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Why Economic Freedom Is the Best Weapon against Poverty

This blog post is adapted from a speech delivered to the Foreign Service Institute at the United States Department of State on August 29, 2017.

Over the past few decades, the world has seen one of the most incredible reductions of poverty ever recorded. Hundreds of millions of people who previously lived in dire poverty have emerged to grow into a powerful global middle class.

This unprecedented rise is one of the most exciting developments in human history, yet it comes as no coincidence. It has overwhelmingly been the result of a shift to a more free and open global market economy—a shift to embrace greater economic freedom. Understanding just what economic freedom entails for developing nations is therefore one of the most important tasks of the 21st century.

What is Economic Freedom?

Economic freedom enshrines personal choice, voluntary exchange, and protection of private property at its core. It is the freedom to start a business or hire an employee without government interference or to invest and trade with whomever you please. It is development from the bottom up by individuals, as opposed to top down by governments.

Economic freedom can be fleshed out into five broad categories:

  1. Limited government;
  2. Strong legal structure and secure property rights;
  3. Sound money;
  4. Freedom to trade;
  5. Low regulation.

Why Does Economic Freedom Matter to Development?

Academic institutions have been measuring economic freedom for decades. The Fraser Institute, a Canadian think tank, began publishing its annual report in 1996 examining the impacts of economic freedom.

Over the years it has proven to be an incredibly robust prediction of how prosperous countries are or will become. The Fraser Institute has found that countries with institutions and policies more consistent with economic freedom have higher levels of income, more rapid economic growth, and a greater reduction in poverty rates. For example, in 2015, nations in the top quartile of economic freedom had an average adjusted per capita GDP of over $40,000, compared to around $5,000 for bottom quartile nations. Further, there is a strong correlation between prosperity and economic freedom even for the poorest nations. Out of the poorest 20 percent of countries, those with greater economic freedom have incomes that are 50 percent greater than those with less economic freedom.

The rise of China and India is further proof that economic freedom is the greatest driver of prosperity. Both countries were previously governed under central planning, with little respect for individual freedom. They eventually began to give this up, China after 1978 and India after 1991. After the partial freeing of markets, they started growing exponentially, at 7 to 12 percent, up from miserable rates of around 2 percent. While neither country is close to entirely economically free, they have both drastically improved their scores, opening up markets to international trade, deregulating the economy, and allowing individuals to exchange voluntarily. This has led to the greatest reduction in absolute poverty the world has ever seen.

South Korea is another example. A desperately poor country just 60 years ago, it is now one of the wealthiest in the world. It makes for a particularly interesting comparison with the African nation of Ghana, as Ghana and South Korea had the same GDP per capita in 1957. Since then, South Korea embraced foreign investment, liberalized trade, and strong property rights. Ghana, instead, went down another path, with a socialist government that was propped up by foreign aid. By 1990, South Korea’s GDP was 10 times that of Ghana. By 2015, Ghana’s GDP per capita sits at just under $2,000, while South Korea is over $25,000. This was while Ghana was receiving enormous amounts of foreign aid, whereas South Korea received substantially less. More importantly, the aid South Korea did receive did not dominate its domestic policy like it did in Ghana.

Can You Plan a Market?

Free market reforms have ushered in a new generation of prosperity for millions of the world’s poor. But can governments and international organizations plan a market economy from the top down?

The short answer is “No.” In the same way that the United States military cannot build democracy in Iraq and Afghanistan, the World Bank and International Monetary Fund (IMF) cannot build market economies in the developing world. Free institutions cannot be designed from the top down and they cannot be bribed into existence by foreign aid. Successful market economies rest on a framework of law, culture, and history. An expert at the World Bank cannot instantaneously create this.

Unfortunately, many experts have believed that they could “plan a market.” They have tried to solve technical problems like low manufacturing capacity or lack of financial services through government programs and transfers of aid money. This is instead of encouraging nations themselves to create the institutional environment that allows their societies to flourish.

This approach has not been short of funding. Trillions of dollars of development aid have been transferred over the last 60 years, but the results have been dismal. Economists have often found that foreign aid has no influence on economic growth whatsoever, while some have found that it even has a negative influence. Those studies that do find that aid money can spur growth, find that it is only effective when transferred to countries that already have good institutions and policies in place. At very best, the results are inconclusive, even though we have transferred trillions of dollars and employed thousands of experts to try and engineer growth.

