June 6, 2012

Jumpstart the Economy!

Return to first principles: limited government, markets, incentives, rule of law, and predictability.

The best way to understand the problems confronting the American economy is to go back to the first principles of economic freedom upon which the country was founded. As these principles developed over the years, we can see periods when careful attention was paid to them and alternating periods when they were neglected. And we can draw clear conclusions from this history: When policymakers stuck to the principles, economic performance was good. When they ignored or compromised on the principles, economic performance deteriorated.

Our problem now is that we are paying too little attention to these principles, and even worse, we are moving in the wrong direction. The good news is that if we begin to apply these principles to our current circumstances, we can restore America’s prosperity and our confidence in the future.

 first principles by john b. taylor  
 Photo credit: Norton

At its most basic level, economic freedom means that families, individuals, and entrepreneurs are free to decide what to produce, what to consume, what to buy and sell, and how to help others. The American vision was that those decisions would be made within a predictable government policy framework based on the rule of law with strong incentives derived from the market system and with a clearly limited role for government.

The principles of economic freedom are naturally intertwined with political freedom—speech, press, assembly, religion. Excessive government interventions and economic controls will tend to constrain people’s freedom to speak out or take public political positions for fear of retribution through more interventions and controls. The loss of political freedom can in turn reduce economic freedom further.

One of the most amazing things about these defining principles of economic freedom . . .

—predictable policy framework

—rule of law

—strong incentives

—reliance on markets

—clearly limited role for government

. . . is that they also constitute a set of principles for economic success. Economic theory and experience show that they lead to superior economic outcomes, including strong economic growth and rising prosperity. The principles of liberty that Thomas Jefferson and the other founding fathers first delineated in the Declaration of Independence in 1776 are remarkably similar to the principles of economics that Adam Smith first heralded in the Wealth of Nations in the same year, and that remain central to economics today.

Markets, incentives, and a carefully delineated role for government are the main pillars of basic economics courses and texts, including the introductory course I’ve taught college students for years and my textbook Principles of Economics. In a market economy, most decisions about what to produce, how to produce it, and for whom it is produced are made by individuals, firms, and organizations interacting in markets. Prices in those markets signal what goods and services people want, and the prices create incentives to produce those goods and services.

The principles of economic freedom are also those of economic success.

For instance, a greater demand for healthy foods increases their price and thereby gives firms the incentive to produce more healthy foods. The higher price also provides incentives to people to invent new healthier (and perhaps even tastier) foods and to create firms to sell the new products.

The higher wages paid for skilled labor offer people the incentive to become skilled, whether by staying in school or by learning on the job. As they respond to these incentives, people who become more skilled are frequently led by Adam Smith’s “invisible hand to promote” the interests of society through more effective medicines, more entertaining movies, or more efficient search engines. When greater economic freedom increases opportunities to trade at home and abroad, the existing incentives expand and economic prosperity increases. Lower income tax rates increase incentives by raising the benefits (higher incomes) one gets from investing in education or a start-up business.

The foundational economic principles recognize a role for government in providing public goods such as national defense, maintaining the environment, protecting individual rights and liberties, and creating a social safety net for those who are poor or disabled. But when assigning these and other roles to government, we must clearly define their extent, we must take into account both benefits and costs, and we must explain the case for a government role rather than a market-based solution. We must also recognize that government programs can fail, sometimes because they give power to people who favor entrenched interests. Indeed, Adam Smith railed against the power of mercantilist government officials in England who unfairly transferred wealth to themselves or their small group of friends, actions that perversely prevented the creation of wealth by the multitude of people through the free exchange of goods within and between countries. We see these same moral sentiments today in populist complaints about crony capitalism where government, in the name of picking winners and losers, is actually picking friends and enemies.

America’s founders stressed these same principles of markets, incentives, and limited government. In the Declaration of Independence, they denounced the authoritarian monarchy “for cutting off our trade with all parts of the world” and “for imposing taxes on us without our consent.” They clearly had incentives in mind when they put clause 8 into Article I, Section 8, of the Constitution: “To promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries.”

Of course, they recognized the role of government “instituted among men” to secure the rights of “life, liberty and the pursuit of happiness,” as Thomas Jefferson memorably put it. They relied on many checks and balances to limit the power of government officials, and in the Tenth Amendment they explicitly limited centralized power: “The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.”

The Special Importance of Predictability and the Rule of Law

The two principles I put at the top of the list—policy predictability and the rule of law—are sometimes given less emphasis than markets, incentives, and limited government. Yet they are just as important. Indeed they have grown in importance.

Seventy years ago Friedrich Hayek wrote, in The Road to Serfdom, that

nothing distinguishes more clearly conditions in a free country from those in a country under arbitrary government than the observance in the former of the great principles known as the Rule of Law. Stripped of all technicalities, this means that government in all its actions is bound by rules fixed and announced beforehand—rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge . . . [T]he discretion left to the executive organs wielding coercive power should be reduced as much as possible.

