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First Principles: Five Keys to Restoring America's Prosperity

Thursday May 2012


About the Author

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the George P. Shultz Senior Fellow in Economics at the Hoover Institution. He is director of the Stanford Introductory Economics Center. He formerly served as director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow.

He served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, and as a member of the President's Council of Economic Advisers from 1989 to 1991. For four years from 2001 to 2005, Taylor served in the Department of the Treasury as undersecretary for international affairs. He was responsible for currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the IMF and the World Bank.

Previously, Taylor was a professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

Event Transcript

by Paul Gigot, Wall Street Journal

It's my privilege to be able to introduce John Taylor, the winner of this year's Hayek Prize, and in my view, the most important economist on the planet. I mean that as a compliment.

Economists may be held at minimum high regard by most Americans, somewhere above journalists and members of congress, but that has nothing to do with John Taylor, who is a true heir to Stigler, Schumpeter, Friedman, and Hayek. One thing to appreciate about John is that he has managed to get tenure at Stanford University while being a free market economist. No small feat.

As you may know, John is so highly regarded as a monetary economist that he has a rule named after him. The Taylor Rule is intended as a guide to central bankers so that they can rely less on discretion, which really means the seat of their pants, when determining monetary policy. So great is John's reputation that central bankers now claim to be following the Taylor Rule even when they are not following the Taylor Rule.

For example, in justifying their many monetary interventions, Federal Reserve board members these days routinely say that they are merely following the Taylor Rule. Never mind that the father of the Taylor Rule says that they really are doing no such thing. You might think that this would be a tad embarrassing to the imitators of the Taylor Rule, but the very fact of their imitation is in fact a sign of their admiration. And it underscores, I think, that among monetary economists, John is, if I may use the phrase in polite company these days, the gold standard. I also want to say a few words about John as a monetary practitioner, because this is not as well known as his writing, but I think it reflects the fact that he is not merely a denizen of the ivory tower.

From 2001 to 2005, John served as undersecretary for international affairs of the Treasury Department. And many of you probably do not remember the great Latin American currency crisis of 2001 and '02. You don't remember that crisis because it did not happen. Argentina defaulted on its debt, the contagion quickly spread to Uruguay, and then something wonderful happened. Nothing. There was no crisis. There was no other contagion. That's because in his treasury role, John Taylor rode to the rescue with a currency support package that backstopped the Uruguay peso and stopped what might have been one more in a very long line before and since of monetary crises that spread far and wide, and roiled markets far and wide.

The IMF at the time wanted Uruguay to join Argentina in defaulting on its debt. John said, "No, that probably isn't a good idea." And with a team of folks from the Treasury, he worked with Uruguayan officials to come up with an alternative policy. They stopped the contagion and there was no crisis.

You may also not recall the great Iraq currency crisis of 2003. After the fall of Saddam Hussein, there was no hyperinflation, no food riots, no hoarding of currency. That's because John Taylor planned and executed one of the most successful currency reforms since Ludwig Erhard introduced the Deutschmark in post-war Germany. First John arranged to have Saddam's dollar assets in American banks brought to Baghdad immediately after the invasion to be distributed to the population. That had a calming effect and avoided a collapse of the financial system. Then a few months later, stage two created a new Iraqi dinar that was printed at seven different locations around the world and brought to bear on Baghdad. This had a great success and became the underpinning for Iraq's financial stability.

I don't know about you, but I would like to start grading Treasury officials less on crisis management, and more on crisis avoidance. I'm rather tired of listening to government officials praise themselves for allegedly saving us from crises they either ignored or failed to prevent or in some cases helped to cause. I think we could call that the other Taylor Rule.

For all that John has accomplished in academia and in government, however, I think his most significant work has come in the wake of the financial crisis since 2008. And that has been the utterly vital role, I think, that he's played as a public intellectual in trying to tell us what happened, what went wrong, what were really the causes of the crisis, what policy mistakes we've made, and what we can do about it.

I think one of the lessons of the last few years is that we realize now that there are no permanent policy victories in American politics, particularly on economic policy. Some of the victories that some of us had thought we'd won in the 70s and 80s, we now learn those weren't permanent and we have to relearn those policy lessons. So I think now more than ever, we need men—accomplished men like John Taylor—to help educate us about what works and what doesn't, and how we can get back to the prosperity that we seem to have lost.

