Heritage Foundation, 2008 Index of Economic Freedom, Executive Summary.
"Although the dispute over neoliberalism is often characterized in left/right terms, that characterization is misleading."
The neoliberal policy revolution that began in the late 1970s might be the most important recent event in world history. But it remains a curiously elusive and underreported phenomenon. Many on the left question the motives behind the reforms, as well as their efficacy, while some on the right talk as if the neoliberal revolution never happened.
Yet, the neoliberal revolution has been widespread and highly successful. And the motives of neoliberal reforms are much purer than one would imagine after reading left-wing criticisms of free-market reforms.
First, to understand what neoliberalism it, we need to start with the term "liberal." The best way to make sense of liberalism, in all its permutations, is to assume that liberals are people with constantly evolving policy views but relatively stable utilitarian values. In the late 18th and early 19th centuries, idealistic utilitarian reformers, aka "classical liberals," believed that free-market capitalism was the best way to improve human welfare. Views shifted over the course of the 19th century, as capitalism was increasingly associated, whether accurately or not, with overly-powerful corporations and increasing inequality. After the Great Depression, many liberals saw laissez-faire not just as unfair, but also as dysfunctional. In the United States, self-described "liberals" moved toward somewhat more socialist policy views.
Modern liberalism (or social democracy outside the United States) reached its peak between the 1930s and 1970s. The policy mix included a great deal of statism (barriers to trade, price controls, high marginal tax rates (MTRs) and government ownership of industry), as well as greatly increased government spending, especially in government transfer programs. Then, beginning in the late 1970s, there was a sudden and dramatic shift away from one aspect of socialism—statist policies were discarded and free markets came back into vogue. However, there was no significant reduction in government spending: In most countries, the government's share of GDP has been fairly stable in recent decades.
The neoliberal revolution combines the free markets of classical liberalism with the income transfers of modern liberalism. Although this somewhat oversimplifies a complex reality, it broadly describes the policy changes that have transformed the world economy since 1975. Markets in almost every country are much freer than in 1980; the government owns a smaller share of industry; and the top MTRs on personal and corporate income are sharply lower. The United States, starting from a less-socialist position, has been affected less than some other countries. But even in the United States there have been neoliberal reforms in four major areas: deregulation of prices and market access, sharply lower MTRs on high-income people, freer trade, and welfare reform. Many other countries saw even greater neoliberal policy reforms, as once-numerous state-owned enterprises were mostly privatized.
There is an unfortunate tendency to associate the term "neoliberal" with right-wing political views. In fact, the quite liberal social democracies of northern Europe have been among the most aggressive neoliberal reformers. Indeed, according to the Heritage Foundation's Index of Economic Freedom, Denmark is the freest economy in the world in the average of the eight categories unrelated to size of government.1 The Nordic countries2 have begun to privatize many activities that government still performs in the United States. These include passenger rail, airports, air-traffic control, highways, postal services, fire departments, water systems, and public schools, among many others. These countries do have much larger and more comprehensive income-transfer programs than the United States has, but are not otherwise particularly socialist.
So why is the left so skeptical of the neoliberal revolution? And why does the right tend to overlook it, except for the obvious cases, such as the collapse of communism? Many on the left are skeptical about how much freer markets have actually achieved. Part of this skepticism reflects the slowdown in worldwide growth since 1973. Because almost all countries instituted at least some reforms, and yet growth slowed in most countries, there is a tendency to assume that the reforms failed. Others point to well-publicized fiascos in electricity and banking deregulation and assume that these represent the broader reality. On the right, many American economists focus on the failure of Reaganomics to reduce the size of government, as well as on increased regulation in areas such as health, safety, and the environment, while the so-called "economic regulations" were trimmed back.
