October 16, 2000

October 16, 2000 | WebMemo on Trade, Economic Freedom

The Future of Economic Freedom

A lecture originally given as part of our Leadership for America series, on August 16, 2000.

We have reached the new millennium, and find freedom on the march around the world. The new century reflects a continuing era that began in 1989 with the fall of the Berlin Wall. The most remarkable aspect of this new era is the spread of democratic capitalism. The twin freedoms of the ballot box and the open marketplace are the recognized formula for national development, and country after country struggles to put them in place. The remaining authoritarians are on the defensive, trying to manage the intricate and probably impossible task of suppressing political freedom to retain power while implementing economic freedom to achieve growth.

My subject for the day is economic freedom, but I strongly believe that economic and political freedom are ultimately inextricable. Indeed, I believe this all the more strongly after reflecting on tonight's subject, the future of economic freedom. On the theory that the best guide to where we're headed is a look at where we've been, I propose to review the course of economic, and political, freedom over the past century. The main lesson of this review is that the resurgence of economic freedom was not preordained; at many points it was a near thing. This is surely a warning that we cannot be complacent about the current benign trend, that the future is not in the stars but in our own hands.

A second strong lesson, though, is that over the century economic and political freedom have tended to ebb and flow together. In places such as Taiwan and Korea, we are currently witnessing the reality that an open economic system will create a middle class demanding a bigger say in the political decisions that shape the lives of its members and especially its children. My review of history makes me doubt that democracy built and sustained without a workable economic system. Men and women surely desire a say in how they are governed, but they also want material well being and a sense of progress. If these fail, for example in the Weimar Republic, it opens avenues for dictators who promise a quick fix.

An open political system, on the other hand, will eventually find its way to open markets as the only means of satisfying the demands of its citizens for material well-being. You can find examples of economic freedom with limited political freedom-Singapore, for example. Or of political democracy without workable open markets-Russia, for example. But I take these examples as passing ones.

I do think that economic freedom is worth discussing in its own right. For one thing, in the current conventional wisdom it is the poor cousin of ballot-box democracy. In the post-Berlin-Wall era, though, we are learning that the latter is no panacea. Viable democracy depends not only on formal access to the ballot, but on a much broader nexus. The American Founding Fathers took great pains to design protections for perhaps momentary minorities, for example. Not least, passing majorities and ambitious politicians are restrained by a deep respect for the rule of law tracing its roots to the Magna Carta.

Among the protections stressed by the Founding Fathers was a preeminently economic ones, the right to private property. It should not be lightly dismissed that the freedom to enjoy the fruits of your labor, that is to sell them, is in itself a fundamental human right.

For all of these reasons, it is certainly promising that economic freedom is spreading in our new era. We can measure this spread systematically in a joint product of the Heritage Foundation and my newspaper, the Index to Economic Freedom. The first index was compiled in 1995, when the trend toward freedom was already underway. It showed 40 countries rated free or mostly free. By the 2000 index, 13 nations had joined that category, not counting 20 more that weren't rated in the first survey. So 73 of 161 countries are now in the free/mostly free category. The 2001 index will be released Nov. 1 in Hong Kong. The results are closely guarded and eagerly awaited by developing countries around the world. But I think it's safe to say it will show further advances in freedom.

These trends are certainly worth celebrating, and in one sense the trend is a sturdy one. I think it's propelled by deep forces, particularly information technology that both communicates freedom and demands it.

Yet I also worry about complacency. The trend toward freedom-especially economic freedom-is a recent thing, and perhaps a fragile one. Many of us who advocate free markets grew up in an age when these ideas were scarcely fashionable, when leading intellectuals thought in terms of central planning or "fine tuning." When Frederick von Hayek convened the Mt. Pelerin Society in 1947, he gathered the beleaguered. In abandoning Communism, Whittaker Chambers said he was joining "the losing side."

