First Principles

1. Economic freedom principles foster prosperity and stability

The premise of this book is that 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.

Five key principles. Economic freedom is built on five fundamental principles:

1. Predictable policy framework
2. Rule of law
3. Strong incentives
4. Reliance on markets
5. Clearly limited role for government

These principles not only define economic liberty but also lead to superior economic outcomes. When policymakers adhere to them, economic performance improves; when ignored, it deteriorates.

Historical evidence. The 1980s and 1990s saw a return to these principles, resulting in:

• Lower inflation
• Higher productivity growth
• Longer economic expansions
• Lower unemployment
• Shorter, less frequent recessions

In contrast, the interventionist policies of the 1960s and 1970s led to stagflation and economic instability.

2. Government interventionism leads to economic instability

The attempt to do more than we can will itself be a disturbance that may increase rather than reduce instability.

Keynesian activism revival. The 2000s saw a resurgence of interventionist policies, including:

• Temporary tax rebates (2001, 2008, 2009)
• Federal Reserve's deviation from rules-based policy (2003-2005)
• Large-scale bailouts during the 2008 financial crisis
• Massive stimulus packages and quantitative easing

Unintended consequences. These interventions often had negative effects:

• Housing boom and bust fueled by low interest rates
• Increased economic uncertainty
• Weakened economic recovery
• Rising government debt

The 2008 financial crisis and subsequent weak recovery demonstrate the dangers of abandoning economic freedom principles in favor of discretionary interventions.

3. Monetary policy should follow predictable rules, not discretion

Monetary policy alone determines the overall price level and thus inflation, the percentage change in the price level, and thus should be responsible for price stability.

Rules-based approach. A predictable, rule-based monetary policy leads to:

• Lower and more stable inflation
• Reduced economic volatility
• Increased central bank credibility

The Taylor Rule, proposed in 1992, offers a benchmark for setting interest rates based on inflation and economic output gaps.

Reforming the Fed. To improve monetary policy:

1. Replace the dual mandate with a single focus on price stability
2. Require the Fed to establish and report on a specific policy rule
3. Implement accountability measures for deviations from the rule
4. Develop a plan to reduce the monetary overhang created by quantitative easing

These reforms would limit discretion while maintaining flexibility to respond to economic shocks.

4. Fiscal responsibility is crucial for long-term economic health

America needs to get back to living within its means. By doing so, its means will expand dramatically as an economic recovery takes hold and employment and incomes rise.

Debt explosion. The U.S. federal debt is projected to reach unsustainable levels:

• 75% of GDP in 2012
• Over 100% by the end of the decade
• Potentially over 900% in the long term

This debt growth threatens economic stability, risking:

• Higher inflation
• Higher interest rates
• Reduced private investment
• Another financial crisis

Budget strategy. A sound fiscal plan should:

1. Gradually reduce federal spending to 19.5% of GDP
2. Balance the budget without increasing tax rates
3. Implement revenue-neutral tax reform to spur growth
4. Consider a constitutional amendment to limit spending growth

This approach would restore fiscal health while promoting economic growth and job creation.

5. Entitlement reform is necessary to prevent unsustainable growth

To defuse the debt explosion, we must first spike the entitlement spending explosion.

Entitlement state growth. Entitlement programs have expanded dramatically:

• 55% of U.S. households receive some form of entitlement payment
• Social Security and health care spending projected to reach 18% of GDP in 30 years
• Creating harmful disincentives and threatening fiscal stability

Reform principles. Entitlement reform should:

1. Place limits on spending growth
2. Improve program efficiency and effectiveness
3. Preserve the social safety net for those in need
4. Encourage personal responsibility and market-based solutions

Specific reforms:

• Medicare: Transform into a premium support system with competitive private insurance options
• Medicaid: Devolve to states with block grants and increased flexibility
• Social Security: Adjust benefits to maintain purchasing power without increasing as a share of GDP

These reforms can improve lives while controlling costs and preserving programs for future generations.

6. Regulatory policy should prioritize simplicity and transparency

Government regulation should rely more on the rule of law and less on the rule of men.

Regulatory overreach. Recent financial and health care legislation has:

• Increased government discretion and power
• Created regulatory uncertainty
• Raised costs for businesses
• Slowed economic recovery

Reform principles:

1. Simplify and streamline regulations
2. Increase transparency in rulemaking
3. Implement rigorous cost-benefit analysis
4. Limit opportunities for regulatory capture and crony capitalism

Specific reforms:

• Financial regulation: Replace "too big to fail" policies with a predictable bankruptcy process for large institutions
• Health care: Remove restrictions on insurance offerings and increase consumer choice
• General approach: Implement a moratorium on new regulations with exceptions for national security or public health and safety

These reforms would reduce regulatory drag on the economy while maintaining necessary protections.

7. American economic leadership benefits the global economy

A decline in American economic leadership would be dangerous for the world economy and thus for America itself.

Historical leadership. Post-World War II, America promoted economic freedom globally through:

• Creating open trading systems (GATT, now WTO)
• Establishing international financial institutions (IMF, World Bank)
• Supporting market-based reforms in developing countries

Recent decline. U.S. economic leadership has weakened due to:

• Deviation from economic freedom principles
• Promotion of short-term Keynesian policies abroad
• Lack of support for market reforms in emerging economies

Global consequences. U.S. policy deviations affect other countries:

• Low interest rates contributed to European housing booms and subsequent debt crises
• Quantitative easing policies exported inflation to emerging markets

Restoring leadership. To rebuild American economic leadership:

1. Implement domestic reforms based on economic freedom principles
2. Promote free trade and open markets globally
3. Support market-based reforms in developing countries
4. Lead by example in fiscal and monetary responsibility

A stronger U.S. economy based on sound principles will benefit the entire world.

8. China's economic rise requires adherence to free market principles

Despite the introduction and enormous success of Deng Xiaoping's market reforms, the Chinese economic system still fails to embrace many of the principles of economic freedom.

China's economic transformation. Market-based reforms have led to:

• Rapid economic growth
• Poverty reduction for millions
• Increased global economic influence

Remaining challenges. China still lacks:

• Strong rule of law
• Open and fair markets
• Protection of property rights
• Political freedom

U.S.-China engagement. To promote economic freedom in China:

1. Encourage further market reforms
2. Address unfair trade practices and intellectual property theft
3. Support increased economic openness and transparency
4. Lead by example in adhering to free market principles

As China's economy grows, its adherence to economic freedom principles becomes increasingly important for global stability and prosperity.

Last updated: November 4, 2024