Paul Krugman, one of the most forceful advocates of the view that neoliberal reforms in the United States caused economic growth to slow, wrote:
Basically, US postwar economic history falls into two parts: an era of high taxes on the rich and extensive regulation, during which living standards experienced extraordinary growth; and an era of low taxes on the rich and deregulation, during which living standards for most Americans rose fitfully at best.3
Because economic growth slowed almost everywhere after 1973, however, we need to look at relative economic performance in order to identify the effect of neoliberal policy reforms. The following data show per capita income in terms of purchasing power parity [PPP].4 All data are from the World Bank and are expressed as a ratio to U.S. per capita income:
Note that four countries gained significantly on the United States, two were roughly stable (Australia and Japan) and the rest regressed. The four that gained were Chile, Britain, Hong Kong and Singapore. Of course, many poor countries also gained on the United States, but that's to be expected. As we will see, the relative performance of each of these economies is consistent with the view that neoliberal policies promote economic growth.
Britain: At the time Margaret Thatcher became Prime Minister in 1979, decades of statist policies had turned Britain into the sick man of Europe. The government owned the big manufacturing firms in industries such as autos and steel. The top individual MTRs on income were 83 percent on "earned income" and an eye-popping 98 percent on income from capital. Frequent labor strikes paralyzed transportation and led to garbage piling up in the streets of London. Much of the housing stock was government-owned. Britain had lagged other European economies for decades, growing far more slowly than most economies on the continent. Thatcher's reforms were among the most comprehensive in the world, and by the mid-1980s, Britain was growing faster than the other major European economies. By 2008, it had a higher per capita income than Germany, France, and Italy.
United States: The United States was doing better than Britain in 1980, but not particularly well. We had also been growing much more slowly than Europe and Japan. Unlike Britain, we were still richer than most other developed countries, and so many people viewed this convergence as partly inevitable (the catch-up from World War II) and partly reflective of the superior economic model of the Germans and Japanese. It was widely expected that Japan and Germany would eventually surpass the United States in per capita GDP. Paul Samuelson claimed in 1973 that Soviet GDP might surpass U.S. GDP as soon as 1990.5 Obviously none of this happened, and by the 1990s, the United States was growing faster than most major European economies.
Australia: A traditionally rich country whose commodity export model started to sputter in the 1970s, Australia began free-market reforms in the 1980s (under a left-wing government) and accelerated the reforms after the conservatives took power in 1996. After 1994, Australia's relative decline reversed.
Japan: Japan is just the opposite of Australia. Its free-market export model did very well in the post-war years and didn't hit a wall until about 1990. After that, domestic growth sputtered as Japan's dysfunctional government refused to reform its statist domestic economy.
Hong Kong and Singapore: These two countries top most surveys of "economic freedom" (which include size of government.) Both are in the process of becoming much richer than the United States. Some of that is due to their status as city-states. But even in larger developed economies, the population is mainly urban, and so Hong Kong's and Singapore's success is due to more than just demographics.
Canada: Canada is similar to Australia, except that it was not as statist as Australia in the earlier period, and its reforms occurred in the 1990s, when Canada began shrinking the size of government as a share of GDP, after having, in 1988, adopted free trade with the United States. These reforms were successful, as its decline relative to the United States was reversed, and Canada started catching up after 1994.
France and Germany: Both passed some reforms, but much less than Britain. They suffered a decline relative to both Britain and the United States. Note that the German data for the whole time period include the East, so their relative decline cannot be explained by the 1990 absorption of that less-productive region.
Italy: Italy instituted a few reforms, but has a significantly more statist model than most of Western Europe. Italy fell far behind Britain.
Sweden: Sweden had a bad recession in the early 1990s after having suffered decades of relative decline. It made major cuts in MTRs, privatized, and deregulated during the 1990s, and its relative performance improved after those reforms.
Switzerland: Switzerland has always been regarded as one of the most capitalist countries in Western Europe, but has also been among the least aggressive countries in terms of neoliberal reforms. That pattern would predict high levels of GDP/person, but relative decline vis-à-vis the United States And that is exactly what has occurred.
