The Poor Fare Best Under Free-Market Capitalism

By Edward P. Lazear

Wednesday, September 09, 2020

 

President Trump and former vice president Biden have different visions of the country’s future. President Trump, during a recent event in Wisconsin, charged, “Joe Biden is just a Trojan horse for socialism.” Although it is unlikely that a President Biden would turn the U.S. into a socialist state, Mr. Biden has made it all too credible that he will move the country leftward if elected president. He stated in early July, “It’s way past time to put an end to the era of shareholder capitalism.” He chose as his running mate Kamala Harris, who has the most liberal voting record in the Senate. He joined with self-declared socialist Bernie Sanders to issue “Unity Task Force Recommendations,” which Mr. Sanders describes by saying, “If those task force proposals are implemented, you know what, Joe Biden will become the most progressive president since Franklin Delano Roosevelt.” Who would benefit from the more progressive agenda that is suggested by Mr. Biden’s actions and words?

 

Advocates of free-market capitalism extol the growth that the system produces and its freedom of choice over work and consumption. Detractors protest that capitalism is harsh and leaves too many behind. The market ignores hardships that afflict normal people through no fault of their own.

 

The issue is primarily an empirical one. Do market economies grow faster than those with a heavier governmental footprint, and if so, do the poor benefit sufficiently as those economies grow? My recent research suggests that market economies generate substantially higher living standards for the poor than do government-dominated systems. A country’s lowest earners fare best when markets are allowed to work, when the means of production are privately owned, and when government’s role in economic activity is limited.

 

Data on standard of living and economic freedom from as many as 161 countries over the last few decades demonstrate that rich and poor alike are economically better off in countries that have free-market economies. One measure of capitalism is the rank of a country on the Fraser Economic Freedom Index, which is a composite of indexes that reflect the use of markets, the lack of regulation, the openness of the economy, and private ownership of capital. Countries that score highest on this index include Singapore, Switzerland, the United States, Ireland, and the United Kingdom. Venezuela has the lowest ranking of all countries on the index. There are a number of similar indexes, which are highly correlated with one another, and the conclusions are insensitive to the choice of index.

 

The evidence that free markets enhance the well-being of the poor is compelling. Define the rich as the uppermost 10 percent and the poor as the lowest 10 percent of a country’s earners. In countries that rank in the top half on the Economic Freedom Index, the rich have incomes that are on average almost three times as high as the rich in countries that rank in the bottom half of the index. But more striking is that in the free-market half of countries, the income of the poor is almost six times higher than in the more restrictive half. What’s more, within the ranks of the wealthiest half of countries, the poor are more than twice as well off in those that are freer and more market-oriented.

 

General economic growth tends to benefit all. The income data show conclusively that, as President Kennedy was fond of saying, a rising tide lifts all boats. Among the 161 countries studied, periods of high-income growth for the rich also tend to be periods of high-income growth for the poor. In 82 percent of the ten-year periods during which wages of the rich grew, so too did wages of the poor. Conversely, the wages of the poor tended not to grow during periods when wages of the rich declined. The movement is general. A 1 percent rise in median income is associated with just over a 1 percent rise in income of the poor and just under a 1 percent rise in income of the rich. The historical record suggests that the poor do not get left behind as economies grow.

 

Despite the strong statistical relationship between wages of the rich and poor, the movement is not in lockstep. Sometimes the incomes of the richest members of an economy increase more rapidly than those of its poorest members. This has led some to conclude, incorrectly, that rising inequality implies falling or stagnant incomes of the poor. Economic development is often marked by increased disparity between incomes of the rich and poor, even as the standard of living of the poor rises substantially. Hong Kong’s rapid growth from 1960 to 2000 is a case in point. In 1960, the rich earned about 20 times as much as the poor. By 2000, that ratio had risen to 33. At the same time, though, the income of the poor increased fivefold, making the Hong Kong poor of 2000 far better off than the poor of the earlier generation. More recently, Vietnam experienced a similar pattern. In 2000, the rich earned 27 times as much as the poor. Vietnam experienced rapid growth after that, and the ratio of rich to poor earnings rose to 33. But the income of the poorest Vietnamese went up two and a half times over those years.

 

One surprising finding from my study is that changing a country’s name to eliminate the terms “socialist,” “democratic,” or “people’s” is associated with an 18 percent rise in incomes of the poor over the subsequent years. Of course, it is not the name change per se that helps the poor, but the change in the form of government and the adoption of more market-oriented institutions that accompanies the name change.

 

The Nordic countries (Denmark, Finland, Norway, and Sweden) are market economies that have large government budgets and engage in substantial redistribution. Unsurprisingly, the evidence implies that transfers do have a positive effect on the disposable incomes of the poor—at a point in time. If a country decides to transfer resources to the poor, then the poor will have more to spend. Still, a number of considerations are relevant. First, redistribution is a luxury that only wealthy countries can afford. There is a close correlation between a country’s wealth and the amount that its citizens transfer to the poor. Countries that rank in the top half in terms of transfers and subsidies are almost three times as rich, as measured by median income, as countries that rank in the bottom half. Second, the effect of increasing economic freedom on raising incomes of the poor is typically greater than that of direct transfers to the poor. Third, as I have argued before, high government spending is an impediment to general economic growth and high income in the future. Even countries such as Denmark and Finland, with high living standards but also high government spending, have experienced slow growth over the past decade. Finally, redistribution, which every wealthy country implements to some extent, is a temporary patch. It does not provide a fundamental long-term remedy for raising incomes of the poor. To raise incomes over the long run, it is necessary to improve the productivity of the lowest half of wage earners, as I have found in other research. Redistribution, while serving an immediate humanitarian goal, does nothing to improve worker productivity, on which wages ultimately depend.

 

Incomes of the poor are higher and grow more rapidly under free-market capitalism than they do in economies with less private ownership, more restrictions on trade, and a greater governmental role in allocation. If a system’s benevolence is measured by the living standards of the poor, then free-market capitalism receives high marks.