JANUARY 24, 2012, 7:26 P.M. ET

Economics for the Long Run

Individuals should be free to decide what to produce and consume, and their decisions should be made within a predictable policy framework based on the rule of law.


As this election year begins, a lot of people are wondering what we can do to restore America's prosperity and create more jobs. Republican presidential candidates are offering their ideas, and at his State of the Union message on Tuesday President Obama presented his. I believe the fundamental answer is simple: Government policies must adhere more closely to the principles of economic freedom upon which the country was founded.

At their most basic level, these principles are that families, individuals and entrepreneurs must be free to decide what to produce, what to consume, what to buy and sell, and how to help others. Their decisions are to 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.

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Ronald Reagan: He and advisers such as George Shultz shunned the idea of stimulus and agreed on the need for a long-term point of view.

The history of American economic policy displays major movements between more and less economic freedom, more and less emphasis on rules-based policy in fiscal and monetary affairs, more and less expansive roles for government, more and less reliance on markets and incentives. Each of these swings has had enormous consequences. Taken together, they make for a historical proving ground to determine which policy direction is better for restoring prosperity.

A big move toward more interventionist policies started in the mid-1960s, after more activist Keynesian economists came to town in the Kennedy and Johnson administrations, and it lasted through the 1970s in the Nixon, Ford and Carter administrations. We saw short-term stimulus packages, temporary tax rebates or surcharges, go-stop monetary policy with inflationary overexpansion followed by severe contraction, wage-and-price guidelines and controls. The eventual result was high unemployment, high inflation and slow economic growth.

This was followed by a shift toward more predictable policies and a more limited role for government starting in the Reagan administration and largely continuing into the George H.W. Bush and Clinton administrations. The result was lower unemployment and higher economic growth with long expansions and few recessions.

More recently—beginning during the George W. Bush administration but really taking wings in the current Obama administrationpolicy has returned toward more and more government intervention, with results we are all experiencing.

How to move the country back toward the policies that sustain economic freedom and prosperity? To start, much can be learned from the stories of the politicians and economic officials who got us in and out of these messes, and remembering that the cast is bipartisan. Most pertinent to our current predicament is the story of how we got out of the economic mess of the late 1970s.

It's difficult to recall now the seriousness of the U.S. economic slump at that time. Unemployment was high and persistent. Inflation had increased past the creeping stage to a trot. Confidence in U.S. economic leadership was plunging at home and abroad.

That changed when Ronald Reagan became president in 1981. Temporary, short-term Keynesian actions and interventions were out. Stable, permanent policy was in. Reagan proposed and Congress passed critical long-term reforms, especially across-the-board tax rate reductions.


The president was a firm believer in economic freedom, an avid reader and follower of economists like Milton Friedman and Friedrich Hayek. Between the time he failed to unseat President Gerald Ford in the 1976 Republican primaries and his announcement to run again in 1980, Reagan gave innumerable radio addresses putting forth his principles. He used down-home stories of economic freedom that he could tell in three minutes or less. There were no ghost writers—he wrote his stories in long hand on lined yellow paper as he traveled around the country. The failed policies of the 1970s made Reagan's case appealing across the political spectrum. He based his winning election campaign on these principles.

Reagan appointed a large number of economic officials who also were firmly committed to moving away from interventionist policies. No members of the original Council of Economic Advisers under Reagan had come from the Keynesian school of thought, and most of them during the Reagan administrations were influenced by Milton Friedman.

In addition, the president appointed a group of outside economic advisers—originally including George Shultz, Milton Friedman, Alan Greenspan, Arthur Laffer, William Simon and Thomas Sowell—who helped him and others in the administration implement policies to move the country toward economic freedom and then stay the course.

As an example of Reagan's firm commitment to principle, consider monetary policy. When he became president, Federal Reserve Chairman Paul Volcker, a Democrat appointed by President Carter, was determined to reduce inflation and end the go-stop interventions of the 1970s. That meant temporarily high interest rates, which contract the economy. One might have expected Reagan to pressure the Fed to lower interest rates to give a short-term boost to the economy. He did not, despite the political costs. In comparison with the political pressure put on Fed Chairman William McChesney Martin by the Johnson administration and on Arthur Burns by the Nixon administration to follow easy money policies, Reagan's decision to support Mr. Volcker was remarkable.

