all’ — by 2015”.

In another scenario, the so-called 3D Club, a “shadow bank” in China, is held as an “ingenious example” of a phenomenon that makes up the very sinews of capitalism in China.

“Without 3D and the many permutations of what is generically known as ‘informal finance’, China’s capitalist revolution would have been stillborn,” the authors conclude.

On a more general level, the Index infers, the story of private enterprise is a story of economic freedom and growth.

Not surprisingly, the Index results show conclusively that changes in government policy towards more freedom correspond with stronger growth and employment levels: North America and Europe continue to be the world’s most economically free regions in the world, economic freedom in Latin America and the Caribbean improved marginally, North Africa and the Middle East have experienced a net decline in economic freedom, albeit a slightly worse score than last year, and the scores for the Asia-Pacific region are better for most countries.

And sub-Saharan Africa? Nothing has changed, it seems. In fact, the annual Economic Freedom Index ranks Africa as the only region without a “free economy”.

The results show that while the region has made progress toward economic freedom since 1997, no region has further to go.

The continent improved its average score by 0,34 and its mean score by 0,37 points. The overall improvement in ratings came despite the fact that Angola and Burundi were graded for the first time since 2001.

According to the Index, released in Johannesburg last month, sub-Saharan Africa differs from the other two poor performers — North Africa and the Middle East — in that its overall level of economic freedom continues to improve, with 25 countries’ economic freedom scores improving and 12 countries’ scores declining. These improvements, however, are from very low levels of economic freedom, and sub-Saharan Africa remains the world’s least economically free region.

Sub-Saharan Africa remains one of just two regions in the world, along with North Africa-Middle East, that lacks an economy rated as “free” in the Index. It has five rated as “mostly free”, including Botswana, Cape Verde, South Africa, Madagascar and Uganda (which improved just enough to jump from the “mostly unfree” category).

The country that represents the median score for sub-Saharan Africa — Zambia — ranks 111th of the 161 countries measured in the 2006 Index.

More specifically, over three-quarters of the region’s countries — 33 out of 40 graded in the 2006 index — remain “mostly unfree”.

Benin was the region’s most improved country, followed closely by Tanzania and Botswana. Thanks to improvements in its fiscal burden of government and government intervention scores, Botswana’s market-led economy widened its lead in the region in economic freedom; it improved its Index score by 0,20 and now ranks 30th in the world due to the world’s highest average growth rates over the past several decades.

But it was Benin that showed the most improvement of any country in the region. A small deterioration in its fiscal burden of government score was offset by improvements in its trade policy, informal market, and government intervention scores, resulting in a gain of 0,23 points. It’s still well within the “mostly unfree” category, but it reversed a decline of 0,14 last year. Similarly, Tanzania’s also managed to improve. Government spending grew, but was more than offset by a lower tariff rate and a greater openness to foreign investment.

A notable change is the fact that Angola and Burundi have been graded for the first time since the 2000 Index. While both countries were repressed economies when last graded, both have improved markedly and are “mostly unfree” in the 2006 Index.

Regrettably, the situations in the Democratic Republic of the Congo and Sudan have not improved enough to merit grading.

Guinea declined more than any other country in the region. An improvement in Guinea’s fiscal burden of government score was more than offset by declines in its trade policy, monetary policy, and banking and finance scores. Equatorial Guinea followed Guinea with the second biggest decline in economic freedom, with worse scores in the fiscal burden of government and government intervention in the private sector.

Even though its score improved marginally, Zimbabwe continues to be the least free country in the region.

Overall, while the score of 99 countries in the world have improved over the last ten years of the Index, the scores of 51 mainly African countries are worse, and the scores of five, including Burkina Faso, remain unchanged from last year’s Index.

So what does all this mean?

University of Cape Town economist, Brian Kantor, at the launch of the Index in Johannesburg, argued that there is a direct correlation between the extent of economic freedom and GDP per capita growth.