I'll finish with a story about John as a teacher. A few years ago, he was teaching a very large basic economics course at Stanford. I guess that's probably about 700 people. And he showed them a chart that displayed—a common chart that you'll see nowadays—that showed the exploding U.S. national debt as a share of GDP: 70 percent, 100 percent, 200 percent, 400 percent, as far as the eye can see. But the chart didn't seem to register with the students. So John told them that he would bring in a guest lecturer at a future class to explain it better to them. And at a future class, John brought in his granddaughter. She was not yet a year old. Holding her in his arms, John explained to the students—Stanford students, brilliant men and women—that this was indeed the guest lecturer. So he put the chart up again, and his granddaughter looked at the chart, and then appeared to be talking with John. Then the two of them turned to the class, and John told them that his granddaughter had said, "Fix it."

So I think we are all very, very fortunate to have John Taylor available at this crucial time in economic history to help us fix it. Ladies and gentlemen, John Taylor.

Why We Still Need to Read Hayek
by John B. Taylor

It is an honor to receive the Hayek Prize for First Principles and a special pleasure to give the Hayek Lecture. The first piece by Hayek I read was his famous "The Use of Knowledge in Society," published in the American Economic Review in 1945. It's a beautiful paper, showing why economic prosperity is best achieved by letting individuals interact together using their unique knowledge sets which people at the top do not have. It is the same paper that Matt Ridley focused on in last year's Hayek Lecture. I recall first reading this paper as a college student, but I have re-read it many times, and I still recommend it.

But today I want to focus on another part of Hayek's work, a part that I came to appreciate much later, after years of research and experience with economic policy. This is his work on policy rules, the rule of law, and the importance of predictability—topics he discusses in The Road to Serfdom and in much more detail in The Constitution of Liberty. I have been interested in policy rules or strategies as a way to make policy for as long as I have been doing economics. I was drawn to this way of thinking because of the kind of dynamic economics I was first taught in college, originally by a young assistant professor E. Philip Howrey. As I will show in this lecture, Hayek's work on these topics goes well beyond economics into fundamental issues of freedom and the role of government. And that is why we need to keep reading Hayek.

First Principles and the Need for a Concrete Reform Strategy

Let me begin with First Principles. It is becoming increasingly apparent that America's economic future is uncertain. The economy is growing slowly. Unemployment is high, especially long-term unemployment. We have just gone through a painful financial crisis and a deep recession, the recovery from which is nearly nonexistent. The federal debt is exploding and threatening our children and grandchildren. In my view the reason for this predicament is very clear: We have deviated from the First Principles of economic freedom upon which America was founded.

As Hayek would insist, we need to be careful about what we mean by economic freedom. The basic idea is that people are free to decide what to produce, what to buy, where to work, how to help others. The American vision was that they would make these choices within a predictable policy framework, based on the rule of law, with strong incentives, emanating from a reliance on markets, and a clearly-limited role for government. Over the years America has adhered to these principles more than most countries. That's why so many people came to America, and why it has prospered as a nation.

But there have been ebbs and flows in the degree to which the principles have been followed, and we can learn from these ebbs and flows. Leading up to the Great Depression, policy deviated from a reasonably predictable policy framework, as the Fed cut money growth sharply. Then the federal government raised tax rates and tariffs, and went well beyond sensible limits on government and the rule of law in the National Industrial Recovery Act which overrode many market principles.

There's even more evidence in the past half century. From the mid-1960s through the 1970s, policy deviated from the principles. There were unpredictable short-term stimulus packages, discretionary go-stop monetary policies, and wage and price controls—the anathema of a market system based on incentives. The results were terrible: double digit unemployment, double digit inflation, and a marked slowdown in economic growth. Hayek's view about such short-termism was always clear. He wrote "I cannot help regard the increasing concentration on short-run effects…not only as a serious and dangerous intellectual error, but as a betrayal of the main duty of the economist and a grave menace to our civilization."

Then America moved back to First Principles in the 1980s and 1990s, and until recently. Temporary stimulus programs were out. Permanent tax reform was in. Steady-as-you-go monetary policy replaced go-stop monetary policy. The last vestiges of price controls were removed and inappropriate regulations were reduced. The major federal welfare program was moved to the states. The result was declining unemployment, lower inflation, and a revival of economic growth.