The president's economic strategy was ready to go as soon as the votes were counted in November 1980. That same month, George Shultz, along with many of the economists who had worked in the campaign, wrote an extraordinary memo to Reagan entitled "Economic Strategy for the Reagan Administration." It began with a call for action: "Sharp change in present economic policy is an absolute necessity. The problems . . . an almost endless litany of economic ills, large and small, are severe. But they are not intractable. Having been produced by government policy, they can be redressed by a change in policy. . . . The need for a long-term point of view is essential to allow for the time, the coherence and the predictability so necessary for success."

That predictable, long-term view continued well beyond the Reagan presidency, but it is no longer with us. The clear lesson is to find and select those leaders, regardless of political party, who along with their advisers are most firmly committed to the principles of economic freedom and who know how to implement and maintain them.

Mr. Taylor is a professor of economics at Stanford and a senior fellow at Stanford's Hoover Institution. This op-ed is adapted from "First Principles: Five Keys to Restoring American Prosperity," published this week by W.W. Norton.
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January 24, 2012 7:16 pm

A blueprint for Germany to save the eurozone

For almost 60 years, Germans have maintained that it is their responsibility to participate in a modern Europe. Today, Germany’s responsibility is to lead in saving that Europe. This shift is not easy for Germans, who have often been urged to step forward, only then to be criticised for aggressiveness. But no other country can lead Europe out of crisis and into revival.

Europe has stumbled from one partial solution to another, buying time without solving the interconnected problems of sovereign debt, banks and competitiveness. Germany has recently urged a fiscal pact as part of a renovated European project. Chancellor Angela Merkel knows that while Germans do not want to waste money, they are deeply committed to their European identity and will offer support if presented with an achievable plan.


Combined with new governments pushing fiscal discipline and structural reform in Italy and Spain, as well as support from the European Central Bank, Ms Merkel’s new direction has improved prospects. But these steps are not enough. Risks abound.

Italy, Spain and others will find it much harder to make fiscal and structural reforms without growth. What will happen to prime minister Mario Monti’s political support if Italy does not see results? And what are the costs of a eurozone breakdown if seemingly precipitated by Germanausteritypolicies?

Germany needs to expand its proposal for a fiscal pact into a plan that offers incentives and support to countries that translate words into action. Germany cannot and should not save countries if they do not act to save themselves, but it can assist reformers to sustain political support. Rather than be dragged grudgingly to help bit-by-bit at the last moment, Germany and its European partners should put incentives on the table now. What might a revival plan look like?

Mario Draghi, ECB president, knows the central bank cannot bail out countries that have lost control of their finances. But he can assist reforming countries and their banks through the transition. Germany seems to be accepting this support already by stating that politicians should not criticise the ECB. Central-bank assistance is also likely to lead to a depreciation of the euro, which could help stressed countries.

The European Commission, backed by the European Investment Bank, should deploy underutilised funds to match investments to countries’ structural reforms. European businesses could then support this through private investment. These steps would enable reformers to show how structural changes produce jobs and financing.

A revival plan would also embrace the fact that a fiscal union needs greater mobility of workers. Labour policies have been oriented towards old protections, not matching abilities and needs across the EU. Focusing the Commission on this new mission would ease unemployment, increase remittances and build a real economic union.

These steps would offer modest support as budgets tighten and protected markets open. But the success of reform governments and the eurozone depends on a bolder incentive. Some have suggested eurobonds or bigger funds. Consider a more targeted idea, from Alexander Hamilton, which is more consistent with Germany’s aim of combining fiscal union with discipline.

As the new US Treasury secretary, Hamilton assumed the revolutionary war debts of the US states – but only once. After that, states’ debts have been subject to market discipline. US states can – and diddefault. Germany’s aim should be to keep eurozone states subject to market discipline, on top of the procedures of a fiscal pact. However, as an incentive to sustain reforms, Germany could propose a eurobond to fund some share of past debts – but only if deeds matched words.