Similarly in his 1962 classic Capitalism and Freedom, Milton Friedman argued for economic policies based on “a government of law instead of men,” explaining its commonality with the arguments for “the first amendment to the Constitution and, equally, to the entire Bill of Rights.”

In the time since Hayek and Friedman wrote their books, we have learned much more about the advantages of rules and predictability, especially in the modern world of high technology and fast-moving news and markets. If people are forward-looking and adjust their behavior to new circumstances, then economic policy works best when formulated as a rule. Government’s adherence to known rules allows people to have a clearer sense of what is coming, and therefore to make more informed decisions about long-range plans.

A commitment to a reasonably sound rule is preferable to discretionary policies.

Setting out a sensible rule and sticking to it also helps policymakers resist interest-group pressure. Rather than having to consider the merits of every special-interest plea for more government support, a rule can set a standard that applies to all cases and limits the role of government broadly. Rules can also avoid overreactions to short-term blips in the economy. They allow people to exercise their freedom and their judgment, and enable their leaders to keep their eyes on long-term goals.

Economists Finn Kydland and Edward Prescott won the Nobel Prize for showing that discretionary policies produce poor results by denying people the benefits of policy commitments. Such government commitments are needed for the proper functioning of a market economy. A commitment to a reasonably sound rule—even if it is very far from a perfect rule—is thus preferable to discretionary policies. Highly discretionary policy creates uncertainty and limits the ability of market participants to plan. It also tends to distort market behavior, driving it toward inefficient short-term responses.

Economist Robert Lucas, who was also awarded a Nobel Prize, developed a subtle yet key argument for predictability of policy and for the rule of law. He showed that clear policy rules are needed to determine how an economic policy would work. Since people’s expectations are heavily dependent on future policy, effective evaluation of the policy requires stipulating not only what the policy will be today but also what it will be in the future. A policy rule or law does just that. In contrast, the evaluation of discretionary policies breaks down because people do not know what they imply for the future.

Defining Principles in Practice

No bright line can determine whether or not a particular policy satisfies the principles of economic freedom. The degree to which the principles are applied in practice depends on how they are interpreted and on how they are perceived to work in practice. Their application to particular issues depends on the commitment and motivation of government officials and on both internal and external constraints. And some policies may look good according to one criterion but look terrible according to the others, and would thereby fail miserably to satisfy the principles. Prohibition was made a rule of law by the Eighteenth Amendment to the Constitution, but its restrictions on buying and selling alcohol, unpredictable enforcement, and intrusion of government proved to be a disaster for the country.

When policymakers lean in the direction of economic freedom, they pursue less interventionist, more predictable, and more systematic policies. In the area of fiscal policy, legislators and executive-branch officials set long-term policies for spending and revenues consistent with a balanced budget; they rely on the automatic responses of tax revenues to fall in recessions and transfer payments to rise in recessions through programs built into the law—the so-called built-in stabilizers or automatic stabilizers—to help prevent and moderate booms or busts in a predictable way; they try to avoid short-term Keynesian discretionary interventions. In monetary policy, central-bank officials adhere to steady-as-you-go policies and rules for setting the amount of money in circulation and adjusting the interest rate to maintain the purchasing power of the currency.

In regulatory policy, government officials set clear rules based on what works and what doesn’t, and regulators enforce those rules rather than use their power to deviate from them to help certain well-connected people or businesses. In safety-net and education programs, they tend to devolve decisions to state and local governments, where costs and benefits can be better assessed with on-the-ground knowledge. They worry about providing the right incentives to work or to save. More generally, when economic freedom is a guiding principle, the role of government is limited to areas where the market cannot do the job alone, such as national defense and justice, and is assigned when appropriate to state and local governments.

In contrast, when policymakers neglect economic freedom, they pursue less systematic, more interventionist policies; rather than long-lasting reform, they use temporary discretionary actions, which make it nearly impossible “to foresee with fair certainty,” à la Hayek, future policy actions. Fiscal policy focuses on temporary and targeted stimulus programs, the goals of which are usually to produce a short-term gain with less concern about long-term sustainability. Monetary policy seeks to influence or respond to momentary economic fluctuations without a long-term strategy. Public policies to educate and assist people in need tend to be drawn into more powerful central government bureaucracies and away from towns and communities, where people know more and have more ability to vote with their feet. 


John B. Taylor is the George P. Shultz Senior Fellow in Economics at the Hoover Institution and the Mary and Robert Raymond Professor of Economics at Stanford University. He was previously the director of the Stanford Institute for Economic Policy Research and was founding director of Stanford's Introductory Economics Center. He has a long and distinguished record of public service. Among other roles, he served as a member of the President’s Council of Economic Advisors from 1989 to 1991 and as Under Secretary of the Treasury for International Affairs from 2001 to 2005.


Reprinted from First Principles: Five Keys to Restoring American Prosperity by John B. Taylor. Copyright © 2012 by John B. Taylor. With the permission of the publisher, W.W. Norton & Company, Inc.

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