What makes economies grow?

And, more importantly, why should you care? Because economically free countries make good bedfellows - and good investments.

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 Street Journal 1997 Index of Economic Freedom, written by Harvard Business School professor Bruce R. Scott and published in the May/June 1997 issue of the Harvard Business Review. In it, Scott argued that the principal cause of economic growth could be traced to activist public policies and that such policies promote economic expansion by strategically encouraging the development of physical and human capital while constraining market excesses through the tax and regulatory arms of the government. Scott's view echoes a long line of professional opinion advocating government's strong central role in economic life.

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 the economies must first be mature before they can secure significant 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 by 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 U.S. exports and be good destinations for U.S. investment; and identify stable emerging markets.

ASSESSING AND HEDGING AGAINST RISK

The dramatic increase in U.S. exports and foreign investment over the past decade has resulted in an increasing demand for analyses on country risk. Businesses have a number of basic concerns about a country before they can commit their resources. Central to the risk and potential return on investments are issues such as whether the country has a clear and fair commercial code governing contracts as well as an independent judicial system in the event of dispute, or whether it allows repatriation of profits. Likewise, exporters are concerned with the amount and type of tariffs, quotas, or non-tariff barriers in a potential market, the stability of the currency, and price controls enforced by the government.

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.

China may be an exception to the conclusion that economically free countries, being less risky than unfree countries, are better markets for exports and investment. China is ranked poorly, 125th out of 150 countries in the Index, yet it has attracted large amounts of foreign investment. This is the result of many influences, including China's skill in advertising its attractive qualities to lure investors, and, most glaringly, the huge size and potential of its market, which leads investors to ignore or accept the risks.

However, a closer look reveals that foreign investment in China is centralized in several "special economic zones" (SEZs), not subject to many of the regulations, taxes, and government interference endemic to the economy at large. China has already utilized the principles of economic freedom to initiate and bolster its success. This is evident from the pattern of migration from the countryside to the SEZs as the Chinese people recognize the greater possibilities for wealth available in a more economically free environment. Viewed in this light, China may be a greater risk than widely perceived because its economic success cannot be maintained unless the economy at large is liberalized.

OPEN MARKETS MAKE GOOD INVESTMENTS

The U.S., and U.S. businesses in particular, have benefited from the spread of open markets, a core ideal of economic freedom. As markets for U.S. products and investment, foreign countries are more accessible than ever and are playing a key and possibly indispensable role in future opportunities for U.S. businesses.

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 U.S. companies, which benefit from reduced expenses to sell their products in foreign markets as well as to buy goods, services, or raw materials from overseas.

There are numerous examples of how open markets benefit U.S. businesses. America is the world's largest exporter, selling $830 billion in goods and services worldwide in 1996. Global U.S. trade (exports plus imports) totaled $1.76 trillion in '96 - more than 23 percent of America's GDP, compared with 13 percent in 1970. Since 1988, nearly 70 percent of the growth in the U.S. economy has been derived solely from exporting goods and services. Moreover, the U.S. Trade Representative's office estimates that by 2010, trade will represent 36 percent of America's GDP. Clearly, America profits from and is becoming more reliant on international trade, which is bolstered, in turn, by economic freedom.

U.S. foreign direct investment has grown sharply over the past decade. According to Dept. of Commerce figures, the U.S. direct investment position abroad has increased every year since '84 at an annual average of 6.23 percent through 1995. When only the last five years are considered, that average increase jumps to more than 10 percent.

This increase in U.S. foreign direct investment has been particularly sharp in developing countries. Total capital flows to the developing world are six times as large as they were a decade ago and now exceed $250 billion. Between 1991 and 1995, U.S. direct investment in the member countries of the Organization for Economic Cooperation and Development - composed of the industrialized countries - has increased at an annual average of less than 10 percent. By contrast, U.S. foreign direct investment to non-OECD countries has increased an average of more than 15 percent annually, never dipping below 14 percent in any year.

Given the evidence, there is no denying that the export and foreign investment sectors of the U.S. economy offer some of the greatest opportunities for U.S. businesses. In an analysis conducted for CE, Heritage analysts studied whether a relationship exists between the amount of U.S. exports to and foreign direct investment in individual countries and the level of economic freedom in those countries. The analysis showed conclusively that a statistically significant relationship exists. The study indicates that lower Index scores - which correspond with a higher level of economic freedom - are associated with greater amounts of U.S. exports and higher levels of U.S. direct foreign investment. Specifically, each time a country demonstrates a 1 percent improvement in the Index score, it is matched by a 5.4 percent improvement in exports and investment.

The Index also clearly identifies those [TABULAR DATA OMITTED] 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 Katbryn 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.