If you look back to the turn of the last Century, in particular, you will find a mood much like today's. The principles outlined by Adam Smith in 1776 reigned supreme in 1900. Smith taught that economic progress comes from open markets, that consumers and producers trading freely will lead each to his comparative advantage and increase the pot to be shared by all. As these principles supplanted the earlier mercantilism, prosperity spread beyond the titled and landed classes. The careful work of Angus Maddison identified 1820 as the great inflection point in world growth. World GDP per capita increased, he estimates, from about $420 in 1990 dollars in the year 1000 to about $545 in 1820. By 1995, it had soared to $5,188. And the most economically free nations, Western Europe, North America and Japan, grew the fastest, reaching a per capita GDP of $19,990.

Great Britain, dominant after Waterloo, had digested Smith's lesson well. With repeal of the Corn Laws by Sir Robert Peel in 1846, Great Britain practiced free trade unilaterally. The Royal Navy insured freedom of the seas, except of course for slave traders. The pound Sterling provided an international currency, the City of London an international capital market. The generation celebrating the year 1900 had accomplished the breathtaking task of developing the North American continent, peopled by free immigration and financed by British capital. There was an amazing flowering of science and art, above all in Belle Époque France. Sir Norman Angell, later to receive the Nobel Peace prize, published "The Great Illusion" arguing that the world economy had become so interdependent that war was no longer possible. Its first printing was in 1910, four years before the world was plunged into a great war and indeed an era of turmoil that lasted until 1989.

My favorite description of this remarkable world comes from John Maynard Keynes, in The Economic Consequences of the Peace, published in 1920.

What an extraordinary episode in the economic progress of man that age which came to an end in August 1914!

The greater part of the population, it is true, worked hard and lived at a low standard of comfort, yet were, to all appearances, reasonably contented with this lot. But escape was possible, for any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts and amenities beyond the compass of the richest and most powerful monarchs of other ages.

The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend.

He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could dispatch his servant to the neighbouring office of a bank for such supply of precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable.

All this was lost in a flash. World War I was one of the great turning points of history. Why Norman Angell proved so wrong remains a bit of a mystery to me, as I gather it does to historians. The roots of the conflict seem to lie in the rise of Germany after unification, the decline of Great Britain after the Boer War, and the incapacity of the United States to discharge the leadership role that fell upon it as it became a world power. By 1895 the United States was producing more steel than Great Britain, for example, and with the completion of five transcontinental railroads its rail network was five times the size of all of Europe's. 

Whatever its causes, World War I toppled the Hapsburg and Ottoman empires, redrawing the map of Europe. It allowed Lenin to found one of history's great totalitarian empires, finding in Marx's ruminations on capitalism an excuse for using terror in an effort to change human nature. The Great War broke the back of British domination, turning the world's military and economic reins over to a United States unprepared by philosophy or history to manage such affairs. It destroyed the gold standard and undermined Sterling. It left a legacy of war debts and reparations that laid a basis for the Depression. And it set in train resentments in Germany that led to a second and even larger conflagration.

The war was senseless enough, but the world's inability to recover from it was a matter of not getting the economics right. Keynes, in the book I have just quoted, predicted that the peace settlement placed an economic burden on Germany that it could not sustain, and that this was likely to lead to political aberration of one sort or another. Being presented the Nobel Prize in Economics last December, Robert Mundell entitled his lecture "A Reconsideration of the Twentieth Century." He interpreted the century in terms of the international monetary system, arguing that economic and political events, above all the Great Depression, have to be understood as reflections of perturbations in exchange rates, the gold standard and international liquidity.

Prior to World War I, the gold standard gave governments and central banks a reliable guidepost. Gold was at least part of the base for national money, so that if a nation lost gold its money supply would contract, automatically correcting depreciation of its currency. This in effect created an international money, facilitating the flow of goods and capital across borders. The inflation rate shared by all nations on the gold standard might vary, influenced by such accidents as new gold discoveries or nations leaving or returning to the gold standard, but in general the standard was, as Mundell put it, a "self-regulating rudder that guided policy makers toward equilibrium."