But now we have—tragically—deviated again. Leading up to the crisis, monetary policy deviated from the rules-based policy that worked in the 1980s and 1990s by holding interest rates too low for too long. Sound regulatory rules were broken or ignored, including those on Fannie Mae and Freddie Mac. And then the inevitable crisis came along with the Wall Street bailouts, which soon crept beyond their original mission into automobiles, resulting in arbitrary deviations from the legal rights of creditors and interventions into the operations of businesses.

Then came the return of the failed stimulus packages of the 1970s, the Fed's quantitative easing, and the regulatory uncertainty associated with 2010 health care legislation and Dodd-Frank financial reform bill, which gives government the discretionary authority to take over any failing financial firm and rescue its creditors.

We have some numerical measures of the increase in policy uncertainty. The number of provisions of the tax code expiring each year has skyrocketed from 18 in 2000-2002 to 141 in 2010-2012. And we have measures of increased regulation: The number of federal workers engaged in regulatory activities (excluding the Transportation Security Administration) has grown by 25 percent from 2007 to 2012. The epitome of the deviations from basic principles is the self-inflicted fiscal cliff where virtually the entire tax code changes at the end of this year. And the Fed has effectively replaced the money market with itself and set a zero-interest rate policy through 2014. Some of these actions and interventions began toward the end of the previous administration, but the current administration has doubled down on them. Overall economic performance has been very poor.

The good news? Because government policy has been the cause of the problem, we can get back to prosperity by changing the policy. Indeed, in my view a concrete and workable plan follows directly from the principles. It consists of (1) bringing federal spending as a share of GDP to what it was in 2007, which will mean the budget can be balanced and the debt explosion can be stopped without an increase in taxes and with a revenue neutral pro-growth tax reform; (2) unwinding the monetary excesses and normalizing policy with a rules based policy of the kind that worked well in the 1980s and 1990s; (3) halting the rapid expansion of the entitlement state by keeping entitlement spending growth equal to GDP growth and doing it in a way that gives key decision making responsibility to individuals and states rather than Washington; and (4) replacing most of the Dodd-Frank bill with a reformed bankruptcy law that has the goal of ending government bailouts. My book First Principles explainsin simple terms why this kind of strategy will work, and I am glad that one of the foremost practitioners of economic policy today, Paul Ryan, endorses it.

Now let me focus on why policymakers need Hayek's help to reinforce these ideas and implement the strategy.

First note that two of the five principles of economic freedom—the rule of law and policy predictability—have not been stressed as much in economics as have the other three—markets, incentives, and a limited role of government. That is why I put these two at the top of my list. But both are big themes of Hayek. He wrote4 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."

The Dual Case for the Rule of Law: Freedom and Prosperity

I have emphasized in my research that more rules-based policy lead to a more stable economy with more sustainable economic growth, and there is much empirical and theoretical evidence for this. When people make decisions they look ahead to the future. Prices which convey information and provide incentives reflect the future. So both good decisions and the prices which guide them depend on the predictability of future policy and thus on clear policy rules. Rules-based policies promote a more prosperous economy.

But Hayek emphasized that rules for government policy do something more. The rule of law protects freedom, an idea that is conveyed in the very title of Hayek's The Constitution of Liberty. Hayek traces this idea back to Aristotle, and then to Cicero, about which Hayek writes, "No other author shows more clearly… that freedom is dependent upon certain attributes of the law, its generality and certainty, and the restrictions it places on the discretion of authority," and then to John Locke, whom he quotes as saying, "The end [meaning the purpose] of the law is, not to abolish or restrain, but to preserve and enlarge freedom… where there is no law there is no freedom," and ultimately to James Madison and other Americans who put the ideas into practice in a newly founded nation. These writers distrusted government officials' ability to protect and preserve freedom. In the classic dichotomy of rules versus authorities, they viewed rules as less arbitrary. The rule of law brought individual freedom.

So rules have a dual purpose and they are supported by two different constituencies— those interested in freedom and those interested in economic prosperity.

There is probably no better way to understand the dual advantages of rules than to examine what happens in their absence, as in the case of wage and price controls. Controls are arbitrary, requiring decisions by people at the top about virtually every price and wage. They also screw up the economy, distorting signals and incentives and creating shortages and surpluses. This occurs whether the price controls are on the whole economy or on a major part of the economy such as health care.

