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January 15, 2002* Federal Reserve Bank of Cleveland Infrastructure and the Wealth of Nations by Ed Nosal and Peter Rupert W hy are some countries so wealthy and others so poor? The wealthiest nation in the world, the United States, is about 50 times wealthier than the poorest, Chad. Understanding the determinants of wealth and the growth necessary to achieve it is arguably the most important endeavor of economics, because that understanding can help to improve overall living standards. Economists will tell you that a key ingredient in a country’s economic growth and prosperity is the state of its infrastructure. A developed infrastructure allows competition to flourish and resources to flow to their highest-valued use. It enables investment and the accumulation of capital, both material and human, which lead to greater productivity and wealth. This Commentary explains why infrastructure is necessary for growth and explores how important its contribution might be by examining the relationship between infrastructure and growth across 123 countries. ■ The Infrastructure of Nations Commonly, when people speak of a nation’s infrastructure, they mean its roads, bridges, dams, rail lines, telecommunication networks, power-generating facilities, and so on. Infrastructure encompasses not only these tangible forms of capital but also some less tangible resources that are just as essential in promoting growth and prosperity. Such resources include things like property rights (and a legal system to help enforce them), a standard system of accounts, stable money, and a secure financial system. It is obvious why tangible capital is necessary. The ability to move goods, capital, labor, ideas, and information to their ISSN 0428-1276 *Printed March 2002 highest-valued use is a key factor in determining growth and well-being. Advances in heating, ventilation, and air conditioning, along with improved materials and building design, made it possible to construct skyscrapers, which provide benefits by bringing high concentrations of people and trade close together. The list of such innovations is long. What may not be obvious at first is where the less tangible type of infrastructure fits in. Think about why organizations undertake investment in costly research and development. Or what persuades investors to give up the certainty of wealth today for a claim to wealth in the future. How does one determine how much wealth an investor must give up for that future claim? It is precisely the less tangible items, like those already mentioned (and certainly others), that enable all of these things to happen. As an example, patent laws allow innovators to reap the fruits of the years of research and development necessary to produce new ideas and products. Welldefined and enforced property rights give the owners of capital the confidence to install and use it and to collect its rewards. These rights also assure owners of claims to future wealth that their claims cannot be ignored. This means that confiscation of property, including confiscation by the ruling government, cannot occur without due process of law. A standardized accounting system ensures that the financial data necessary to make informed decisions are reliable. This holds true for figures such as the U.S. national income and product accounts as well as firms’ earnings reports. Decisions about when and how much to invest, whether to shut down a Economies can’t grow without a sufficiently developed infrastructure, but how deep does the infrastructure have to be to make a difference? The authors take a look at some research from the Fraser Institute that examines the relationship between economic growth and economic infrastructure across 123 countries. They find that infrastructure is a bit of an all-or-nothing proposition. current product line, and so on may depend on the health of the industry, nation, or global economy. Reliable information allows companies and individuals to accurately assess the risks and possible rewards of any current or potential investment. A standard system of accounts is also necessary for placing a meaningful value on future claims. This holds true for individual companies as well as nations. ■ A Stable Financial System One important element of economic infrastructure is a secure, stable