After the war the optimum policy would have been to return to the gold standard, but at new parities accepting the wartime inflation. The world's chanceries and exchequers did try to return to gold, but at the pre-war parities. Mundell points to a handful of economists-Charles Rist in France, Ludwig von Mises, Gustav Cassel of Sweden-who understood that this was in effect an attempt to bring the general price level back to prewar levels, and that this kind of deflation would devastate production and employment. But more generally, Mundell noted, "economists blamed the gold standard instead of their mishandling of it and turned away from international automaticity to national macroeconomic management."

The result was a massive decline in economic freedom, epitomized by the Smoot-Hawley Tariff in the United States. World trade imploded, as Charles Kindelberger has documented. The closing of markets, as Adam Smith would have predicted, led to a general economic collapse. And this in turn led to political instability. By 1934, as Mundell put it, "the world depression had deepened, economic nationalism was on the march, and the disease of totalitarianism had spread over most of the European continent." Hitler took power in January of 1933 and assumed totalitarian powers with Hindenberg's death in 1934; a new World War and the Holocaust were in train.

A similar if somewhat less virulent mechanism, it's worth noting, took place in Asia. It is not widely understood that the 1920s were a period of spreading liberalism in Japan. In an ongoing struggle over the place of the military in Japanese life, military budget proposals were curbed in 1922 and 1925. A successful general election was held in 1924, and universal manhood suffrage was legislated. In 1926, Emperor Hirohito took the throne, naming his reign Showa, or "enlightened peace" and taking as his chief mentor Prince Saionji Kimimochi, the most liberal of the Japanese elders. Of this period Edwin Reischauer would write "the carefully controlled revolution of the Meiji period was developing into a runaway liberal movement of the urban middle classes."

This trend ended abruptly on Jan. 1, 1930. When the world powers formed the Bank for International Settlements in February 1929, all had returned to the gold standard, except Japan, which maintained its 1917 "gold embargo," forbidding the export of gold. Japan sought to join the big leagues, and repealed the embargo effective Jan. 1, which is to say two months after the stock market crash and during the debate over Smoot-Hawley. The exchange rate was set at 2.0 to the dollar, compared to 2.27 the previous March. Over the objections of a petition signed by 1,028 economists, President Hoover signed the Smoot-Hawley tariff in June. By October the Japanese price of silk, the principal export and cash crop for subsistence farmers, stood at a 34-year low.

Support for the military, one thing a source of employment for impoverished farm youths, soared. After winning ratification of the London Naval Disarmament Treaty, Prime Minister Hamaguchi Osachi was disabled in an assassination attempt in Nov. 1930. An army coup in Tokyo was aborted in March 1931, but its perpetrators escaped serious punishment. In September 1931, the Japanese Kwantung army seized the City of Mukden, acting without benefit of orders and indeed in defiance of traditional control from Tokyo. It then advanced into the rest of Manchuria, and the Pacific War was underway.

In both Europe and Asia, the interwar period is a huge demonstration that economic and political freedom are inextricable, indeed that economic freedom and the progress it brings are cement holding political freedom in place. Happily, this lesson was pretty well digested by the generation brought to power in World War II. The Morgenthau plan for a de-industrialized Germany was rejected and the emperor was allowed to reign in Japan. Konrad Adenauer put Germany on market principles, and Douglas McArthur reformed Japan politically and economically. And Keynes, Harry Dexter White and their counterparts met at Bretton Woods, N.H. to design a world economic order restoring economic freedom.

Even during the depression, Cordell Hull kept talking about reciprocal trade agreements; no one else could quite understand why. But this evolved into the General Agreement on Tariffs and Trade, one of the great market-opening movements of history. Though perhaps not exactly intended by Keynes and White, Bretton Woods evolved into a system of stable exchange rates, monitored by the International Monetary Fund and anchored through the dollar to gold. The GATT has somewhat ossified in the current World Trade Organization, and is in some danger of becoming a series of reciprocal protection agreements. The IMF has by now lost its role and its direction. But we should not lose sight of their spectacular achievement.