“Not only is a higher level of economic freedom associated with a higher level of per capita gross domestic product (GDP), but GDP growth rates also increase as a country’s economic freedom score improves,” he said.

According to the Index, economic freedom is defined as “the absence of government coercion or constraints on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself”.

In other words, people are free to work, produce, consume and invest in the ways they feel are most productive.

The underlying assumption is that when government interference rises beyond the supply of ‘public goods’, it risks trampling on freedom. When it starts interfering in the market beyond the protection of individuals and property, it risks undermining growth.

To validate this assertion, the Index suggests that citizens of countries that are classified as “mostly unfree” or “repressed” earn 70 percent less than citizens of “mostly free” countries. In addition, the citizens of “free” countries enjoy a per capita income that is more than twice as high as their counterparts in “mostly unfree” countries.

The lesson? Countries that committed to improving economic freedom enjoy the most progress toward prosperity.

Yet, while it is true that “individuals in an economically free country can pretty much determine their natural abilities, figure out how best to use them, and go about their business”, the Index should be treated with caution. At the very least, many African economies are picking up speed. Figures published earlier this year by the World Bank showed that the continent’s average GDP grew by 5,5 percent in the last quarter of 2005, the fastest in three decades. In fact, there are now signs that domestic demand in several countries is stirring. Bank loans in countries like Kenya, South Africa and Nigeria have started to rise and a recent business confidence survey showed a strong uptake in retailing, suggesting that consumers are opening up their wallets.

By American standards this looks sluggish. Even so, African growth is steady, raising questions as to whether there is in fact a direct correlation between freedom and growth.

One explanation, according to Kantor, is that the perverse counter-intuitive effect of economic freedom is that as GDP per capita rises, so too does government’s share of the economy.

“The reason,” he says, “is that people demand more of government. It’s a demand-driven response: As incomes rise, people want more security. And this isn’t the poor; it’s the middle classes.”

So there’s a twist to free markets in that they inevitably demand government intervention.

Economist Jeffery Sacks has argued that a basically correct insight — that market economies outperform centrally planned ones — has been taken to the extreme, and then used as a substitute for analysis.

For Sacks, the prescription of the Index “has the virtue of simplicity” on two grounds. First, free market ideologues maintained that markets should rule every nook and cranny of the economy — not just the basic productive sectors of farms, factories and service trades, but also health, education and social security. Second, they argue that all shortfalls in growth can be accounted for by the absence of free markets.

As Sacks puts it, “Scoring well in the Index of economic freedom is “not a ten-step plan to Nirvana”, nor a very powerful explanation of differences in economic growth rates. There are many cases where the score on economic freedom is rather low, but economic growth is rather high.”

China is the notable case. In that country, the state has single-handedly driven a global investment strategy that has catalysed China’s unprecedented growth. The former Soviet Union is another typical example of a repressed society that produced spectacular results — for several decades at least.

“On the other hand, there are many countries where the score on economic freedom is good, and yet economic growth is low, like Switzerland and Uruguay,” argues Sacks.

He may be on to something interesting. He suggests that a key weakness in the Index may be its failure to consider the findings of recent statistical studies which have shown that differences in economic growth rates across countries depends on a multiplicity of factors: initial incomes, education levels, fertility rates, climate, trade policy, disease, proximity to markets and the quality of economic institutions, to name but a few.

The 2006 Index measures 161 countries against a list of 50 independent variables divided into 10 broad factors of economic freedom. The higher the level of government interference in the economy, the higher the score on a factor and the less economic freedom a country enjoys (see tables).

“The real challenge,” Sacks says, “is to understand which of these many variables is posing particular obstacles in specific circumstances — what I mean by ‘differential diagnosis’.”

But it’s Sacks’s alternative that is arguably the subject of a new public discourse following the collapse of the WTO Doha Round recently. “Just as the communist attempt to banish coercion from the economic scene via state ownership failed miserably, so too would an attempt to manage a modern economy on the basis of market forces alone. All successful economies are mixed economies, relying on both the public sector and the private sector for economic development.”