What about in the developing world? Even most progressives concede that India has benefited by moving away from the "License Raj," the term used to describe the morass of controls and regulations facing anyone who wanted to start or run a business. There's even less controversy about China's abandonment of Maoism after 1979. But there is controversy about the impact of neoliberalism in middle-income regions such as Latin America. Once again, here's Paul Krugman:
Latin Americans are the most disillusioned. Through much of the 1990's, they bought into the "Washington consensus"—which we should note came from Clinton administration officials as well as from Wall Street economists and conservative think tanks—which said that privatization, deregulation and free trade would lead to economic takeoff. Instead, growth remained sluggish, inequality increased, and the region was struck by a series of economic crises.6
It's certainly true that neoliberal reforms have not worked miracles in Latin America. But a major part of the reason is that despite reforms such as trade liberalization, most economies in that region remain strikingly statist. Among Latin American nations, Chile has by far the best record of neoliberal reforms. It ranks tenth on the Heritage Index of Economic Freedom and is the only Latin American country, other than St. Lucia, to make the top 30. In contrast, Argentina ranks 135th. Chilean incomes were barely half those of Argentineans in 1980, but by 2008, Chile had actually become slightly richer.
Argentina did some neoliberal reforms in the early 1990s and grew rapidly between 1991 and 1998. But Argentina slipped into a highly deflationary monetary policy in the late 1990s. The resulting depression led to a backlash against neoliberalism, and a more left-wing government moved Argentina back toward statism after 2002. One lesson of both Argentina after 1998 and the United States after 1929 is that even a fairly efficient free-market economy cannot easily adapt to deflationary monetary policies.
Other critics of neoliberalism point to the discouraging economic situation in the former Soviet bloc. While the performance has been disappointing, the critics often overlook two important considerations. First, the entire Soviet bloc experienced a severe depression in the late 1980s and early 1990s, even before economic reforms had begun in most areas. (The reforms began in 1992 in Russia.) Second, economic growth tended to be higher in areas that reformed most rapidly and lowest in areas that remained unreformed. Estonia did better than Russia, which did better than the Ukraine. The one communist country that adopted no reforms (North Korea) saw an almost-complete collapse of its economy during the 1990s.
The preceding examples suggest one aspect of the neoliberal revolution that is often overlooked. By the 1970s, growth was slowing sharply almost everywhere, which led Margaret Thatcher to proclaim: "There is no alternative." Britain did not grow significantly faster after the Thatcher reforms, but did overtake Western European countries that reformed their economies less aggressively. Interestingly, academics were often the last to understand what was going on. In 1981, 364 British economists signed a petition7 warning that Thatcher's polices would fail. But, by the 1990s, there was a sort of tacit understanding8 among policy-oriented economists that when countries get into trouble, market reforms are the only real option. Indeed, the term "economic reform" became almost synonymous with "market reforms."
Although the dispute over neoliberalism is often characterized in left/right terms, that characterization is misleading. Neoliberal reforms occurred in nearly every country during the 1980s and 1990s, regardless of whether a left- or right-wing government was in office. A few years ago, I researched9 the relationship between cultural attitudes and neoliberal reforms among the developed countries. It turns out that, between 1980 and 2005, those countries with more idealistic or civic-minded cultures (as indicated by surveys on attitudes toward the common good and by indices of corruption10) tended to reform their economies much more rapidly than countries with less civic-minded attitudes.11 Interestingly, Denmark has by far the most civic-minded culture in the group of 32 developed countries, and, as noted above, ended up with the least statist economic system in the Heritage's 2008 rankings (excluding the two size-of-government categories). Greece has the least civic-minded attitudes and ended up with the most statist economy in 2008. Far from being a right-wing plot to enrich corporations, the neoliberal revolution was liberal in the truest sense of the term: a rational response by idealistic policymakers to the increasingly obvious failure of statist economic models in the 1970s and 1980s.