For these movements toward economic freedom unleashed a spectacular era of growth. Maddison refers to the years 1950-1973 as the golden age. He calculates that world GDP, per capita, grew by 2.9% a year-nearly 3.9% a year in Europe and 8% a year in Japan. These are spectacular numbers, and are clearly associated with a blossoming in economic freedom.

Unhappily events took a different turn in 1973, and we found ourselves in a different and unsettling environment. On Aug. 15, 1971, President Richard Nixon convened his advisers at Camp David to abandon economic freedom overnight. He introduced wage and price controls and incidentally closed the gold window and collapsed the Bretton Woods Monetary System. These events dominated the decade of the 1970s, later known as the malaise decade.

The conventional wisdom, of course, is that 1973 was the year of the oil embargo, when the Organization of Oil Exporting Countries set the price of oil soaring. But OPEC's actions were a direct result of the August 71 decision to close the gold window. How do we know this? Because OPEC told us so. Five weeks after the Nixon shock of August 15, it met in extraordinary session in Beirut and passed its Resolution XXV.140, which reads,  

The Conference,

having considered the report of the Secretary General concerning the recent international monetary developments and their adverse effect on the purchasing power of the oil revenues of Member Countries;

noting that these developments have resulted in a de facto devaluation of the United States dollar, the currency in which posted prices are established, vis-a-vis the currencies of the major industrialized countries;

recalling Resolution XXI.122 which calls, inter alia, for adjustment in posted or tax-reference prices so as to offset any adverse effect resulting from de facto or de jure changes in the parity of monies of major industrialized countries:

resolves

1. that Member Countries shall take necessary action and/or shall establish negotiations, individually or in groups, with the oil companies with a view to adopting ways and means to offset any adverse effects on the per barrel real income of Member Countries resulting from the international monetary developments as of 15th August, 1971.

2. that the results of negotiations shall be submitted to the next Conference. In case such negotiations fail to achieve their purpose, the Conference shall determine such action as necessary for the implementation of this Resolution.
"Such action as necessary," at least in my suspicion, included the 1973 Arab-Israeli War, the immediate impetus for the boost in oil prices. As their 1971 declaration shows, the sheiks of OPEC understood the implications of the closing of the gold window far better than the Western elites did. The severing of the link to gold meant a great inflation was coming, though repressed by wage and price controls to get past the 1972 election.

Again, a handful of economists understood what was taking place, but could get no one to listen. In particular, Robert Triffin of Yale warned prior to 1971 that the huge accumulation of international reserves made a world-wide inflation inevitable. Under the Bretton Woods arrangements, the Federal Reserve in effect served as a world central bank, creating dollars that served as reserves for other banking systems. Its creation of reserves was in theory limited by a $35 gold price, and for a brief period of time the public could actually redeem gold at this price through the London Gold Pool. But the Gold Pool was dissolved in 1969, and the Fed would redeem gold only from other central banks, who were discouraged from presenting claims.

So dollars created in financing the Vietnam War accumulated abroad. Finally the Bank of England asked that its dollar holdings be protected against a devaluation of the dollar; This was taken as a demand for gold, and led directly to the Aug. 15 meeting, wage and price controls and the rest. Again, the correct answer would be to keep the gold link but change the price, increasing it to provide the liquidity the world economy needed. This was in fact suggested by Jacques Rueff, but rejected by American elites because it would benefit France, which held large gold stocks, and South Africa, which produced gold.

Instead, U.S. policymakers in the 1970s reversed the mistake of their counterparts of the 1920s. Where the latter had imposed a deflation, the former unleashed an inflation. Inflation of course always creates winners and losers. In this case, the Arab sheiks were clever enough to get to the head of the line, insuring that they were the winners.

