The literature on economic growth, development, and prosperity mostly agrees that the key to prosperity is open markets and sound institutions, particularly a strong rule of law.1 Sound institutions and a strong rule of law permit individuals to accumulate wealth, through savings, investment, or purchases, and permit people to work and enjoy the fruits of their labor. The protection of private property is the pillar to foster and sustain economic growth, because for individuals to work, save, and invest, or for companies to begin and expand their operations, they need to have a guarantee that their property will not be taken from them.2
Latin America went through a period in the early 1990s in which countries began to open their markets more aggressively than ever before. The opening of the markets, it was said, would modernize the Latin economies, eliminate bureaucratic distortions, attract foreign investment, and ultimately enable ordinary Latins to have more jobs and a better standard of living. A persistent recession since 1997 that spread out throughout the region, along with political instability, financial crisis, and increasing poverty, shattered the hopes for prosperity and left many wondering if the U.S. free-market theory would really work in Latin countries, or if it were a plan to benefit the rich at the expense of the poor. I am here today in an attempt to provide an answer to that question and to look at what can be done so that Latin countries can grow and prosper as they hope to do.
I would like to use the Heritage Foundation/Wall Street Journal annual Index of Economic Freedom3 to frame the Latin American economies and to help understand what liberalization in the region was about. Economic freedom is defined in the Index as "the absence of government coercion or constraint on the production, distribution, or consumption of goods and services, beyond the extent necessary for citizens to protect and maintain liberty itself." The Index measures economic freedom in 10 different factors:
- Trade
Policy
This factor looks at the obstacles to trade in the form of tariffs or non-tariff barriers, including quotas, licensing, and corruption in customs. - Fiscal Burden of
Government
This factor looks at the top income and corporate tax rate, as well as government expenditures as a percentage of GDP. - Government
Intervention
This factor measures government consumption as a percentage of GDP, government ownership of business and industries, the share of government revenues from state-owned enterprises, and government ownership of property. - Monetary
Policy
This factor includes the weighted average inflation rate for the past 10 years. - Banking and
Finance
This factor looks at the amount of regulation affecting banking and finance activity. - Capital Flows
and Foreign Investment
This factor looks at the degree to which foreign investment faces the same regulations as domestic investment, and at restrictions on capital flows. - Wages and
Prices
This factor assesses the freedom to set prices privately, whether there is a minimum wage, and government subsidies. - Regulations
This factor looks at the regulations affecting businesses, such as steps required to open a business or to get a license, labor and environmental regulations, and corruption in the bureaucracy. - Property
Rights
This factor assesses the strength and independence of the judiciary to enforce the law and whether expropriation exists in a country. - Black
Market
This factor assesses the size of the informal sector.
For each factor, a country receives a score from 1 to 5--where 1 is freest and 5 most repressed. These scores are averaged to obtain a country's overall score. Finally, the countries are placed in a world ranking of economic freedom.
One of the major findings of the Index is a strong, positive correlation between economic freedom and income per capita (See Chart 1). In fact, every country in the world with more than $16,000 annual per capita income is economically free or mostly free in all of the Index factors, not just a few. A recent research study by Richard Roll and John Talbott from the University of California at Los Angeles, on the relationship between political and economic freedom indicators and income per capita, indicates that these variables of study explained about 80 percent of the variation in per capita income across countries.4 Of all the variables involved in the study, the property rights, regulation, and black market factors of the Index were found to have the highest significance in explaining that variation. In other words, this study indicates that individuals and businesses invest, save, and work where it is less costly to do so and where the fruits of their efforts are best protected.
Reform in Latin America
The early 1990s were years of promise for Latin America. The world saw democracy strengthening, markets opening, freedom flourishing, and investment flowing to the region. The developed world applauded reform efforts in Argentina, Peru, Chile, Bolivia, Colombia, and saw reform replicating, although at a slower pace, in Uruguay, Mexico, and Brazil. People who had left their countries for economic or political reasons returned to bet, along with their compatriots, on the promise of prosperity in their countries.
Using the Index as a framework to take a picture of the reform process in the countries I just mentioned, we find that economic freedom took the form of privatization, tamed inflation, deregulation of the banking sector and of foreign investment, and price liberalization. But with the exception of Chile, no Latin country strengthened its judicial system to protect property rights, nor did any of them ease regulations on starting and operating, primarily, a small and medium-sized business. In addition, the informal sector activity increased. All of these are areas that, as the research we just mentioned indicates, are key to long-term economic growth and prosperity.
So, the answer to our original question--why liberalism did not deliver prosperity in Latin America--is that liberalism did not deliver prosperity because it never existed. To call this partial opening of markets a "free market" is to not understand what a free market is in the first place. And to expect a partial opening of markets--which precisely for being "partial" concentrates wealth, destroys small businesses, and benefits parts of society at the expense of, mostly, the poor--to deliver the kind of prosperity that developed countries enjoy is like hoping to win the lottery without buying a ticket.
Let me quickly mention that Uruguay is a peculiar reform case. Reform in Uruguay has been slow, although progressive, and reform efforts have been preserved. It has a sound judiciary. So, from this perspective, Uruguay has a tremendous opportunity to advance reform and bring prosperity, since it seems to have the institution--the judiciary--that will make that reform sustainable. All it needs is the political will to open the markets fully.
Looking back, again, to the Latin experiment with reform in the framework of the Index, let me offer a few insights about our region:
- Except in Chile, there is no principled commitment to the reform process in Latin America. The Latin countries reform in response to a crisis, or to the prospect of good relations with the United States that eventually can give them some kind of access to the U.S. market. Also, reform sometimes is imposed by international organizations like the World Bank or the International Monetary Fund (IMF) in exchange for loans. When reform is imposed, it is hard to sustain.
- Without easing the burden of taxation, corruption and bureaucracy on small and medium business, the Latin countries will not be able to foster a dynamic economic environment. As a result, problems of unemployment, recessions, and political instability will become persistent.
- And the most important conclusion is that economic reform without a strong rule of law cannot be sustained.
With the right policies, Latin countries can expect to have economic ups and slowdowns, but they will not plunge into a deep crisis every 10 years, wiping out years of reform efforts. It is ultimately their choice whether they want to develop or to live eternally in poverty and instability.
Ana I. Eiras is Senior Policy Analyst in the Center for International Trade and Economics at The Heritage Foundation. She spoke at the Artigas Institute of Foreign Service in Montevideo, Uruguay, on March 12, 2003.