Certainly, this holds true for one of the factors in the Index — trade. In a stinging rebuttal of free trade ideologues, Washington economist, Peter Dorman, in a recent policy briefing paper by the Washington-based Economic Policy Institute argues that “an assumption of free trade plays havoc with the real world analysis”.

“In the real world, if trade barriers are removed in agriculture but remain unchanged elsewhere, countries that export agricultural goods will tend to have greater trade surpluses than they would otherwise, and this will be to their advantage. Single-minded liberalisation of international capital flows, foreign exchange markets, and trade in goods and services heightens the risks of crises while depriving national governments of important policy tools to counteract the underlying causes.”

In other words, the importing country in a world of economic freedom can pay for its additional imports with the money made from all the additional exports that automatically come along. Meanwhile, the elimination of barriers puts an exporting country in a bind. Its exports have increased, but their price has fallen.

Of course this is not to suggest that the Heritage Foundation Index results are a fallacy. Until recently, barely any empirical work had been done relating economic growth to specific indicators of economic freedom. The few reports, other than the Heritage Foundation Index, from around the world that did attempt to study the relationship between growth and freedom strongly suggest that countries which have reduced the direct involvement of governments in economic activities show rising rates of growth. Most research findings often connect the relationship between freedom and growth to policies of privatisation, changes in laws which make the relevant countries more accommodating to foreign and domestic private business, as well as to other measures which allow citizens to enjoy the fruit of their labour.

A good example is a study by Georgios Karras, an American economist, a few years ago on the impact of property rights in 21 OECD countries, or the lack thereof, on growth. The results confirmed the importance of institutions that protect property rights in enhancing growth. In another relevant study, economist Eliezer Ayal and Karras explored the impact of bureaucracy, which can be a major impediment to economic freedom, on growth. Constructing a measure of bureaucracy, they showed in the end that it is negatively related to economic growth because of its negative effects on investment.

But how does one explain the apparent anomaly of state-led Chinese growth today and the heavily regulated Asian Tiger success stories during the 1990s? Do they suggest a causal relationship from economic freedom to growth? And how might economic freedom promote economic growth?

The results of the Heritage Foundation Index and other similar surveys are very supportive of the proposition that aggregate economic freedom enhances growth by increasing productivity and encouraging foreign investment. There’s certainly nothing controversial about this. What is in dispute, however, is the relevance of the indices employed to measure freedom. To come back to Sacks, there are grounds for a “differential diagnosis” of obstacles that impede growth.

Aside from the flawed assumption that absolute freedom to trade between sectors and between countries will yield growth, some economists have listed as alternative measures low money growth rates, the role of government enterprises, negative real interest rates, the official and black market exchange rates, the size of the trade sector, and freedom of citizens to engage in capital transactions with foreigners.

Indeed, studies that adopted a differential diagnosis have tended to provide statistically significant answers to anomalies like China.

Still, a number of unresolved questions remain. Is the freedom to exchange and trade in one country equal to the freedom of another where there’s an imbalance in the level of growth between the two countries? Importantly, can we conclude that the economic success of industrialised countries like the US has been on the back of the lack of economic and political freedom in countries with which the US has had trade relationships? And how might general economic freedom affect the balance of trade globally?

The answer to these questions may be at the centre of the collapse of the World Trade Organisation talks between six big players in July. It is also at the centre of the Heritage Foundation’s advocacy of a “Global Free Trade Alliance” open to countries that have demonstrated their commitment to free trade and free markets.

But with one proviso: economic freedom should be limited to everything other than the public good. In other words, the market should mediate transactions that relate to the private sector. According to the authors, the “Lockean” idea of freedom was embodied in the US Constitution where citizens are taxed to provide the revenue for the protection of person and property as well as for common defence. Most political theorists also accept that certain goods – what economists call “public goods” — can be supplied most conveniently by government.