In the U.S., the results of this were wondrous to behold. The conventional wisdom declared an "energy crisis," deciding that its problem was that the earth's crust was running out of hydrocarbons. The Department of Energy was created to provide better central planning than the oil companies could. The President of the United States blamed it all on "malaise" among the public. "The erosion of confidence in the future is threatening to destroy the social and political fabric of America," he told the public. His proposed answer was a six-point energy program, including quotas on imports, subsidies for oil shale and gasohol and standby gasoline rationing.

Economic freedom seemed in tatters and political freedom seemed in danger. In 1980, the Western economic system seemed to have broken down. In that year, inflation ran at 13.5% measured by the consumer price index. A brief recession dawned, and unemployment averaged 7.1%. The prime rate reached a record 21.5%.
Meanwhile, political unrest spread. The Soviet Union invaded Afghanistan and mounted crowds in the streets of Europe to stop an American weapon, the "neutron bomb." A militant Islam took over Iran and seized American hostages. All this, only 20 years ago.

Happily, an open political system provides for correcting economic mistakes. Indeed, in many senses the 1970s were a profound learning experience. For starters, we tried wage and price controls and learned they didn't work. After President Carter's rather pathetic effort at "voluntary" wage and price controls, and an abortive effort by the Federal Reserve to apply credit controls, by the end of the decade price controls applied only to energy.

What's more, after calling for the resignation of his entire cabinet, President Carter removed G. William Miller from the chairmanship of the Federal Reserve and made him Treasury Secretary, apparently on the notion that this was a promotion. And he found himself filling the Fed vacancy with Paul Volcker, the paragon of a tight-money man. Meanwhile, the notion that malaise might have something to do with high taxes, that is with economic freedom, was taking hold in Congress. Over opposition from the administration, the Democratic Congress passed Congressman Bill Steiger's capital gains tax cut in 1978. The same year Senator Sam Nunn succeeded in attaching a version of the Kemp-Roth across the board tax cut to a spending bill, and the House voted to instruct its conferees to accept it, though in the end Senator Russell struck it from the bill as "too big a deal."

All of this, as I'm sure you're anticipating, laid the groundwork for Ronald Reagan. The electorate learns as well, and by the 1980 election was in a mood to look for some new ideas. I have recounted the Reagan experience at length in my book, The Seven Fat Years, but tonight I would like to make a few salient points:

First, it was a policy mix. It involved incentive-directed tax cuts, lopping the highest marginal rates out of the tax code, but it involved monetary tightness as well. In February of 1982, with recession already underway, the Federal Reserve tightened, and was promptly and publicly supported by Ronald Reagan. The idea, articulated at the time and before by Bob Mundell, was that tight money would contain the inflation, and incentive tax cuts would stimulate growth.

Second, there was a timing mismatch. Paul Volcker had been trying to tighten money since his appointment in 1979, and clamped down after the election. The tax cut, by contrast, was passed in August 1981, effective in October. What's more, because of fear of deficits, it was staggered in, fully effective only in 1983. When the cuts came into place, the policy mix worked. The trough of the recession is dated to November 1982, and the boom ran for seven years. Indeed, except for a short recession associated with the Savings and Loan bailout, we have enjoyed 18 years of prosperity since.

Third, the Reagan policy was not merely tax cuts, but a systematic restoration of economic freedom. In particular, the President abolished the remaining controls on energy prices; gasoline lines ended and no dire consequences were evident. Similarly, the Reagan administration continued the policy of deregulation, which actually started under the Carter administration.

Fourth, economic freedom spread political freedom. In the early days of the Reagan administration, some prominent conservatives argued for tax increases to fund the defense effort, that is, for ignoring the economic crisis to tend to the military threat. It was apparent to me that you could not fix one without fixing the other. In the end, the Soviet Union collapsed because its command economy could not match the Reagan military build-up, in particular the technological threat of his proclaimed missile defense system.