Despite the insistence of the development community, it is not so simple that another “big push” of development aid will spur economic growth. This is because, as former World Bank economist William Easterly has argued, the real cause of poverty is not about a shortage of experts or a shortage of aid. It’s not about getting the right people or right plan to solve poverty from the top down.

What poverty is really about is a shortage of rights and of freedoms and the institutions that emerge as a result of this. The technical solutions that experts try to solve are a symptom of poverty, but they are not the cause. The absence of an institutional environment that empowers individuals to solve their own problems and an absence of political and economic freedoms are the cause of poverty.

Mobile Money and Permissionless Innovation

Market institutions are best formed from the bottom up, when governments take a hands-off approach and allow markets to form organically rather than try to direct them from the top down. A great example of this has been the rise of mobile money in Kenya.

Just over 10 years ago, the telecom company Safaricom launched M-Pesa, a mobile money service in Kenya. M-Pesa allows users to send and receive digital payments anywhere in the country through texting money to each other. This is an amazing service that has allowed customers to safely store money, pay for goods and services, and deposit and withdraw cash without ever having to go to a physical branch. In 2015, Safaricom reported that M-Pesa payments accounted for around 44 percent of the country’s GDP with over 25 million accounts.

This is an incredible phenomenon. Out of all the financially innovative countries in the world, Kenya is one of the leaders in mobile money. How did that happen?

There is a range of factors in Kenya’s development of mobile money. The high risk of theft and lack of affordable financial alternatives made it a particularly profitable technology for budding entrepreneurs. But the real key to M-Pesa’s success was that Kenya’s regulatory environment was relatively accommodating. Whereas banks and financial institutions are heavily regulated, M-Pesa was a product of a telecom company and was exempt from many burdensome regulations. An innovative company was thus able to serve millions of “underbanked” customers without the hassle of layers of red tape. The problem of financial inclusion was solved through creating an environment of “permissionless innovation.”

This approach is in stark contrast to what development experts have pursued in the past. For decades, many policy makers assumed that the market could not be trusted to serve poor customers. Their answer was to try and engineer financial and economic development. This included nationalizing foreign-owned banks and using foreign aid to establish state-owned banks. Experts believed they could plan and direct the financial sector, but this has turned out to have dismal results. As Scott Burns of the Mercatus Center has argued, Sub-Saharan Africa had by far the lowest financial inclusion rate in the world, with only one in seven adults having access to a bank account before mobile money was introduced.

Economic freedom and new technology achieved what decades of state planning could not: widespread financial inclusion in Africa. Based on Kenya’s success, the best thing governments can do to promote financial development is to stop trying to engineer it. Fostering a supportive regulatory environment allows entrepreneurs, not government bureaucrats, to serve customers more effectively.

African Development and Economic Freedom

The stunning development across the past few decades has been driven predominately by the rise of economic freedom in Asia, through the “Four Tigers” of South Korea, Taiwan, Hong Kong, and Singapore, as well as China and India. But there is hope that other regions of the world are starting to embrace free market reforms, too.

Since the start of the new millennium, Africa’s average per capita GDP rose by more than 50 percent and Africa’s growth rate has averaged almost 5 percent per year. Further, the extreme poverty rate in Africa fell from 58 percent in 1999 to 44 percent in 2011. It is expected that this will fall to around 24 percent by 2030. Certainly some of this growth was driven by high commodity prices, but much of it was driven by economic reforms.

According to the Fraser Institute’s report, economic freedom rose from 4.75 to 6.23 between 1990 and 2013. This is thanks to increased openness to foreign trade and investment, some improvements in domestic business regulations, improving property rights regimes, and more stable currencies.

These have no doubt been phenomenal improvements. But there still are substantial problems with economic freedom in Africa, and the continent remains at the bottom of the rankings. In particular, regulatory barriers and legal institutions are notoriously weak and ripe for improvement. This is perhaps illustrated best by the problem of the “informal economy.”