financial system. This includes not only secure financial institutions and markets, but also the stable purchasing power of money. Secure institutions ensure that credit markets are accessible and reliable and that transactions can be accomplished quickly and accurately. Almost always, a stable financial system includes a central bank that can give the banking system the necessary liquidity (money reserves), thereby minimizing the possibility of disruptions from largescale banking panics. This liquidity will have great value—to both the financial sector and consumers—if money’s purchasing power is stable. Money is useful in an economy precisely because it can overcome certain trading frictions, such as a lack of double coincidence of wants. Money is said to be essential if a society can achieve better outcomes with money than without it. The characteristics of money taught in introductory economics courses— medium of exchange, unit of account, and store of value—all contribute to making money essential. Money’s effectiveness varies directly with its quality, that is, its ability to hold its value. And, like other macroeconomic statistics, the quality of the signal that money sends makes us surer of the response to the information that the signal provides. If the signal’s quality is high, money prices give households and businesses reliable information about the relative costs of goods and services. This information enables them to make sound economic decisions, thereby fostering economic prosperity. Unexpected inflation greatly impairs money’s role as a signal, making it difficult to separate a general rise in prices from a change in the relative price of a good. At some sufficiently high rate of inflation, money is no longer essential and substitutes appear, such as a currency board or the use of another country’s money. Dollarization, which is widespread in the world today, is one example of a money substitute. Neither inflation nor deflation enhances economic performance. Both, if unanticipated, induce a redistribution of wealth—especially between debtors and creditors—and lower the average standard of living. When money’s quality is high, people can make decisions in the confident expectation that all observed changes in money prices are changes in relative prices, and all observed changes in interest rates are changes in real rates. Money with stable purchasing power provides a means of payment that allows the economy to achieve higher levels of prosperity. Consumers, producers, and financial institutions all benefit from stable money. ■ Infrastructure and the Performance of Nations If a nation’s economic infrastructure—its legal and political institutions, monetary policy, and so on—is a major contributor to economic growth and prosperity, we ought to see a clear correlation between COMPONENTS OF THE ECONOMIC FREEDOM INDEX Category Weight (percent) Size of government: consumption, transfers, and subsidies 11.0 Structure of the economy and use of markets (production and allocation via governmental and political mandates rather than private enterprises and markets) 14.2 Monetary policy and price stability (protection of money as a store of value and medium of exchange) 9.2 Freedom to use alternative currencies 14.6 Legal structure and property rights (security of property rights and viability of contracts) 16.6 International exchange: freedom to trade with foreigners 17.1 Freedom of exchange in capital and financial markets 17.2 SOURCE: The Fraser Institute, Economic Freedom of the World, 2001 Annual Report, 2001. better infrastructure and greater economic growth across countries. To test this hypothesis, we need an objective measure of the infrastructure. Fortunately, one exists: The economic freedom index produced by the Fraser Institute, a nonprofit public policy research organization. The index evaluates countries’ economic infrastructures in terms of seven major categories (see box above). It captures some basic economic freedoms, such as the ability to exchange goods and currencies, as well as the likelihood that those and other types of property will be confiscated. The index gives about 40 percent of its weight to stable money, the ability to trade currencies easily, and the freedom to exchange in capital and financial markets. Obviously, it is hard to quantify a concept as amorphous