Germany also needs a vision that extends beyond the eurozone. It should prepare a path for Poland to join the euro, keep the UK as an active participant, avoid disputes over secondary issues and prevent a credit crisis in south-east Europe.

There is no simple solution to the eurozone crisis. But muddling through, without clear directions and incentives, is fraught with mounting dangers. Germany must now point the way. A clear revival plan would help. But the path and incentives need to match Europe’s capabilities, not just Germany’s. That is European leadership.

The writer is World Bank president

Copyright The Financial Times Limited 2012.

January 24, 2012

I.M.F. Reduces Estimates for Global Growth

WASHINGTON — The International Monetary Fund warned on Tuesday that global growth prospects had dimmed as the sovereign debt crisis in the euro zone entered a “perilous new phase.”

Releasing quarterly updates of three reports on the outlooks for the economy, debt and global financial stability, the fund cut its estimates of global growth this year to 3.25 percent, from the 4 percent it forecast in September, on “sharply escalatedrisks emanating from Europe.

In light of that market uncertainty and sluggish growth, the fund is seeking to raise up to $500 billion in additional lending capacity. It is also calling on the European Union to expand its bailout fund to at least $1 trillion from its current capacity of 440 billion euros, or about $570 billion, according to a person with knowledge of the negotiations.

José Viñals, director of the I.M.F.’s monetary and capital markets department, told reporters that the fund sought to build a “global firewall” — both to help ease the euro crisis and to ensure that no bystanders to it find themselves locked out of the global financing markets.

In a speech in Berlin on Monday, Christine Lagarde, managing director of the fund, said: “The longer we wait, the worse it will get. The only solution is to move forward together.” She call on the world to help bolster the I.M.F.’s resources and on Europe to bolster its own. “The world must find the political will to do what it knows must be done.”

In its quarterly update, the fund said that “risks to stability have increased, despite various policy steps to contain the euro area debt crisis and banking problems.”

The I.M.F. cited continued high financing costs for European countries and weakness in European banks as two risks that had the capability to intensify each other and lead to “sizable contractions” in economic activity.

Other risks include investor fear over the debts of big countries like the United States and Japan, a “hard landing” in emerging economies and spiraling oil prices as the European bloc and the United States confront Iran.

The fund cut its growth forecasts for every region in the world, as well as for trade and commodity prices. The fund now estimates that Europe will experience a mild 0.1 percent contractiondown from a September forecast of 1.4 percent growth — with a sharper contraction of 0.5 percent among the 17 countries that use the euro currency and deeper recessions in Italy and Spain. It also cut its estimate of global trade volumes.

The I.M.F. did not change its growth forecast for the United States, however. Speaking with reporters, Olivier Blanchard, the fund’s chief economist, said that the “good and bad news” about the American economy were “more or less canceling each other out":

The country’s economic growth is now self-sustaining, but a Europe in recession and a slowdown in emerging-markets promise to weigh on the United States in 2012.

The fund also made a stark warning about the safety of the American financial system. The fund said that “potential spillovers” from the euro area crisis might “include direct exposures of U.S. banks to euro-area banks, or the sale of U.S. assets by European banks.”

In recent months, American regulators and policy makers have played down such risks, pointing to sharply reduced exposure to Europe among money-market funds and investment banks.

The I.M.F. also warned that the United States might turn to austerity budgeting too soon, imperiling its own recovery. Carlo Cottarelli, the director of the fiscal affairs department, cited such premature fiscal tightening as a “concrete risk.” He noted that the steep, automatic budget cuts put into place by Congress last year would lead to the biggest hit to spending in four decades. He called for a more gradual decline in the deficit.”

The same advice applies to the rest of the world, the fund said. Mr. Cottarelli warned that “both too little and too much adjustment will be bad for growth. Both extremes will be bad for growth.” The main risk is that too many countries will cut their budgets too deeply, too soon, sapping demand from the still-weak global economy.