So far, I have focused on the move away from statism and haven't addressed the long-term viability of the welfare state. Here, the evidence is mixed. It is true that governments in rich countries tend to spend a higher share of GDP than governments of poorer countries. On the one hand, fans of the welfare state point to the relatively high living standards in places like Sweden and Denmark, which have extensive income transfers and low income inequality. On the other hand, both of those countries have been aggressive neoliberal reformers, and so part of their success is despite their high tax burdens.
There is some evidence that the high-tax European model may eventually lose out to the low-tax/high-saving economy, the kind one observes in Singapore. The graph in Figure 1 shows the relationship between per capita GDP and the Heritage Index of Economic Freedom, including size of government. I included all sizable countries with GDPs exceeding $23,000/person (PPP), except for a few small Middle Eastern oil producers and Luxembourg (which was literally off the charts).
There are two obvious outliers. Norway, the highest-income country, is much richer than other countries with similar levels of economic freedom, and New Zealand, at 80 on the economic freedom scale and only $27,260 in per capita income (US PPP dollars), is somewhat poorer than expected. Norway's position is almost certainly attributable to its vast oil wealth. Perhaps New Zealand's disappointing performance is due to its remote location and its comparative advantage in agriculture holding it back in an increasingly globalized economy in which many governments subsidize farming. But other than those two exceptions, there is a close relationship between economic freedom and income per capita. Although developed countries tend to have large governments, the very richest have smaller governments than the next tier. The lowest tier consists of relatively statist economies such as Greece. And the wealth gaps are set to widen over time. Countries with relatively small government sectors, such as the United States, Australia and Canada, are expected12 to modestly outgrow Western Europe and Japan over the next few years, even in per-capita terms. And extremely low-tax Singapore and Hong Kong are likely to dramatically outperform Western Europe and Japan.
For a podcast with Scott Sumner on neoliberalism, see Sumner on Growth and Economic Policy. EconTalk, June 21, 2010.
Singapore is able to combine universal health care with extremely low taxes and large budget surpluses. The government does this by requiring workers to self-insure for retirement, unemployment and non-catastrophic medical expenses. This economic model provides much greater incentives for wealth creation and may explain why Singapore leads the world in millionaires per capita (roughly 11 percent of the population and rising fast13). As Europe struggles with its enormous public-debt challenges, this sort of small government/high-saving model will look increasingly attractive.
This group usually comprises the four Scandinavian countries (Sweden, Denmark, Norway and Iceland), Finland, and the Netherlands.
Purchasing power parity adjusts for cost of living differences between countries. Because non-traded goods such as haircuts are often quite inexpensive in poorer countries, data that are not adjusted for purchasing power differences will tend to understate the real income of low-income economies.
See "Soviet Soviet Growth and American Textbooks". David M. Levy and Sandra J. Peart, working paper, Dec. 3, 2009.
Philip Booth, ed., Were 364 Economists All Wrong?, London: Institute for Economic Affairs, 2006. PDF file.
My view here is obviously somewhat subjective. Interested readers might wish to examine Wikipedia's extensive entries for "neoliberalism" and "socialism." The neoliberalism entry is packed with many recent examples of economic reform in almost every type of economy, from the former Soviet bloc to the developing world to the welfare states of Western Europe. In contrast, the entry on socialism has a very dated feel. With a very few exceptions such as Venezuela, most of the examples are quite old, such as the 1946 Labour Party reforms of the British economy.
Sumner, Scott. "The Great Danes: Cultural Values and Neoliberal Reforms." (unpublished, 2008).
The cultural attitudes indicator is the average of two indices: (1) Transparency International's Corruption Index, and (2) survey results from the question, "Under what circumstances is one justified in accepting government benefits to which one is not entitled?"
The 1980 and 2005 data are from a ranking of economic freedom done by the Fraser Institute.
This is based on economic growth forecasts for 2010 and 2011 from the consensus forecasts in The Economist, June 12, 2010.
Frank, Robert. "Millionaire Population Bounces back to Pre-Crisis Peak." The Wall Street Journal, June 11, 2010.