Presidential Jobs Council Calls for
Economic Growth
“Eager to show he is doing something about jobs,
President Obama receives a ‘progress report’ today from his Jobs and
Competitiveness Council a group of industry leaders who are warning
that the economy is a long way from full recovery. ‘America needs more
growth,’ a pair of council members write today in The Wall Street
Journal.”
(
USA Today)
How much did the taxpayers pony up
for that?
Economic Freedom and Economic
Growth
Political Freedom, without Economic Freedom,
Does Not Bring Growth
Randall G. Holcombe
February 1998 • Volume: 48 • Issue: 2 •
Randall Holcombe is DeVoe Moore Professor of Economics at Florida
State University.
One of the most enduring questions in economics is what causes
economies to grow. The full title of Adam Smith’s well-known treatise,
An Inquiry into the Nature and Causes of the Wealth of Nations,
published in 1776, clearly shows that the causes of prosperity were
Smith’s primary concern. He concluded that free markets, the protection
of private property rights, and a minimal government presence in the
economy lead to prosperity. In other words, economic freedom leads to
economic growth.
Smith’s conclusions were generally accepted among economists until the
twentieth century, when developments in economic theory reversed the
conventional wisdom and led economists to advocate central planning and
government control as a better way to produce prosperity, especially
among less-developed economies. At the end of the twentieth century,
economists seem to be turning back to the ideas of Adam Smith. How could
they not, especially after the collapse of most centrally planned
economies around the world? Yet, driven by abstract economic theory,
there still remains a challenge to the idea that laissez-faire policies
best promote economic growth.
Adam Smith made the case that prosperity is produced through a
competitive market economy. In such a setting, Smith noted in one of his
more famous observations, individuals pursuing their own interests are
led as if by an invisible hand to do what is best for the whole society.
To promote resource allocation in competitive markets, Smith advocated
low taxes and government expenditures, the protection of private property
rights, and low tariffs to promote international trade. In other words,
Smith argued that if a market environment were created and maintained,
the economy would grow and prosper.
A few decades later, David Ricardo advocated the lowering of tariffs to
promote free trade as a route to prosperity, supporting his arguments
with his famous book, Principles of Political Economy, first
published in 1817. Ricardo is perhaps best known for showing how everyone
ends up better off when people specialize in the activities in which they
have a comparative advantage and trade with others. The arguments of
Smith, Ricardo, and others brought a reduction in government intervention
in Britain and elsewhere, leading to a freer world economy and making the
nineteenth century an era of unprecedented economic growth.
Another View on Growth
Although the idea that economic freedom leads to
economic growth was not challenged directly, it nonetheless fell by the
wayside earlier this century. That was due partly to developments in
economic theory and partly to world events. Around the turn of the
century, methods in economics began to more closely resemble the hard
sciences, especially physics. Economic theory was developed through
increasingly complex mathematical models. The economics profession
supported those changes, believing that a more scientific understanding
of the economy could produce better policies and even more prosperity. In
mathematical terms, an economy’s output could be depicted in a production
function, where output is a function of inputs such as land, labor, and
capital. More inputs produced more output, and the production function
was able to show in clear mathematical terms the relationship between
inputs and outputs.
When the world was beset by the Great Depression in the 1930s, the
development of economics had already traveled far along this path. The
National Bureau of Economic Research was established in the 1920s to
produce better economic data to allow for more scientific management of
the economy. The Keynesian revolution hit economics with the publication
of John Maynard Keynes’s The General Theory of Employment, Interest,
and Money in 1936. Keynesian economics argued that modern economies
need active government policies to manage them and to maintain
prosperity. After World War II, those two developments in economics
conspired to completely turn around the conventional wisdom on economic
growth.
