Clearing A Path To Economic Freedom

Thursday, September 10, 2020
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Editor’s Note: This is an excerpt from a fuller essay by Mr. Taylor, titled "Obstacles To Free-Market Capitalism That Help Make Way For Socialism." It is published by the Hoover Institution as part of a new initiative, "Socialism and Free-Market Capitalism: The Human Prosperity Project."


In Choose Economic Freedom, a book George Shultz and I published this year, we explained why one must choose a path that opposes socialism. Economic freedom, or free market capitalism, the term of art used in the Hoover Institution’s important Human Prosperity Project, means a rule of law, predictable policies, reliance on markets, attention to incentives, and limitations on government. Socialism, on the other hand, means arbitrary government actions replace the rule of law, policy predictability is no virtue, central decrees can replace market prices, incentives matter little, and government does not need to be restrained.

Choosing economic freedom is difficult. Obstacles have arisen and will arise again, and policy makers must be on guard to remove them. Such impediments were common in the 1950s and 1960s and grew worse in the 1970s, subsiding under President Reagan’s obstacle-clearing policies. Today we hear renewed calls for government interventions and restrictions. Some spring from the effects of the terrible coronavirus, but others began earlier: calls for occupational licensing, wage and price controls, and government interventions in trade and supply chains. Even the Business Roundtable weighed in last year with a statement calling on management to look at the interests of a broader set of stakeholders, a big change from its 1997 statement affirming that management’s principal duty is to stockholders.

Since the demise of the Soviet Union, real-world case studies showing the harms of excessive government intervention and central planning seem to have been forgotten. It’s understandable that students in my Economics 1 class at Stanford might not know about the harms of deviating from market principles: they were born long after the Soviet Union ceased to exist. “Why do we need to study market economics anymore?” they sometimes ask. “With artificial intelligence and machine learning, government can allocate people to the best jobs and make sure they get what they want.” Some students in Stanford’s MBA program even question the importance of profits. Teaching economic history has never been more important.

Two kinds of obstacles stand in the road to free market capitalism. First are claims that first principles of free market capitalism are wrong or do not work. Many made such claims in the 1940s and 1950s, when communist governments were taking hold and socialism was creeping in everywhere. Today these claims have been revived in criticism of free market capitalism as a way to improve standards of living. Second are obstacles to bringing ideas into action—political barriers to implementing the principles of economic freedom. This second set is evident in renewed calls by politically powerful vested interests for restrictions on school choice and for government interventions.

Return to Economic First Principles

How do we deal with doubts about the value of free market capitalism? Many economists tackled this problem in the past, and their work still stands. But we need to go further.

Milton Friedman wrote in 1994 in his introduction to the fiftieth anniversary edition of Friedrich Hayek’s Road to Serfdom that the book remained “essential reading for everyone seriously interested in politics in the broadest and least partisan sense, a book whose central massage is timeless, applicable to a wide variety of concrete situations. In some ways, it is even more relevant to the United States today than it was when it created a sensation on its original publication in 1944.” Hayek wrote:

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 . . . and to plan one’s individual affairs on the basis of this knowledge.

Hayek set out to contrast the benefits of market-determined prices and the incentives they provide with central planning and government-administered prices. In his 1945 American Economic Review article “The Use of Knowledge in Society,” he explained the value of markets, saying that

the “data” from which the economic calculus starts are never for the whole society “given” to a single mind which could work out the implications and can never be so given.

Milton Friedman, writing in the New York Times in 1994, said, “The bulk of the intellectual community almost automatically favors any expansion of government power so long as it is advertised as a way to protect individuals from big bad corporations, relieve poverty, protect the environment, or promote ‘equality.’ . . . The intellectuals may have learned the words, but they do not yet have the tune.”

We can build on these ideas. I have long taught the basic Principles of Economics course at Stanford. It emphasizes the costs as well as the benefits of government programs, that government failure—not just market failure—is a reality, that there are private remedies to externalities, that the rule of law needs to be front and center if markets are to work, and that monetary and fiscal policy rules are good for both economic efficiency and liberty. I find it helpful to start with a series of participatory markets, or “double auctions,” based on the innovative work of Vernon Smith and Charles Plott. Here students see how buyers and sellers set prices in a market and how prices serve as signals and provide information. This approach automatically introduces ideas such as consumer surplus and profits. Only then comes the model of supply and demand to explain and interpret these outcomes. The approach reinforces the ideas in Hayek’s American Economic Review article, including the concept that prices cannot be set at the center.

With the Soviet Union a fading memory, the case studies many of us used to illustrate the harms of central planning are sometimes obscure to students. It helped, for example, to show a famous cartoon from the Soviet satirical magazine Krokodil mocking how a Soviet production plant could fulfill centrally imposed plans by producing one useless 500-pound nail rather that 500 one-pound nails, as Elaine Schwartz explained in Econlife. It’s important to update such stories and make them memorable for students, as David Henderson does in his Joy of Freedom: An Economist’s Odyssey.