as economic freedom. Assigning a number on a zero-toten scale for each component in every country involves assumptions and subjective decisions. But the economic freedom index seems a reasonable place to begin. (Numerous academic and policy papers have explored the strengths and weaknesses of the index. See Gwartney, Lawson, and Block 1996 for a list. The procedures used to construct the index are described there as well.) Table 1 shows an overview of the countries included in the economic freedom index and their ratings and rankings in 1999. Comparing ratings on the index with figures for output and growth provides substantial support for the hypothesis that economic freedom plays a major role in determining both the level and growth rate of many economic variables as well as other measures of well-being. Figure 1 shows the relationship between income and economic freedom. The average income for the lowest quintile is roughly one-tenth the average income for the top quintile. Much more surprising, the income for the second-highest quintile is only about half that for the highest quintile. In a way, the remarkable difference between the top and bottom quintiles of the index ratings is not that surprising. The top 20 percent of the countries studied have the requisite freedoms and institutions that provide incentives to invest, accumulate capital, and so on; the bottom 20 percent lack them. But what about the middle 60 percent? While these countries have achieved some of the basic freedoms (perhaps even the more important ones), the freedoms achieved are insufficient to generate substantial prosperity; the obstacles are still too great. Unless those obstacles are removed, the countries in the middle quintiles will not be able to catch up to those in the top quintile. This observation is supported by figure 2, which shows the relationship between index ratings and GDP growth over the 1990s. The difference between the highest and second-highest quintiles in figure 2 is smaller than the difference in figure 1, but this is deceiving. Even small differences in growth rates can lead to large differences in levels over time. Figures 1 and 2 imply that these countries’ levels are not converging. The figures suggest that differences in levels between the FIGURE 1 ECONOMIC FREEDOM AND INCOME TABLE 1 ECONOMIC FREEDOM INDEX, COUNTRIES’ SUMMARY RATINGS AND RANKINGS, 1999 GDP per capita (1998 purchasing power parity U.S. dollars) 25,000 Country 20,000 15,000 10,000 5,000 0 Bottom 4th 3rd EFI Quintiles 2nd Top SOURCE: The Fraser Institute, Economic Freedom of the World, 2001 Annual Report, 2001. FIGURE 2 ECONOMIC FREEDOM AND GROWTH IN THE 1990s Percent, real GDP growth per capita (1990s) 2.5 2.0 1.5 1.0 0.5 0 –0.5 –1.0 –1.5 Rank Rating Country Hong Kong Singapore New Zealand United Kingdom United States Australia Ireland Switzerland Luxembourg Netherlands Argentina Bolivia Canada Finland Austria Chile Denmark Germany Iceland Belgium El Salvador Japan Sweden Costa Rica Italy Norway Portugal Bahrain Oman Panama Peru Philippines Spain France Nicaragua Estonia Mauritius Greece Paraguay Taiwan Dominican Rep. 1 2 3 4 5 6 6 6 9 9 11 11 13 14 15 15 15 15 15 20 20 20 20 24 24 24 24 28 29 29 29 29 29 34 34 36 36 38 38 38 41 9.4 9.3 8.9 8.8 8.7 8.5 8.5 8.5 8.4 8.4 8.3 8.3 8.2 8.1 8.0 8.0 8.0 8.0 8.0 7.9 7.9 7.9 7.9 7.8 7.8 7.8 7.8 7.7 7.6 7.6 7.6 7.6 7.6 7.5 7.5 7.4 7.4 7.3 7.3 7.3 7.2 Rank Rating Country Kuwait 41 Hungary 43 South Korea 43 Uganda 43 Latvia 46 South Africa 46 Trinidad/Tobago46 Unit. Arab Em. 46 Botswana 50 Namibia 50 Egypt 52 Jordan 52 Thailand 52 Uruguay 52 Guatemala 56 Israel 56 Malaysia 56 Malta 56 Czech Rep. 60 Honduras 60 Lithuania 62 Mexico 62 Bahamas 64 Cyprus 64 Ecuador 64 Guyana 64 Belize 68 Kenya 68 Slovak Rep. 68 Zambia 68 Fiji 72 Indonesia 72 Morocco 72 Slovenia 72 Turkey 72 Venezuela 77 Tunisia 78 Bulgaria 79 Jamaica 79 China 81 Colombia 81 7.2 7.1 7.1 7.1 7.0 7.0 7.0 7.0 6.9 6.9 6.8 6.8 6.8 6.8 6.7 6.7 6.7 6.7 6.6 6.6 6.5 6.5 6.4 6.4 6.4 6.4 6.3 6.3 6.3 6.3 6.2 6.2 6.2 6.2 6.2 6.1 6.0 5.9 5.9 5.8 5.8 Rank Rating Sri Lanka 81 Tanzania 81 Barbados 85 Poland 85 Ghana 87 Cote d’Ivoire 88 Haiti 89 Nepal 89 Zimbabwe 89 Benin 92 India 92 Mali 92 Croatia 95 Brazil 96 Niger 97 Pakistan 97 Cameroon 99 Bangladesh 100 Senegal 100 Albania 102 Burundi 102 Chad 102 Iran 102 Ukraine 106 Congo, Rep. of 