Is Decline in Economic Freedom Responsible for Dismal U.S. Economic Growth?

by the Curmudgeon

Introduction:

I usually disagree with whatever Barron's ultra permabull Gene Epstein writes, but not this week. In his column titled, What Really Killed Economic Growth (print) /The Slow Economic Recovery Has a Surprising Culprit (online), Epstein sees a causal connection between the trend in economic growth and in the Fraser Institute’s Index of Economic Freedom. The latter consists of five components: measures of regulation, the rule of law, the size of government, the soundness of money, and openness to trade.

Here's a very interesting chart (not shown in Barron's) that depicts Economic Freedom vs Economic Growth for countries in four distinct quadrants:

Fraser’s Index of Economic Freedom for the U.S has plunged since 2000 to a level comparable to 1970. That decline has coincided with very weak U.S. economic growth. Private-sector GDP growth in the George W. Bush and Barack Obama expansions were the slowest on record (yet the stock market has soared to new all-time highs!).

Epstein doesn't explain why there is a correlation between the decline in economic freedom and growth. He simply says, “that confirms the view that the decline in economic freedom since 2000 is the main cause (of dismal economic growth)—a view that has important policy implications.” He doesn't even quote from the press release announcing the 2014 Annual Report. We do so here:

“The United States, once considered a bastion of economic freedom, now ranks 12th in the world, tied with the United Kingdom.”

“The United States has suffered from a weakened rule of law, the ramifications of wars on terrorism and drugs, and a confused regulatory environment. Consequently, it’s dropped from second place in the world rankings in 2000 to 12th place this year, behind countries such as Jordan and the U.A.E.,” said Michael Walker, Fraser Institute senior fellow and co-founder of the Economic Freedom of the World project.

Declining U.S. Economic Freedom Explained:

From the 2014 Economic Freedom of the World (EFW) Annual Report:

“Throughout most of the period from 1980 to 2000, the United States ranked as the world’s third freest economy, behind Hong Kong and Singapore...By 2005, the US rating had slipped to 8.20 and its ranking fallen to 9th. The slide has continued. The United States placed 15th in 2010 and 16th in 2011 before rebounding slightly to 14th in 2012. The 7.81 chain linked rating of the United States in 2012 is more than 8/10 of a point lower than the 2000 rating.”

“What accounts for the US decline? While U.S. ratings and rankings have fallen in all five areas of the EFW index. The reductions have been largest in the Legal System and Protection of Property Rights, Freedom to Trade Internationally, and Regulation. The plunge in the first area listed has been huge. In 2000, the 9.23 rating of the United States was the 9th highest in the world. But by 2012, the area rating had plummeted to 6.99, placing it 36th worldwide.”

“Expanded use of regulation has also been an important contributing factor to the declining ratings of the United States. During the past decade, non-tariff trade barriers, restrictions on foreign investment, and business regulation have all grown extensively. The expanded use of regulation in the U.S. has resulted in sharp rating reductions for components such as independence of the judiciary, impartiality of the courts, and regulatory favoritism. To a large degree, the U.S. has experienced a significant move away from rule of law and toward a highly regulated, politicized, and heavily policed state.”

The decline in the summary economic freedom rating between 2000 and 2012 on the 10-point scale of the index may not sound like much, but scholarly work on this topic indicates that a one-point decline in the EFW rating is associated with a reduction in the long-term growth of GDP of between 1.0 and 1.5 percentage points annually (Gwartney, Holcombe, and Lawson, 2006).

“This implies that, unless policies undermining economic freedom are reversed, the future annual growth of the U.S. economy will be only about half its historic average of 3%.” Hence, Epstein says the decline in U.S. economic freedom has “important policy implications.”

Continued Subpar Economic Growth in 2015?

According to a Saturday NY Times article, Fed researchers only expect 1.55% economic growth in 2015!

In a July 17^th note to subscribers, ShadowStats John Williams wrote:

"New" Recession Remains in Play—a Virtual Certainty—But Broad Recognition of Same Still May Be a Couple of Months Out.”

“The U.S. economy never has seen such a weak six-month period of growth, in industrial production and real retail sales, without being in recession...I had expected by the now-rapidly-approaching end of second-quarter economic reporting that two other key elements of the U.S. economy would be faltering clearly, as well, specifically foreign trade activity and housing-sector activity. Such reporting would have moved market expectations towards a much-weaker initial second-quarter 2015 GDP reporting than now is likely, along with early recognition of the "new" recession. Broad recognition of the recession probably is now several months off.”

The reported real 1^st quarter 2015 GDP is a shallow, annualized contraction of -0.17%. We are anxiously awaiting this Thursday's (July 30^th) benchmark revision, along with the 2nd quarter 2015 GDP estimate.

Acknowledgement:

Many thanks to Brent Berarducci http://www.blacklioncta.com/ for tipping me off to the referenced Barron's article.

Good luck and till next time...

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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