April 23, 2004

April 23, 2004 | WebMemo on Trade, Economic Freedom

Promoting Global Economic Freedom at the G-7 Meetings to Secure Future Growth

As the finance ministers of the world's leading economies gather this weekend at the G-7 meetings in Washington to discuss the global economy, expect a steady drumbeat of criticism directed at the United States from France, Germany, and Japan, all seeking to divert attention from their lack of economic growth. Contrary to constant predictions of imminent demise due to trade and budget deficits, America accounted for 26.3 percent of global economic production in 2002 (constant dollars), the largest share in over three decades.[1] In contrast, Japan and Western Europe have watched their own economies stagnate. The lesson should be clear: European- and Japanese-style government intervention-neo-mercantilism, social safety nets, labor restrictions, and the like-is a barrier to growing prosperity. 

 

Japan's "Lost Decade"

The conventional wisdom of the 1980s was that the Japanese economic model would dominate the world. Yet, in 1989, Japan's economy was hit hard by a stock market collapse and entered into a "lost decade" of growth. Throughout the 1990s, Japan's financial system choked on massive non-performing loans that the government and the banking system are still trying to resolve. The result has been artificially low interest rates but few new loans to new businesses hungry for capital. The continued strategy of keeping the Yen weak in order to maintain a trade surplus seems to be another failing strategy of monetary manipulation.

 

Japan's real growth averaged 1.1 percent per year during the decade from 1993 to 2003, compared to America's 3.3 percent growth rate over that period (see Chart 1). Further, Japan's GDP relative to global output is lower today than in 1973. Bloated government debt towers at over 160 percent of GDP, while banks remain in duress and promises of reform ring hollow.[2]

 

Japan's sudden rebound to 6.4 percent annualized growth in the last quarter of 2003 caused excitement and contributed to a somewhat healthy average of 2.5 percent for the year. But as Japanese citizens know all too well, two or three years of growth per decade do not make a recovery. [3]

 

The European Experience

Despite a few bright exceptions, such as Ireland, Luxembourg, and Portugal, the EU-15 countries as a group have experienced weak growth since the end of the Cold War, averaging compound growth of only 1.8 percent since 1990. The EU's share of the global economy over the past three decades has declined steadily. Today, its share is more than 6 percentage points below its 1973 share and nearly 2 percentage points below its 1992 share (see Charts 2a and 2b). The decline has been particularly serious in France and Germany due to constrictive labor markets, over-regulation, high taxes, and exorbitant government or government-mandated pension and health programs.[4]

 

"Barriers to Riches"

Japan and the two major European economies, Germany and France, have experienced poor growth for a reason: their resistance to free market reform. Economists by Stephen Parente and Edward Prescott argue eloquently that many nations establish "barriers to riches" (the title of their 2000 book) when they attempt to protect special interests and sectors within their countries[5].

 

The Heritage Foundation's 2004 Index of Economic Freedom confirms a strong, positive relationship between economic freedom and per capita GDP. The Index reveals that a country's average GDP growth rate increases as the country's economic freedom score improves.[6] Moreover, the inverse relationship is true: countries that ignore economic freedom grow slowly, limiting future job opportunities.It is no coincidence that "free countries" in the Index tend to experience higher rates of growth than less-free developed countries.

 

Overburdened with high tax rates, spending, and regulation, Japan, France, and Germany are ranked only "mostly free" in the Index (the 38th, 44th, and 18th freest economies, respectively).[7] Their relative lack of freedom inhibits growth. Moreover, Japan's workforce has declined since 1995, and European populations are expected to decline sharply due to low birthrates.[8] Because of their aging demographics, these nations face pension crises in the near future when social spending will increase sharply. Absent fundamental pension reform or an unlikely reverse in population trends, these countries will be forced to drastically increase taxes to fund those pensions, further constraining economic growth. While America faces similar crises in its Social Security and Medicare programs that must be addressed, its situation is not as pressing as those of the EU and Japan because its economy is growing more strongly and America's population is younger and increasing.

 

Japanese and European societies have essentially chosen to grow slowly, and this action not only impacts their own immediate prosperity, but also U.S. economic performance, by shrinking the global economy below its potential.[9] For example, the U.S. recovery from the 2001 recession has been primarily driven by internal factors. 

 

The Answer is Economic Freedom

America faces many challenges itself but is, on balance, much freer and stronger economically than other advanced nations. Japan and Europe should serve as cautionary tales to advocates of trade protectionism and government planning.

 

While poor economic performance has spurred some small changes and forced consideration of more substantial reform, France, Germany, and Japan have only scratched the surface of needed change. The political pressure to cling to anti-growth policies will only increase as rapidly aging populations in these countries become more resistant to proposals that affect their pensions. It is more important than ever that modest growth over the next year and beyond not be allowed to lead to further complacency and lack of reform in Japan and the EU.

 

The United States serves as an example of success through economic freedom. It is an example that is getting harder and harder for other advanced nations to ignore. For its own benefit and the benefit of all nations, the United States should encourage policies conducive to steady, long-term economic growth in developing and developed economies alike. The G-7 meeting of finance ministers in Washington this weekend would be an excellent forum for this vital message.

 

Brett D. Schaefer is Research Fellow in International Regulatory Affairs, Balbina Y. Hwang is Policy Analyst in the Asian Studies Center, and Tim Kane is Research Fellow in the Center for Data Analysis, at The Heritage Foundation.

[1] Estimates for 2003 growth data from "Global economy surges in 2004, but dangerous imbalances continue to mount," United Nations, World Economic Situation and Prospects 2004.

[2] Economist, "Flying again," February 12, 2004.

[3] See Balbina Y. Hwang and Brett D. Schaefer, "Addressing the Looming Financial Crisis in Japan," Backgrounder No. 1530, The Heritage Foundation, March 26, 2002 , at http://www.heritage.org/Research/AsiaandthePacific/BG1530.cfm.

[4] Economist, "Don't give in," June 5, 2003.

[5] Stephen L. Parente and Edward C. Prescott, Barriers to Riches (Walras-Pareto Lectures), MIT Press, 2000.

[6] Marc A Miles, Edwin J. Feulner, Jr., Mary Anastasia O'Grady, 2004 Index of Economic Freedom, The Heritage Foundation and The Wall Street Journal, pg. 21.

[7] Marc A Miles, Edwin J. Feulner, Jr., Mary Anastasia O'Grady, 2004 Index of Economic Freedom, The Heritage Foundation and The Wall Street Journal, pp. 183-4, 191-2, 241-243.

[8] Economist, "A shrinking giant," January 8, 2004; and Economist, "Europe's population implosion," July 17, 2003.

[9] Economist, "Altogether now …" November 20, 2003. There are stability implications as well. For instance, the lack of Japanese growth has ceded economic leadership in Asia to China. If predictions that China's economy is overheating prove correct, this could negatively affect growth elsewhere.

About the Author

Brett D. Schaefer Jay Kingham Senior Research Fellow in International Regulatory Affairs
The Margaret Thatcher Center for Freedom

Balbina Y. Hwang, Ph.D. Senior Policy Analyst
Asian Studies Center

Tim Kane, Ph.D. Visiting Fellow
Center for Trade and Economics (CTE)