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For Growth, Back to Basics

June 6, 2012 by Matthew Denhart

The U.S. economic situation seems hopeless. Unemployment remains high, government debt is piling, the current recovery has been embarrassingly weak, and worst of all, economists are forecasting that the economy will grow at the sluggish rate of only 2% to 2.5% annually. But in his award-winning new book, John B. Taylor — Raymond Professor of Economics at Stanford University — says that reviving the American economy is not overly complicated. We need only to revisit our nation’s founding principles to find a roadmap back to economic prosperity. Taylor’s book: “First Principles: Five Keys to Restoring America’s Prosperity,” is this year’s recipient of the Hayek Prize awarded by the Manhattan Institute for Policy Research. The prize honors the book that best embodies the principles of economic and individual liberty as set forth in the work of the renowned economist Friedrich Hayek. Taylor accepted the award and delivered the annual Hayek Lecture last week in New York City. In the book, Taylor argues that the same principles that guided America’s Founding Fathers should guide our public policies today. These principles are: limited government, rule of law, strong incentives, reliance on markets, and a predictable policy framework. American history is Taylor's guide. Examining U.S. economic performance over the past 60 years, he makes a strong case that economic performance ebbs and flows with the extent to which government policies adhere to these five principles of economic freedom. Economic performance was terrible in the 1960s and 70s thanks to government policies that featured wage and price controls, unpredictable changes to the tax code, and frequent loosening and tightening of the money supply. Conversely, the 1980s and 90s are known as “The Great Moderation,” a time of high growth, low unemployment, and stable prices. Government policy during these years was mostly non-interventionist. Incentive-based welfare reform and rule-based monetary policy that focused primarily on keeping inflation low were the policy hallmarks of the era. Unfortunately the U.S. economy today is weak. But Taylor is optimistic that we can get back on track. The key, of course, is renewing our commitment to economic freedom. Taylor outlines specific ways we can reform our fiscal, monetary, regulatory, and entitlement systems to reflect these principles and unleash the country’s economic growth potential. In fiscal policy, Taylor argues the top priority should be getting the U.S. off its explosive debt trajectory. Painful austerity measures are not necessarily needed, but rather just a return to 2007, pre-stimulus, spending levels. Today government spending accounts for approximately 24% of GDP, up from 19.5% in 2007. Returning to the 2007 level would mitigate the serious problems caused by excessive government debt and could be accomplished gradually without raising taxes. Taylor stresses that all fiscal policy should be predictable, and thus, once the 19.5% target is met, he favors a constitutional amendment “linking the growth of spending with the growth of GDP.” In his Hayek Lecture, Taylor remarked that the Fed has “replaced the money market with itself.” This is indicative of the larger problem he sees with current monetary policy: There’s too much discretion. To remedy this, the Fed should abandon the dual mandate of price stability and maximum employment and instead focus on effectively promoting “long-run price stability within a clear framework of overall economic stability.” In addition, the Fed should be required to report to Congress a monetary rule that it will follow when setting interest rates. While the Fed can deviate from this rule, such deviations would require the Fed chairman to provide a written explanation to Congress and appear before Congress to answer questions. This reform would lead to more predictable policy and provide much needed certainty to financial markets and individual decision makers. As you can see by now, certainty is a major theme with Taylor. Economic actors need to have a reasonable idea of the environment in which they operate to be able to take risks, invest in new projects, and perform other activities that grow the economy. Too much discretion also plagues regulatory policy. It is a common argument these days that the excessive risk-taking that sparked the 2008 financial crisis was caused by a lack of government oversight. Taylor disagrees.  He points out that even before 2008, the financial industry had a slew of regulators. The Federal Reserve, the Office of the Comptroller of the Currency, the FDIC, the SEC, the FHFA, and various state regulatory agencies all play a role in oversight. Rather than having too few regulators, the main problem was that the existing rules were not uniformly enforced. Because of the large amount of discretion given to regulators, something known as “regulatory capture” took hold. Regulatory capture is the tendency of regulators and regulated firms to develop mutually beneficial relationships that are harmful to the overall economy. More accountability of the regulators themselves would help mitigate this problem and ensure that the same rules are applied to all industry participants. Enforcing existing regulations should take precedence over creating new ones. When new regulations are introduced, they should be transparent, simple, and able to pass a rigorous cost-benefit analysis. Entitlement reform is a final policy area that desperately needs attention. Currently 55% of American households receive some sort of entitlement payment from the government. While a social safety net is in keeping with the principles of economic freedom, the net is becoming too large. Social Security payments amount to approximately 5% of GDP and will grow to 6% of GDP during the next 30 years. More alarming are federal health-care entitlements, which, as structured now, are projected to grow to 12% of GDP (from the current 6%) over the next 30 years. Taylor writes that entitlement reform must place limits on spending growth and then restructure the various programs to hold them to these limits. It is important to get out ahead of this now before it is too late. The reason for America’s current economic trouble is that over the past decade — and especially since the financial crisis of 2008 —policy has deviated from the principles of economic freedom. We’ve seen massive stimulus programs, unsustainably low interest rates, multiple rounds of “Quantitative Easing,” a slew of new regulations, and the list goes on. Despite Washington’s best efforts to micromanage a recovery, it just hasn’t worked out. It’s time to return to the basics, and luckily we have John Taylor’s great new book as a guide to get us back on the road to growth.


Author

Matthew Denhart
Matthew Denhart

Matthew Denhart is an expert on immigration policy and is the author of the Bush Institute’s America's Advantage: A Handbook of Vital Immigration and Economic Growth Statistics, now in its third edition. He currently serves as executive director of the Calvin Coolidge Presidential Foundation and is a founder of the Coolidge Scholars Program which provides full-ride merit scholarships to America's most promising college students. A summa cum laude graduate of Ohio University, Denhart has written and spoken widely on a variety of policy topics including the economics of higher education, labor, and taxes. He has contributed articles to numerous national publications including The Wall Street Journal, Forbes.com, CNN Opinion, and Bloomberg View. 

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