Rules Don't Mean You Don't Do Anything

A question I am frequently asked is: "How can a system of policy rules work when politicians and government officials are always called on to 'do something, anything,' and feel incredible pressure to do so?" A related complaint is that rules are not flexible enough. Rules sound good, skeptics say, but rules mean you do nothing, and that is impossible in today's charged political climate and hour-tohour or even minute-to-minute news cycles. My colleague George Shultz calls this the "the urge to intervene" in a forthcoming manuscript which recalls the key times as a policy maker where he did not intervene.

Hayek had an answer to this question. In The Road to Serfdom he pointed out the need to "clear up another confusion about the nature of this system [of formal laws or rules]: the belief that its characteristic attitude is inaction of the state." Hayek notes, by way of a counter example to this common view, that "the state controlling weights and measures (or preventing fraud or deception in any other way) is certainly acting…."

Consider some other examples. Simple rules for monetary policy do not mean that the central bank does not take action to change the instruments of policy (interest rates or the money supply) in response to events, or to provide loans in the case of a bank run. Rather it means that they take such actions in a predictable manner. And inaction can mean that one has deviated from a rule or a strategy. A decision by government regulators, for example, not to act when financial institutions take on risk beyond the limits of the rules and regulations is inaction and certainly is not observing the rule of law. It is important for policymakers to be able to explain that a policy strategy involves a series of actions.

A related claim, especially in the case of the recent crisis, is that crises force policy makers to deviate from rules and the rule of law. But a crisis is sometimes the worst time to deviate from rules. In a crisis, clarity about the strategy rather than more unpredictability is needed. This was very clear following the first bailout of the recent crisis—the Bear Stearns intervention, after which few knew what to expect the next time because no strategy was put forth. The sooner people can make their decisions with knowledge of the rules, the sooner recovery will come.

Who Gets Us In And Out Of These Messes?

What can we do as citizens to help America get back to the principles of economic freedom and stay there? We have to choose leaders who believe in the principles and know how to implement them, and we have to look for laws and rules which will incentivize leaders to follow such principles. But here Hayek issued an important warning. In the chapter "Why the Worst Get on Top?" in The Road to Serfdom, he shows that there is a bias against such individuals taking such positions of leadership. People who have the ambition to get to the top, either by election or by appointment, frequently have a bias toward activism or doing whatever it takes. Interventionists will thus tend to rise to the top. And when they reach high positions these biases can be reinforced, as regulatory capture, crony capitalism, and the promise of further advancement set in.

Those in society who benefit directly from discretionary government interventions will work hard to make sure that officials who favor such interventions will advance. Industries and firms that benefit from a bailout mentality will favor officials who are comfortable with bailouts. Even academic research on economic policy will become biased toward such interventionism. Perhaps the answer to Hayek's warning is to look for people who are viewed as "overly committed" to principles economic freedom. Then after experiencing all the pressures while in office pushing them toward deviating from the principles, they may come out with the right balance. In the 1980s Ronald Reagan appointed many people who had doctorates in economics from the "Chicago school" to positions of economic leadership. In recent years, appointees with such degrees are the rare exception.

In a famous letter8 to Hayek praising The Road to Serfdom, Keynes addressed the issue of government appointments though he clearly preferred those with a more interventionist orientation. Keynes wrote to Hayek: "I should therefore conclude your theme rather differently. I should say that what we want is not no planning, or even less planning, indeed I should say we almost certainly want more. But the planning should take place in a community in which as many people as possible, both leaders and followers, wholly share your own moral position."

In my view the essence of the Keynesian approach to policy is the use by government officials of discretionary actions and interventions usually aimed at preventing or mitigating recessions or speeding up recoveries. Since I have long been critical of the use of discretionary policy in this way, I am anti-Keynesian in this sense of the word. Though the models that I have built have Keynesian features, they support the use of policy rules, which are the polar opposite of the Keynesian policy prescription.

Milton Friedman wrote a wonderful essay9 on Keynes's influence on economics and politics which touches on this letter from Keynes to Hayek. Friedman distinguished between Keynes's political contribution—the advocacy of discretionary actions taken by powerful government officials—and his economic contribution—the emphasis on aggregate demand as a source of business cycle fluctuations. Friedman argues that the political contribution was very harmful while the economic contribution had many important insights.

Even those who support the principles of economic freedom can sometimes get off track. One can argue that such deviations were needed in the panic of the fall of 2008, and perhaps they prevented a more serious panic. While that may be true, it is like saying that the person who set fire to a house should be exonerated because he helped put out the fire and saved a few rooms.