There are also valuable new data sets that help communicate more widely the benefits of economic freedom: the Index of Economic Freedom, published by the Heritage Foundation; the Economic Freedom of the World index from the Fraser Institute; and Doing Business, published by the World Bank. Research gives a powerful glimpse at what works and what doesn’t: good and bad economic outcomes correlate with good and bad policy.

Now to Take Action

Even if we disproved all claims against the principles of economic freedom, there would still be obstacles to carrying them out. As I wrote in my book First Principles, “To get the job done, they [public officials] not only have to be clear about the principles but also have to explain them, fight for them, and then decide when and how much to compromise on them.” Or, as Friedman once wrote, “It is only a little overstated to say that we preach individualism and competitive capitalism, and practice socialism.” Here are a few of the successes and failures in removing such obstacles.

Part of Milton and Rose Friedman’s Free to Choose focuses on implementing the ideas of economic freedom through offering vouchers for students to attend alternative private or charter schools. “The perceived self-interest of the educational bureaucracy is the key obstacle to the introduction of market competition in schooling,” the Friedmans write. To confront and eventually remove that obstacle, they founded the Friedman Foundation for Educational Choice, now known as EdChoice. It advocates for, and provides data on, school choice programs around the United States. Results and practical information are provided in its book The 123s of School Choice.

Milton Friedman’s Capitalism and Freedom argues for the importance of the international monetary system to the principles of economic freedom. He makes the case for an international system with open capital markets; flexible exchange rates between countries or blocs, with no intervention; and rules-based monetary policy. Many obstacles exist to the implementation of such a system and are yet to be removed. In recent years, capital controls for developing countries have been supported by the International Monetary Fund. To some extent, these developments are a reaction to increased capital flow volatility caused by unconventional monetary policy actions, so they could naturally be removed by a return to rules-based policy. The 2018 report of the Eminent Persons Group on Global Financial Governance—on which I served—called for the eventual end of capital controls, and I hope the recommendation will be helpful in their removal. One promising finding, in research I reported elsewhere, is that a global rules-based monetary system could emerge—in the fashion of Hayekian “spontaneous order”—if each central bank around the world simply followed its own rules-based monetary policy and was transparent and accountable about doing so.

Another idea from Capitalism and Freedom is very specific: “Best is a flat-rate tax on income above an exemption.” Such a proposal would satisfy the principles of economic freedom, and the book clearly explains why. Despite bouts of tax reform around the world, we are still far from such a flat-tax system. Even so, the 2017 Tax Cuts and Jobs Act advanced reform, trimming the corporate tax rate from 35 percent to 21 percent, cutting the tax rate on small businesses, creating a territorial tax system, and expanding the tax base by reducing the federal deduction for state and local taxes. The changes reduce the cost of capital and thus should raise investment, productivity, and people’s incomes.

“A veritable explosion in government regulatory activity . . . all have been antigrowth.”

These phrases from Free to Choose are a rallying cry for obstacle removal. Removing regulations and relying on markets in a solid cost-benefit manner is clearly consistent with the principles of free market capitalism, yet there have been a host of impediments to reform, often from special interests that benefit from regulations. Again, keeping track of the obstacles removed and documenting the gains is essential if more obstacles are to be eliminated. Recent changes in regulatory activity in the United States suggest progress. The Congressional Review Act of 1996 has been used to eliminate regulations and the Economic Growth, Regulatory Relief, Consumer Protection Act of 2018 lifted the threshold for stress test regulation from $50 billion to $250 billion. Legislation such as the Financial Institution Bankruptcy Act (Chapter 14) is still needed to end bailouts and the “too big to fail” problem.

“Defusing the Debt Explosion,” a chapter in First Principles, explains the need for a fiscal policy rule with budget balance over the cycle and suggests ways to reduce spending increases. These ideas have long been consistent with the principles of economic freedom and have taken various forms, including constitutional limits on the rate of government spending growth. But the obstacles appear immovable and have even been increasing: the growing federal spending and debt problems are nowhere near containment. Yet as John Cogan, Daniel Heil, and I show, it’s not too late for a change in fiscal policy that slows the growth of federal government spending without increasing taxes.

Staying the Course

Many obstacles have stood in the way of free market capitalism. Some have been scaled down over the years—through recent reductions in tax rates and cuts in regulations, for example—but others remain in areas such as the growing deficit. Meanwhile, the Covid-19 pandemic and the public health imperatives driving government policy bring fresh challenges. We must develop a strategy that does not override markets—one that focuses on removing barriers to free market capitalism and thus avoids socialism. This demands a special emphasis on the private sector and markets.

In short: keep markets free and open—and let new markets be created—and fight to remove the obstacles that could pave the way toward socialism.