Commentary

Why Latin America Needs a Free-Trade Zone

At the Summit of the Americas in Quebec City, the Hemisphere’s leaders may at last give serious consideration to the establishment of free trade from Argentina to Alaska. But the meeting will also give critics an opportunity to cite economic uncertainty and political instability in much of Latin America as a reason to oppose the trade initiative. With the Andean region from Venezuela to Bolivia in varying degrees of turmoil, and with Argentina on the brink of possible default, trade liberalization is under attack.

Yet, more than ever before, sustained economic progress depends upon sound policies and institutions. For the last five years, we have annually constructed an economic freedom index, which rates countries’ policies against free-market principles (for example, small government, low taxes, sound money, secure property rights and free trade). Our Economic Freedom of the World: 2001 Annual Report ranks more than 120 countries. The report confirms Adam Smith’s insight that trading partners in rich and poor countries alike can achieve higher income levels through gains from specialization and large-scale production. Free economies have indeed grown more rapidly and achieved higher income levels than less free economies.

This year’s report also includes a more comprehensive index for a smaller set of 58 nations for which we could obtain more detailed data. As in the past, Hong Kong was rated the most economically free jurisdiction in the world, followed by Singapore, United States, New Zealand, United Kingdom, Ireland and Canada. Chile (tied for 16th with Germany) was the highest ranked Latin American country. Argentina ranked 30th, Mexico 42nd, and Brazil 55th. The economies of Venezuela, Ukraine, and Russia were the least free among the 58.

Our index helps explain some of Latin America’s maladies. For example, a legal system capable of protecting property rights and enforcing contracts in an even-handed manner is central to both economic freedom and progress. Indeed, the sustainability of economic reforms rests largely on the application of the rule of law. The freedom to compete in business is also central to economic progress. Yet Latin American countries rank extremely low in both areas.

Seven of the 10 lowest rated countries in the legal area — El Salvador, Colombia, Mexico, Bolivia, Venezuela, Ecuador and Peru — were Latin American. The situation was much the same in business regulation, where six Latin American countries — Colombia, Argentina, Bolivia, Ecuador, Mexico and Venezuela — ranked in the bottom 10. Among the 58 countries in our comprehensive index, Chile was the only Latin American nation in the upper half in either of these two areas.

Given the Andean countries’ prominence on the lower end of these rankings, the region’s current instability is more understandable. For example, Peru moved swiftly toward the free market in the early 1990s, as did several Latin American countries that privatized enterprises, lowered trade barriers and removed investment restrictions. But Peru’s judicial system and the rule of law remained weak during Alberto Fujimori’s personalist, 10-year rule. The present rise of populist, left-wing candidates as leading contenders for the presidency should not surprise us, then. When Mr. Fujimori fled Peru in the wake of corruption scandals, he left behind a citizenry that mistakenly attributes lackluster economic performance to market reforms. That development is particularly unfortunate in a country with no institutional structure to sustain the reforms that were implemented.

Likewise, Argentina has only gone partially down the path of economic freedom, despite having introduced dramatic reforms a decade ago. As in Peru, Argentina’s political system lost interest in liberalization by the mid- 1990s. Its regulatory environment continues to discourage economic growth and job creation. For instance, the country’s Mussolini-inspired labour regulations are completely out of step with a modern economy, raise the cost of hiring workers, and are directly responsible for Argentina’s chronically high unemployment rate of 14%. Here, too, lack of reform has produced diminishing returns and pushed the country toward crisis.

Still, the region is far better off now than during the inward-looking policies of the lost decade of the 1980s. Latin America’s gains in economic freedom have increased growth and lowered poverty levels. From 1987 to 1998, for example, 7% growth has allowed Chile to reduce its poverty rate from 45% to 22%.

A hemispheric free trade zone would provide indirect benefits that go beyond immediate increases in growth and prosperity because trade openness makes the pursuit of unsound policies costly. When economies are open, both entrepreneurship and investment capital will flee countries that insist on imposing high taxes, restrictive regulations and inflationary monetary policy. This potential exodus constrains the actions of political leaders. It imposes what Thomas Friedman, in The Lexus and the Olive Tree, refers to as a ‘golden straitjacket.’

A Free Trade Area of the Americas will thus discourage bad policies in a region where growth continues to be stifled by a legal and regulatory environment that is prone to play favourites, protect existing firms, and impose a heavy regulatory burden. Hong Kong and Singapore show that openness and economic freedom are complementary. Indeed, the two jurisdictions are the most open and most free economies in the world. The relationship between openness and sound policies is no coincidence. When both trade and capital are free to come and go, political leaders have a strong incentive to follow sensible policies.

It is time to give political leaders a strong incentive to adopt policies that are more consistent with price stability, rule of law, and other dimensions of economic freedom. A Free Trade Area of the Americas will not only increase the competitiveness of markets, it will also increase competitiveness among political jurisdictions. Given the critical need for meaningful reform in Latin America, this might well be the primary benefit derived from free trade in the Americas.

James Gwartney is co-author of Economic Freedom of the World amd Ian Vasquez is director of the Project on Global Economic Liberty.