Most amazingly, the only person I know of to predict the collapse of the Soviet Union was Ronald Reagan. No fewer than four times he openly predicted the Communist empire would fall-including in his famous "evil empire" speech to the National Associating of Evangelicals in March of 1983. He declared, "I believe that Communism is another sad, bizarre chapter in history whose last pages even now are being written." The fall of the Berlin Wall in 1989 was the end of the tumultuous era that started in 1914, and the beginning of the benign era we enjoy in the new century.

The decisive turn toward economic freedom Ronald Reagan embodies took place, I repeat, a mere 20 years ago. We have been enjoying its fruits for an even shorter period of time. And despite our advances, we still do not live in as open a world economy as a century ago. Remembering that experience, it seems prudent to scan the horizon for threatening clouds. Is there a way the current climate of economic freedom could end in a flash, as happened in 1914?

The most obvious parallel, it seems to me, is between the rise of Germany at the beginning of the last century and the rise of China today. I am certainly not predicting the China will spark World War III, but we ought to be thinking about how to incorporate a rising new power peacefully in the international system. I do not think this means frustrating China's ambitions, but channeling them in constructive directions.

China's leaders have not walled themselves off from the West as Stalin did with the Soviet Union; they are betting they can have open trade with the West and still control their citizens at home. This is a bet I think the West should cover, for I think it likely that openness, trade and rising living standards will erode their totalitarian control at home. At the same time, however, we should stoutly resist any temptation to expand by military means. The test will be whether Western democracies in general and the United States in particular can maintain such a nuanced policy. It is not easy, but in pursuit of the containment of Communism, we did patiently stand for two generations at the Fulda Gap, commanding the invasion routes to Western Europe.

Following Bob Mundell, as obviously I do, we should be particularly alert to disturbances in the international monetary system. We have after all already had shocks from international crises in Mexico, Asia and Russia. I do not believe we have given good advice to developing nations. In particular, our policies in Russia have helped entrench a criminal class, discrediting open markets with the Russian people. This has a whiff of the Versailles policies toward Germany.

On the broader financial scene, we are still in the uncharted waters of fiat currencies. "The main thing we miss today is a universal money," Mundell said in Stockholm. We do not have an international "standard of value, the link between the past and the future and the cement of civilization linking remote parts of the human race to one another." We have evolved "three islands of monetary stability," the dollar, the euro and the yen, but "exchange rates between them will be the source of greatest disturbances to the international monetary system."

I think we need to rethink the "conservative" position on exchange rates. The conventional conservative wisdom is that we should have freely floating exchange rates, that markets should determine exchange rates. But free markets require freedom of entry, and currencies are a monopoly of respective central banks. There was a time when the conventional conservative wisdom was that only gold is real money. This was an exaggeration, but as I have elaborated the gold standard did serve highly useful purposes, and it would be wise to recognize this grain of truth. 

Finally, I believe the future of economic freedom will be determined in the United States. The U.S. needs to lead the world with respect to China and Russia and the international monetary system. But it also needs to keep its own house in order, and it's easy enough to detect backsliding. We have some 14% of our economy, the medical sector, under price controls today. We have a serious actuarial problem with our Social Security system, which if left unaddressed might result in serious economic and political strains. We are collecting federal tax revenues at a record peacetime level, and Ronald Reagan's political party has been captured by Ross Perot's policy of subordinating all other goals to ending deficits and then running surpluses to pay down the national debt. And while in many ways the Clinton administration has ratified the Reagan policies in deregulation, welfare reform and the North American Free Trade Agreement, we are now in a presidential campaign in which one of the candidates in essence proposes to reverse these policies and return to the populist liberalism of an earlier era.

Despite these clouds, the recent rebirth of economic freedom makes it difficult to be anything but optimistic. My reading of the last century is that the interplay between an open economic system and an open political system tends to find the right answers, though sometimes by circuitous routes. The current trend is clearly and powerfully in a hopeful direction. As we go further into the new century, we may discover that Norman Angell was not wrong, only a century premature, that economic interdependence will not only avoid major wars but forge a new world civilization based on political democracy and open markets, a world of political and economic freedom.

 

About the Author