Informal Economies and Government Failure

An informal economy is a kind of “grey market,” where a business operates extra-legally, outside of a country’s legal framework. This is a problem for African nations, as registered companies tend to have greater productivity and investment, create more jobs and growth, and enjoy legal protection against fraud for both themselves and their customers. Yet across Africa the informal economy accounts for some 50 to 80 percent of the region’s GDP.

While many development experts have blamed a lack of infrastructure, education and skills training, and limited access to technology, this shadow economy is a natural response to governments restricting economic freedoms. The stifling restrictions that have been placed upon businesses and entrepreneurs have forced people out of the formal economy.

For decades, many African governments have fostered a hostile business environment. Africa ranks at the bottom globally in terms of economic freedom, and the World Bank’s most recent Ease of Doing Business Report deemed Africa the most difficult region in the world for starting a business.

When governments erect these barriers to entry, is anyone surprised that small businesses and entrepreneurs, like fruit vendors or hardware stores, stay in the informal sector? It’s not a lack of technology or infrastructure. It’s governments restricting freedom. African nations need to stop pushing businesses away with burdensome regulatory structures.

Another factor is the lack of secure property rights. Of the five factors of economic freedom, property rights are the most important. Nations with the strongest private property protections have per capita incomes five times higher than those with only moderate protections. They are the basis of a market economy, and without formal land titles, individuals struggle to gain finance, start businesses, or access the justice system.

African nations have some of the least secure property rights in the world and government corruption is a major problem with land registration systems. If individuals and businesses do not have formal titles to their land or other property, how can they be integrated into the formal economy?

African governments should make it as easy and efficient as possible to establish recognized property rights. Luckily, this is becoming much easier with the help of technology. New GPS mapping systems can help codify these land rights to make it easier to register, while another exciting development is blockchain technology. Blockchain is a widely accessible online public ledger that can log land titles digitally. This provides a more secure and efficient alternative to slow, corrupt, and bureaucratic government systems.

The best thing for African nations, not foreign governments, to do is implement free market reforms. Embracing economic freedom will drive growth and prosperity in Africa, as it has every other region in the world.

What Can the West do?

Growth and prosperity will come from developing nations themselves, not from external saviors. But one thing the West can do is stop getting in the way. There are many barriers that foreign nations erect that are detrimental to both themselves and developing nations. The best thing for Western countries to do would be to remove these obstacles to growth.

Embrace Free Trade and Capital Flows

If developed nations want to spur the growth of the least developed, they should embrace greater flows of both trade and capital.

One of the most substantial barriers to this is Western farm subsidies. According to Oxfam, some 10 million people in Central and Western Africa who rely on the production and sale of cotton lose up to $250 million a year due to Western subsidies. This is just the tip of the iceberg when it comes to farm subsidies, and it is low-hanging fruit that would benefit both developed domestic economies and taxpayers, as well as industries in the least developed economies.

Liberalize Immigration

Immigrants are a fantastic resource for the American economy. They are highly entrepreneurial, creating businesses and driving economic growth. But while they are beneficial to the domestic economy at large, they are also a fantastic opportunity for the immigrants’ countries themselves.

Relaxing visa and work requirements can help to develop the human capital of developing nations. This will not only provide an opportunity for individuals to escape poverty, but for them to develop skills and expertise that will benefit their home nations upon return.

Stop Destructive Interventions

Western nations should stop trying to socially engineer outcomes through development aid. There are many problems with large-scale development aid. It is a textbook example of good intentions leading to unintended consequences. But perhaps the greatest problem is that it has encouraged a political framework that is in direct opposition to the kind of economic freedom required for development.

When weak and ineffective governments that are opposed to economic freedom are propped up by large aid flows, they are able to neglect any pressure to reform. Instead of having to court their own citizens for votes and tax dollars, African governments can rely on foreign, unelected donors. Any World Bank, IMF, and Western government programs that contribute to planning development from the top down and prevent countries from embracing economic freedom should be strongly rethought.

Economic freedom is the single greatest driver of prosperity. Since the fall of communism and the rise of China and India, this has become undoubtedly clear. Those countries that have instituted the vision laid out in the declaration of independence—that individual rights and freedoms are paramount to a prosperous society—have grown to experience amazing success. Other approaches are no doubt well intentioned, but they have empirically failed to live up to their goals. If Western governments and developing nations wish to spur development and create a world free of poverty, it is essential to embrace economic freedom.