It is widely acknowledged by development economists that a country’s wealth is correlated to the economic freedom enjoyed by its citizens. The history of Europe supports this idea. From the Italian and Flemish city-states of the 15th century to the United Provinces of the Netherlands in the 17th century and finally England’s Glorious Revolution and the take-off of the industrial revolution in the 18th century, every great surge of prosperity in Europe occurred when republican ideals, open markets and tolerance for new ideas were allowed to flourish and overcome centralized, absolute rule. Moreover, these Anglo-Dutch ideals were the philosophical foundation of the American Revolution and instrumental to the United States’ rise as the world’s most dynamic economy in the 19th century.
The rise of the Soviet Union as an economic power in the 1960s raised doubts about “economic freedom” being the only path to prosperity. Famously, the economist Paul Samuelson included the chart below in his widely read college textbook between 1961 and 1980, showing the Soviet economy on the path to overtake the United States. Samuelson’s basic argument was that the Soviets would grow faster because investment rates were higher and potential for efficiency gains were greater. Similar arguments were made in favor of the Japanese economy in the 1980s and have returned with even more vigor in relation to China in recent years.
The confidence in China’s ability to sustain high rates of GDP growth in the future is grounded in a belief that the government is able to successfully steer investments into sectors of the economy with high growth potential. This thinking is rooted in the extraordinary success of the “East Asia Development Model” pursued by Japan, Taiwan, Korea and China which relies on state support (tariffs, fiscal subsidies, credit subsidies) to corral investments into “frontier” industries with high export potential. It is also supported by arguments, back in favor in Western economic academia (e.g. Mariana Mazzucato, Carlota Perez), which proffer a key role for the state as an inducer of investment in vital industries.
Though it can be debated what the exact role of the state should be as an inducer of economic activity there are a series of objective criteria that can be identified as necessary to provide the appropriate institutional conditions for human and financial capital to be deployed in entrepreneurial activities. These basic conditions can be said then to provide the institutional framework for “economic freedom.”
Several institutions (e.g., The World Bank, The Fraser Institute, The Heritage Institute) have developed methodologies to rank countries in terms of economic freedom over time.
All of these look at a combination of the following factors:
- Rule of Law (property rights, government integrity, judicial effectiveness)
- Government Size (government spending, tax burden, fiscal health)
- Regulatory Efficiency (business freedom, labor freedom, monetary freedom)
- Open Markets (trade freedom, investment freedom, financial freedom)
The table below is from The Fraser Institute’s 2021 report which is based on 2019 data. The countries are ranked and separated into four quartiles, the top quartile being the countries with the highest level of economic freedom. These rankings are available for the past 40 years to provide a history for evaluating progress or regression over time.
The following maps show the Fraser Ranking in both 1980 and 2019. Note the tragic fall of Venezuela from one of the most economically free countries in the world to the bottom.
The following graph looks at the relationship between economic freedom and wealth, using Fraser’s country data and the World Bank’s 2019 GDP per capita as a proxy for wealth. We can see a strong correlation between economic freedom and wealth. Two noteworthy outliers are petro-states (UAE, Quatar, Brunei) and tax havens (Luxembourg) which are considerably above the trend line and Eastern European “reformers” (Lithuania, Lativia, Estonia, Georgia, Poland) which are well below the trendline. Presumably, the Eastern Europeans will experience a period of catching up as they enjoy the benefits of the reforms that have been implemented since the 1990s.
The table below narrows the Fraser Institute’s data for the primary emerging markets of interest to investors. The table shows the four quartiles, the country’s overall rank and the change in the quartile since 1980.
In conclusion, there are several interesting facts to note about the table.
- Overall, EM has had a small improvement over the past 40 years.
- In terms of the importance of countries relative to their weight in benchmarks, the rankings are not auspicious. India, Brazil and China, which are really the core of emerging markets as an asset class, are all in the bottom of the Third Quartile. Vietnam, considered by many the most promising frontier market, is in the Fourth Quartile.
- Those countries in the Second Quartile may offer the best opportunities. I would highlight the Philippines and Indonesia which are on the right path and continue to enjoy high potential growth.
- The three countries in the top quartile – Taiwan, Chile and Peru — are new entrants to this elite, with Peru coming all the way from the Fourth Quartile. In 1980 EM had these three countries in the First Quartile, Venezuela, Malaysia and the UAE. Venezuela went from the First Quartile with a highly ranked 16th overall in 1980 to absolute bottom ranking in 2019. Peru’s rise and Venezuela’s collapse are a testament to the institutional precariousness of Latin American institutions.