Saturday, August 21, 2004

The Main Causes of Prosperity

UPDATED 08/21/04

In an earlier post, I reported that government intervention in the economy since 1906 has reduced per capita GDP in the U.S. by about 40 percent. What happened?:
First, the regulatory state began [in 1906] to encroach on American industry with the passage of the Food and Drug Act and the vindictive application of the Sherman Antitrust Act, beginning with Standard Oil (the Microsoft of its day). There followed the ratification of Amendment XVI (enabling the federal government to tax incomes); World War I (a high-taxing, big-spending operation); a respite (the boom of the 1920s, which was owed to the Harding-Coolidge laissez-faire policy toward the economy); and the Great Depression and World War II (truly tragic events that imbued in the nation a false belief in the efficacy of the big-spending, high-taxing, regulating, welfare state).

The Great Depression also spawned the myth that good times (namely the Roaring '20s) must be followed by bad times, as if good times are an indulgence for which penance must be paid. Thus the Depression often is styled as a "hangover" that resulted from the "partying" of the '20s, as if laissez-faire -- and not wrong-headed government policies -- had caused and deepened the Depression.

You know the rest of the story: Spend, tax, redistribute, regulate, elect, spend, tax, redistribute, regulate, elect, ad infinitum. The payoff: GDP per capita was almost $38,000 in 2003; without government meddling it might have been as much as $68,000.
Now that the U.S., like most other countries, has attained a high level of government spending, taxation, regulation, and welfare, how is the U.S. able to maintain its outstanding record of economic performance?

The relative prosperity of a market economy* today depends mainly on three things: the rule of law, free trade, and the intelligence of its citizens. I base this conclusion on statistical analyses of data for 59 countries. I used the indices of economic freedom for 2000 from Economic Freedom of the World** and 1998 data for average national IQ and GDP per capita published by La Griffe du Lion (who derived the data from an article by Richard Lynn and Tatu Vanhanen, "National IQ and Economic Development: A study of Eighty-One Developing Nations," in Mankind Quarterly (Summer 2001).

There are two indices of freedom with strong explanatory power: the rule of law (Area 2: Legal Structure and Security of Property Rights), which has a significantly positive effect on GDP per capita, and the mean tariff rate (Area 4.A.ii), which has a significantly negative effect on GDP per capita. The rule of law is a measure of the independence and integrity of the judicial system and the degree to which intellectual property rights are protected. The use of law to regulate the economy is captured in various other indices, of which the tariff rate is one.

IQ (verbal IQ to be precise) has a significantly positive effect on GDP per capita.

In equation form:

Y =  - 23,518 + 2,316L - 259T  + 253I

Y = GDP in 1998 dollars (U.S.)
L = Index for rule of law
T = Index for mean tariff rate
I = Verbal IQ

The r-squared of the regression equation is 0.89 and the p-values for the intercept and independent variables are 8.52E-07, 4.70E-10, 1.72E-04, and 3.96E-05.

I don't mean to imply that prosperity is determined solely by the rule of law, free trade, and education. Those three factors simply yield powerful statistical relationships. My analyses of the indices of economic freedom also point to several other significant factors, especially transfers and subsidies as a share of GDP, bribery as a cost of doing business with government, and the regulation of business. Most of the countries in the data set have large welfare programs (transfer payments) and impose a heavy regulatory burden on business. Thus those activities are unlikely to show up as statistically significant in a multivariate analysis of cross-section data. Similarly, it is hard to find a country with a robust economy that doesn't impose high taxes on its citizens.

The moral of the story is that, although we in the U.S. could adopt policies that would make us worse off (e.g., eliminating patents and raising tariffs), we would be significantly better off if we hadn't veered from the path of laissez-faire capitalism a century ago. The main cause of prosperity is economic freedom.
* Command economies are excluded from the analysis because their performance is so far below that of market economies. For example, as of 1998 (the year of the IQ and GDP data) China was far from a market economy. If China had a market economy, and if that economy operated under the same rule of law and tariffs as the U.S. economy, the per capita GDP of China would have been about the same as that of the U.S. because China's average IQ was about the same as that of the U.S. In fact, China's per capita GDP was about one-tenth that of the U.S. That's the cost of decades of political repression and central planning.

** The compilation of indices of economic freedom in Economic Freedom of the World is a continuing endeavor of The Fraser Institute of Vancouver, British Columbia, Canada. There are 37 individual indices. The individual indices are organized into five areas, each of which has a weighted index. And there is a summary index, which is a weighted index of the area indices.