Worried about the possibility of another depression after the war,
mainstream economists argued that the government needed to manage the
economy in order to maintain prosperity. Economic growth, a significant
part of economics since Adam Smith’s day, declined in importance relative
to the goal of promoting macroeconomic stability. Growth remained an
important issue with regard to less-developed economies, however, and
economists believed that they could engineer economic policy to produce
growth in those economies in the same way they could do so in the
developed world.
The most sophisticated economic models, both then and now, depicted a
straightforward mathematical relationship between inputsland, labor, and
capitaland economic output. Thus, economies could grow more rapidly if
they increased their inputs. In addition, increased efficiency might
allow an economy to produce more output from the same quantity of inputs.
Then and now, economists have envisioned increases in efficiency as
products of technological advances. The most advanced economies would
have to develop better technology through research and development, but
less-developed economies may be able to grow simply by adopting the
technology of developed economies.
The focus on inputs, coupled with an increasing acceptance of government
management of the economy, led economists to recommend government
planning as the best way to create growth in less-developed nations.
Central planning, they said, could guarantee that economies invested a
sufficient share of their incomes, could direct that investment to
sectors that would add more value to the economy (for example, away from
agriculture and natural resources, and toward manufacturing), and could
ensure that the new investment embodied the most advanced
technology.
Institutions such as the World Bank and the International Monetary Fund
encouraged central planning in less-developed economies and pushed
capital investment and adoption of modern technology by offering
financial support to less-developed economies headed in that direction.
Even in relatively free-market economies like the United States, economic
experts supported those types of policies to create economic growth in
less-developed nations. Regrettably, the nations that followed such
policies did not grow, despite following the advice of the most prominent
economists of the time. They would have done better to look back to the
advice of Adam Smith.
The Two Views on Growth
Consider in more detail the differences in the
two views on growth described above. Both sound plausible, and neither
one could really be called wrong, but one view leads to good economic
policy and the other leads to bad policy. Why? The twentieth-century
approach to growth theory focuses on the inputs of the growth process. If
we combine these inputs, it reasons, we will get this output. The
Smithian approach looks at the economic environment that is conducive to
growth. Following Smith’s line of reasoning, an environment of economic
freedom is the key to growth. The problem with the production-function
approach is that it ignores the market mechanism that gives people an
incentive to combine resources in a way that creates value for
others.
Inputs are necessary to produce output, but without the right incentives,
it is too easy to combine inputs in a way that makes the final output
less valuable than the original inputs. In a market economy we take for
granted that production leads to an increase in wealth, because firms
that produce output less valuable than their inputs take losses and go
out of business. Thus, in a market economy most firms create output more
valuable than their inputs. In a centrally planned economy, the
government can continue to misdirect inputs into inefficient production
arrangements, perhaps not even realizing that resources are being
squandered. Policy-makers who designed development policy based on the
production-function view of the economy failed to realize that it
accurately represented the way that resources were allocated only within
the framework of a market economy.
By focusing on the environment conducive to economic growth, the Smithian
view pays less attention to inputs. However, Smith also recognized that
the invisible hand of the market, if allowed to work within an
environment of economic freedom, will do an effective job of allocating
resources. Public policy need not be concerned with the production of
capital, the incorporation of technology, or the development of a skilled
labor force if that conducive environment is created. The economy will
attract investment and provide the incentive both for workers to obtain
marketable skills and for the adoption of more advanced technology. The
right environment will attract the right inputs, but providing the right
inputs will not create the right environment. If growth policy focuses on
producing an environment of economic freedom, growth will follow. Without
the right environment, growth will not occur, period.
Evidence Relating Freedom and Growth
Casual (but persuasive) evidence relating
economic freedom and economic growth abounds. After World War II, Korea
was divided: South Korea fostered a market-oriented economy, while North
Korea maintained a centrally planned economy. As this is being written,
many citizens of North Korea are starving because their economy is
failing, while South Korea has one of the fastest-growing economies in
the world. Similarly, after World War II, Germany was divided into East
and West Germany, and again the one with the market economy prospered
while the one with the centrally planned economy fell behind. Less than a
decade ago, East and West Germany were central players in the cold war
that threatened to erupt into World War III. East Germany eventually
surrendered to West Germany without a shot being fired, because people in
the East wanted to have the advantages offered by West Germany’s economic
system.