But, according to the authors of the Index, when government coercion rises beyond that minimal level, it risks undermining economic freedom and growth.

Exactly where that line is crossed is open to reasoned debate. “The goal in the scoring of economic freedom is not to define these extremes — either anarchy or utopia — but to describe the world’s economies as they are,” the Index notes.

Yet it can be reasonably argued that the public and private good are twin sides of the same coin. As Brian Kantor argued at the launch of the Index, “The free market is a place people inhabit to exchange goods and services and determine prices. What matters for the argument is the role of government in determining those prices.”

For Kantor, the extent of that interference varies from country to country — depending on its level of development. That’s the crux of the matter. Against the background of the WTO collapse, it would appear that the few countries which enjoy trade protection have proved far more politically effective than the majority of developing countries which stand to gain from economic freedom and often do not realise it. But the deeper cause may be counter-intuitive: Developing countries stand to gain from greater state intervention in vulnerable sectors of their economies. -Business in Africa Magazine

How the regions rank
Over the last decade, more and more countries have embraced policies that promote economic freedom. The prosperous countries of the North America/Europe region — spurred by rapid moves toward economic freedom by the former Soviet republics — show consistent improvement. But regions such as Latin America, the Middle East and sub-Saharan Africa continue to lag behind in prosperity.

North America and Europe
The world’s most economically open region holds seven of the world’s 11 freest economies and 15 of the top 20. Thirty-three countries, led by Austria, Germany and Cyprus, which joined the ranks of “free” economies, improved their scores; only 10 declined. Romania was the region’s most improved country and the world’s second most improved, and Georgia joined the ranks of the “mostly unfree” economies for the first time. The region received a boost when the 10 eastern European countries that joined the European Union in May 2004 adopted its more open trade policies and improved as a result. Belarus remained last in the region in economic freedom.

Latin America and the Caribbean
Economic freedom improved marginally this year with 15 countries improving in the Index scores and only 10 declining. Chile, the region’s most dynamic economy, remains its only member of the “free” economic club. The region also includes three “repressed” economies — Cuba (which showed some improvement), Haiti and Venezuela. It also includes three countries among the 10 that showed the biggest declines this year — Bolivia, El Salvador and Nicaragua, which slipped from the “mostly free” to the “mostly unfree” category.

North Africa and the Middle East
The only region to experience a net decline in economic freedom in last year’s Index, North Africa and the Middle East saw another decline this year as seven of 11 countries recorded worse scores. Bahrain declined for the second straight year but remained the freest in the region despite deriving 80 percent of its revenues from the state-controlled oil company. Iran and Libya remain the two least-free economies, but they’re moving in different directions. Libya is still considered “repressed” due to a state-dominated industry, trade protectionism and heavy regulation, but it was the most improved in the region for the second consecutive year, thanks to better scores in fiscal burden of government, capital flows and foreign investment in banking and finance. Iran, meanwhile, continued its downward spiral — it recorded its lowest score since 2002 – because entrenched bureaucrats and Islamic hardliners continue to conspire against reform.

Sub-Saharan Africa
The region still lacks a free economy, but one, Botswana, did vault into the world’s top 30, with improved scores on government intervention and fiscal burden of government. Regional improvement did continue, with economic freedom advancing in 25 countries and declining in just 12. Angola and Burundi were ranked in the Index for the first time. Benin was the region’s most improved, while Guinea suffered the biggest decline.

This region remains a study in contrast. Hong Kong and Singapore continue to lead the world in economic freedom and the region includes four of the nine freest economies. In all, 19 countries in the region improved their Index scores from 2005, and just nine declined. Also, four Asia-Pacific countries — Pakistan, Kyrgyz Republic, Turkmenistan and Kazakhstan — are among the 10 most improved. Uzbekistan and Tajikistan no longer qualify as “repressed”. But the region also is home to more “repressed” economies than any other, including last-place-finisher North Korea.

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