107 Nigeria 107 Togo 107 C. African Rep. 110 Madagascar 110 Malawi 110 Rwanda 110 Gabon 114 Pap. N. Guinea 114 Syria 114 Russia 117 Romania 118 Sierra Leone 119 Guinea-Bissau 120 Congo, Dem. Rep.121 Algeria 122 Myanmar 123 SOURCE: The Fraser Institute, Economic Freedom of the World, 2001 Annual Report, 2001. –2.0 Bottom 4th 3rd EFI Quintiles 2nd Top SOURCE: The Fraser Institute, Economic Freedom of the World, 2001 Annual Report, 2001. FIGURE 3 ECONOMIC FREEDOM AND CORRUPTION Corruption index (higher ratings denote less corruption) 8 first and second quintile, which are already large, might only be magnified over time; in other words, wealth inequality across nations may increase. Figure 3 compares economic freedom to a measure of corruption in order to get at things such as bribery and other practices that divert resources. It shows a strong correlation: more economic freedom, less corruption. Bribery acts just like a tax, so that the buyer pays more than the seller receives. This lowers the rate of return for any investment, which decreases the amount of investment. 7 6 5 4 3 2 1 0 Bottom 4th 3rd EFI Quintiles 2nd Top SOURCE: The Fraser Institute, Economic Freedom of the World, 2001 Annual Report, 2001. Over the last two decades or so, many nations have made great strides in achieving a monetary policy that is consistent with a stable value of money. How far have they come? The index’s assessment of the stable money component of economic freedom shows that 5.5 percent of the nations studied were rated 9.0 or higher in 1975 (the highest possible rating is 10). By 1999, roughly 38 percent of the countries studied had that rating. The recognition of the link between stable money and growth and prosperity probably led to the greater use of currency boards and the increase of dollarization witnessed in the past 20 years. 5.8 5.8 5.7 5.7 5.6 5.5 5.4 5.4 5.4 5.3 5.3 5.3 5.2 5.1 5.0 5.0 4.9 4.8 4.8 4.7 4.7 4.7 4.7 4.6 4.5 4.5 4.5 4.4 4.4 4.4 4.4 4.3 4.3 4.3 3.9 3.8 3.5 3.3 3.0 2.6 1.9 Although countries differ along many dimensions, a sound economic infrastructure seems to be a necessary ingredient for achieving prosperity and growth. We’ve seen evidence suggesting how important that infrastructure is. The realization of the connection between infrastructure and growth has probably caused more countries to add at least one important component to their infrastructure—a stable monetary and financial system. Gwartney, James, Robert Lawson, Walter Park, and Charles Skipton. 2001. Economic Freedom of the World, 2001 Annual Report. Vancouver, B.C.: Fraser Institute. <http://www.fraserinstitute.ca/ publications/books/efw_2001/2EFW01 ch2.pdf>. ■ Recommended Reading Heston, Alan, and Robert Summers. Penn World Tables. Philadelphia: Center for International Comparisons, University of Pennsylvania. <http://pwt.econ.upenn.edu/>. Dawson, John W. “Institutions, Investment, and Growth: New Cross-Country and Panel Data Evidence.” 1998. Economic Inquiry. 36(4), pp. 603–19. Easton, Stephen T., and Michael A. Walker. 1997. “Income, Growth, and Economic Freedom.” American Economic Review. 87 (2), pp. 328–32. Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Cleveland, OH 44101 Return Service Requested: Please send corrected mailing label to the above address. Material may be reprinted if the source is credited. Please send copies of reprinted material to the editor. Gwartney, James, Robert Lawson, and Walter Block. 1996. Economic Freedom of the World, 1975–1995. Vancouver, B.C.: Fraser Institute. Ed Nosal is an economic advisor at the Federal Reserve Bank of Cleveland. Peter Rupert is a senior economic advisor at the Bank. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland, the Board of Governors of the Federal Reserve System, or its staff. Economic Commentary is published by the Research Department of the Federal Reserve Bank of Cleveland. To receive copies or to be placed on the mailing list, e-mail your request to 4d.subscriptions@clev.frb.org or fax it to 216-579-3050. Economic Commentary is also available at the Cleveland Fed’s site on the World Wide Web: www.clev.frb.org/research, where glossaries of terms are provided. We invite comments, questions, and suggestions. E-mail us at editor@clev.frb.org. PRSRT STD U.S. Postage Paid Cleveland, OH Permit No. 385
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