The former Soviet Union took the production-function model of growth very
seriously, so the late empire provides an especially compelling example
of the model’s limitations. It invested heavily in physical and human
capital, producing a highly trained and educated work force. It also
invested heavily in research and development, placing great emphasis on
science and engineering. By increasing the quality and quantity of its
capital and labor inputs, and creating technological advances, the Soviet
Union, according to the production-function approach, should have had one
of the world’s fastest-growing economies. Instead, it serves as an
example that growth cannot be created by increasing inputs into the
production process alone. More inputs lead to an increase in the value of
output only when combined within an environment of economic
freedom.
In light of their recent prosperity, it is easy to forget that nations
like Japan, Taiwan, South Korea, Hong Kong, and Singapore were poor only
a few decades ago. Nations that shunned the market system in favor of
central economic planning, like the Soviet Union, China, and India, had
economies that languished. Now that those formerly socialist countries
are moving toward economic freedom, their economies have started to grow.
The casual evidence is so clear that there is now a worldwide movement
toward more economic freedom. Yet, as compelling as this casual evidence
is, it still leaves open the question of what, exactly, the components of
economic freedom are, and how much effect they have on economic
growth.
A number of recent academic studies have helped shed light on this issue.
The most in-depth examination of economic freedom is a study by James
Gwartney, Robert Lawson, and Walter Block, Economic Freedom of the
World: 1975-1995, published in 1996 by the Fraser Institute. They
develop a good numerical measure of economic freedom and show that it is
strongly correlated with economic growth. Other academic studies have
produced similar results, providing evidence that an environment of
economic freedom will attract the inputs necessary to produce economic
growth. Those studies examine many other factors, but conclude that the
key ingredient is economic freedom. After a century in which the theory
of economic growth had moved steadily away from the ideas of Adam Smith,
economists are now returning to them to show how economic freedom is
vital to prosperity.
Economic Freedom and Political Freedom
After the collapse of the centrally planned
economies of eastern Europe in 1989, followed by the demise of the Soviet
Union in 1991, most of those nations enthusiastically embraced the
principles of Western democracy, hoping political reforms would lead to
Western-style prosperity. People in the West offered encouragement, but
they supported democratic government more enthusiastically than
laissez-faire economic institutions. Thus, it is especially important to
understand what is meant by economic freedom as compared to political
freedom, and what can be expected from both. While democracy is valuable
in its own right, the evidence suggests that democracy by itself makes no
contribution to prosperity. Economic freedom produces economic growth;
political freedom does not.
This point is especially important in light of the expectations of those
in emerging democracies. The citizens of those countries are being set up
for a disappointment. If the nations that recently turned to democracy
find that their economic conditions are not improving, they may turn
their backs on democracy, opening up the opportunity for a return to
dictatorship.
The evidence shows that economic freedom leads to economic growth even
where countries have limited political freedom. The reverse is not true:
political freedom, without economic freedom, does not bring growth.
Therefore, it is vitally important that emerging democracies encourage
free markets, protect property rights, provide a stable currency, and
minimize the government’s role in the economy. There is also evidence
that nations with higher incomes tend to be more democratic and more
protective of civil liberties and political freedoms. Thus, indirectly,
economic freedom leads to political freedom.
The evidence clearly shows that without an environment of economic
freedom, growth will not take place. Economic freedom contains a number
of components, all of which must be in place for an economy to grow. An
economy must have a stable monetary system, secure private property
rights, an impartial legal system, low taxes, minimal government, and low
barriers to international exchange. If any of these components are
missing, an economy will not grow.
http://www.thefreemanonline.org/featured/economic-freedom-and-economic-growth/
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