Indeed, during the turbulent 1970s, Hayek himself seemed to say that discretion in monetary policy was needed for a while, and others11 began saying the same thing. But the objection from Milton Friedman was loud and clear in a letter sent to Hayek in 1975: "I hate to see you come out as you do here for what I believe to be one of the most fundamental violations of the rule of law that we have, namely discretionary activities of central bankers."

How Serious Is the Assault on Economic Freedom?

Is today's departure from economic freedom, as I describe it here and in First Principles, any less serious than the assault on freedom that Hayek famously wrote about in The Road to Serfdom? Am I exaggerating when I say the future of American prosperity is at stake? Or even that the future of world prosperity is at stake if America has to back off its leadership position? I don't think so.

While central planning may not be the right word right now, consider the new health law in which the terms of everyone's health insurance package will be mandated by the federal government and in which an Independent Payment Advisory Board will determine the price and quantity of each type of medical service that a medical professional can provide from MRIs to CT scans. Is that so different from determining the price and quality of livestock and crops or the price and quantity or quality of steel that can be produced under central planning?

And consider monetary policy. A few years ago, I coined the term "mondustrial policy" to convey the idea that the Fed's quantitative easing policy was a combination of industrial policy—discretionary assistance to certain firms and industries—and monetary policy—printing money to finance that assistance. Since then the Fed purchased $1.25 trillion of mortgage backed securities, and in 2011 it purchased 77 percent of the newly issued federal debt, long after panic conditions subsided.

Hayek argued that inflationary monetary policy is complicit in taking away economic freedom, in part because it hits the elderly and the poor extra hard, making them more dependent on government, and rationalizing more interventions. Though the inflationary monetary problem is less severe now than in the 1970s—at least so far, the impact of the multi-year zero interest rate policy is like that of the great inflation in the sense that it has significantly cut real incomes for those who have saved a lifetime for retirement.


I have argued in this lecture that by moving away from the basic principles of economic freedom, government policy has become the source of our recent economic problems. It should be no consolation that some of our friends in Europe are having worse economic problems. Indeed, many of them have moved even further away from these principles.

The good news is that a change in government policy will alleviate these problems and restore economic prosperity. I have faith that we will turn things around, but we clearly have not done so yet, and it will be difficult. Paying attention to what Hayek wrote in similar circumstances in the not so distant past will help greatly.

About the Authors

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the George P. Shultz Senior Fellow in Economics at the Hoover Institution. He is director of the Stanford Introductory Economics Center. He formerly served as director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow.

He served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, and as a member of the President's Council of Economic Advisers from 1989 to 1991. For four years from 2001 to 2005, Taylor served in the Department of the Treasury as undersecretary for international affairs. He was responsible for currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank.

In 2010, Taylor received the Bradley Prize from the Bradley Foundation and the Adam Smith Award from the National Association for Business Economics for his work as a researcher, public servant, and teacher. Taylor was awarded the Alexander Hamilton Award for his overall leadership at the U.S. Treasury; the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq; and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. He was awarded the George P. Shultz Distinguished Public Service Award at Stanford, and the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society. He formerly served as vice president of the American Economic Association.

Previously, Taylor was a professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

Paul Gigot is the editorial page editor and vice president of The Wall Street Journal, a position he has held since September 2001. He is responsible for the newspaper's editorials, op-ed articles and Leisure & Arts criticism, and directs the editorial pages of the Journal's Asian and European editions, and the Web site. He is also the host of the weekly half-hour news program, the Journal Editorial Report, on the FOX News Channel.

Gigot joined the Journal in 1980 as a reporter in Chicago, and in 1982 he became the Journal's Asia correspondent, based in Hong Kong. He won an Overseas Press Club award for his reporting on the Philippines. In 1984, he was named the first editorial page editor of The Asian Wall Street Journal, based in Hong Kong. In 1987, he was assigned to Washington, where he contributed editorials and a weekly column on politics, "Potomac Watch," which won the 2000 Pulitzer Prize for commentary. In 2010, he received the Bradley Prize from the Lynde and Harry Bradley Foundation, which recognizes individuals for "the promotion of liberal democracy, democratic capitalism, and the defense of American institutions."

Gigot is a graduate of Dartmouth College.