Economic freedom made America rich — But it's falling

By W. Michael Cox and Richard Alm

Do Americans face a future of living standards that don't grow as fast as they once did or, worse yet, even decline? Previous generations might have scoffed at the question. Becoming better off in terms of consumption per capita was something of a birthright, the result of decades of progress that put Americans at the top of the heap with average spending of $32,000 a year.

But the long-established optimism has faded in recent years — and we have only ourselves to blame. The country has strayed from the economic model that created a consumer cornucopia. We're living above our means, one of a mere handful of countries with diminishing prospects for living standards.

It's important to grasp what makes countries like the United States rich, while so many other places lag, and some even struggle with consumption per capita of less than $1,000 a year.

The focus usually centers on the physical, human and financial capital used to produce goods and services, earning income for consumption. Simply put, the richest countries have a lot of capital, the poorest ones have very little of it.

That's fine — as far as it goes. But the traditional view says nothing about why countries build capital in the first place or whether they use it well or waste it. Something more is needed. And we've found it: freedom capital — a fourth capital stock that explains why some economies are so much better than others at amassing capital and using it effectively to raise productivity and living standards.

Capital doesn't fall like manna from heaven. It takes time and sacrifice to build — and incentives are all-important. Businesses will invest in physical capital when they expect to reap a profit; individuals will acquire intellectual capital when they foresee higher paying jobs. High rates of return will encourage saving, lending and investment.

More people will strive for these rewards when property rights are secure, taxes are low and governments hold their regulatory meddling to a minimum. In short, capital will grow more rapidly when nations commit to markets and economic freedom — the longer the better.

High and rising economic freedom spurs the creation of capital in all its forms, planting the seeds for rising living standards. Where economic freedom falters, capital will be scarce, misused and poorly maintained. Over time, people will become poorer.

In the past two decades, our Economic Freedom of the World report has made great strides in using hard data to measure economic freedom on a scale of 1 (low) to 10 (high) for more than 150 countries — from Albania to Zimbabwe. EFW's 43 components include top marginal tax rates, the ease of starting a business, inflation rates, private-sector credit, hiring and firing regulations, and tariff and non-tariff trade barriers.

EFW scores, going back to 1970, allow us to measure each nation's freedom capital stock — its long-term commitment to good economic policies. We calculate freedom capital as a declining weighted average of past freedom, recognizing how past policies still influence the well-being of consumers today.

Hong Kong and Singapore, two former British outposts in Asia, have the highest freedom capital stocks, followed by the United States. India and China have adopted market-oriented reforms in recent years, but they're still among the countries ranking low in freedom capital — a hangover from decades of central planning. Populism left Venezuela with a meager freedom capital stock.

Economic freedom impacts living standards in two fundamental ways. First, a legacy of economic freedom forges long-term incentives to build physical capital in the first place. Rich countries' soaring office towers, productive factories, hospitals, airports, electricity lines, cell-phone towers and all the rest are monuments to high levels of past economic freedom.

Second, today's economic freedom directly shapes the incentives that push countries to use existing capital effectively and productively. A large capital stock guided by market forces leads to high living standards; cronyism and central planning waste capital, eventually sapping consumption per capita.

Here's the good news: Worldwide, economic freedom has been rising in recent decades. In 1985, the EFW's global average was 5.33. It increased steadily to 6.58 in 2000; since then, progress has been more erratic, but the latest reading was 6.83 for 2011.

And now, the bad news: Until 2000, the United States participated in the world's march toward greater economic freedom, its score rising from 7.6 in 1970 to 8.65 in 2000, when the country ranked second only to Hong Kong in economic freedom.

Since then, U.S. economic freedom has been faltering, declining to 7.74 in 2011 and dropping the United States out of the Top 15 in the worldwide rankings.

We want to know whether — and where — living standards are going to rise. We estimate the long-run expected consumption per capita for the 94 countries with economic freedom scores back to 1970 — assuming they maintain today's levels of economic freedom over the next 40 years or so.

Because of the overall gains in economic freedom, 90 countries can look forward to improving living standards. After a long series of market reforms, China's actual consumption, for example, stands 56.3% below what its economic fundamentals suggest. India consumes 29.3% below its long-term standard. Think of it, about 2.5 billion people are likely to live much better in the decades ahead — a clear testament to the power of economic freedom.

Other counties consuming significantly below their means include Poland, Peru, Ukraine, Brazil, Bangladesh, Iran and Russia. They have the potential for better days ahead, based on continuing or further improving their current levels of economic freedom.

Two countries are consuming slightly above their fundamentals — Switzerland at 2.2% and Iceland at 3.3%. Neither faces a drastic slowing in growth of consumption per capita. Venezuelans, on the other hand, can expect to see their living standards sharply constricted; today, their consumption is 51.3% above what could be sustained in the long term at currently depressed levels of economic freedom.

What about the United States? The economic fundamentals predict consumption per capita of $25,460 a year — a striking 22.2% below today's actual figure. We're living above our means, just as many Americans have sensed without any real reason — until now.

For Americans, the impact on living standards will most likely be gradual rather than sudden, perhaps manifested in sluggish income growth or masked by higher inflation. The country still has a large capital stock per capita, amassed over the decades of very high economic freedom, providing Americans a cushion to maintain living standards or even continue to raise them at a slow rate.

Signs are already pointing to an ebbing U.S. capacity to consume. Both mean and median per capita incomes, which grew rapidly in the 1980s and 1990s, have fallen in the past decade. Unless the United States reverses its decline in economic freedom, the best Americans can hope for is middling growth in living standards, and they may not even get that.

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