Mr. Viñals, the director of the I.M.F.’s monetary and capital markets department, acknowledged that bond yields had declined in Europe in recent weeks. But he warned it “should not be taken for granted, as some sovereign debt markets remain under stress and bank funding markets are on life support by the European Central Bank.”

Banks should continue to deleverage, the fund said, adding that they should do so by raising funds, rather than reducing credit and thus hampering economic activity.

January 23, 2012 8:39 pm

Economic uncertainty is no excuse for inaction

The year has started well for financial markets. Equities are generally up. European sovereigns have borrowed with an ease that has surprised many observers.

Economic data, particularly in the US, have beaten expectations. So as President Barack Obama prepares to give his State of the Union address, and as policymakers and corporate chiefs come together in Davos, there is less alarm among the global community, though not yet a sense of relief. Indeed, anxiety about the future remains a major driver of economic performance.

The news coming from financial markets is paradoxical. On the one hand interest rates remain very low throughout the industrial world. While this is partially a result of very low expected inflation, the inflation-linked bond market suggests that remarkably low levels of real interest rates will prevail for a long time. In the US, the yield on 10-year indexed bonds has fluctuated around minus 15 basis points: on an inflation-adjusted basis investors are paying the government to store their money for 10 years! In Britain, inflation-linked yields are negative going out 30 years.

One might expect that with low real interest rates, income-generating assets would sell at unusually high multiples to projected earnings. If anything, the opposite is the case: the S&P 500 is expected to be selling at only about 13 times earnings. In historical perspective, stocks appear cheap relative to earnings. Similar patterns are seen in most forms of real estate.

The combination of low real interest rates and low ratios of asset values to cash flows suggests an abnormally high degree of fear about the future. This idea is supported by the recent strengthening in the association between higher interest rates and a stronger stock market. In our present economic environment this is exactly what one would expect: when people become more optimistic, both interest rates and stock prices rise due to rising expectations of higher profits and of greater demand for funds.

This is in contrast to the usual situation, where interest rates and stock prices often move in opposite directions because of reassessments about future fiscal and monetary policies.

Uncertainty about future growth prospects also correlates with other observations, such as the abnormally large amount of cash sitting on corporate balance sheets, the reluctance of companies to hire, and consumers’ hesitancy about big discretionary purchases of durable goods despite near-record lows in borrowing costs and low capital goods prices.

All of this suggests that for the industrial world as a whole, the priority for governments must be to engender confidence that the recovery will accelerate in the US and that the downturn in Europe will be limited.

How best to do this remains an area of active debate. At Davos and beyond there will be many who argue that we must prioritise increasing business confidence and who say that government stimulus is at best useless and at worst counterproductive. Others will argue that priority must be given to stimulus and that issues of business confidence are red herrings.

Seventy-five years ago, John Maynard Keynes saw through this sterile debate, writing to President Franklin Roosevelt that either “the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees”, or “public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money”. The right approach involves borrowing from both contending lines of thought.

Government has no higher responsibility than insuring economies have an adequate level of demand. Without growing demand, there is no prospect of sustained growth, let alone a significant fall in joblessness. And without either of these there is no chance of reducing debt-to-income ratios.

There are of course risks: inflation, promoting excessive speculation and inefficient spending. But the simple fact is that, in the main, markets agree with business managersincreasing demand is the surest return to economic health.

Businesses are understandably uncertain about their prospects after the events of recent years. This is not the time to add unnecessarily to their worries.

New regulations that burden investment should be avoided unless there is an urgent and compelling rationale. Inequality cannot be ignored but there is the risk that policies introduced in the name of fairness could actually exacerbate the challenges facing the middle class by reducing investment. Governments could do much to dispel current disdain for their dysfunction by devising clear plans to better align spending and taxing once recovery is established.

The best chance for economic recovery involves governments working directly to increase demand and to augment business confidence. At Davos and beyond, this should be the focus of economic debates.

The writer is Charles W. Eliot university professor at Harvard and former US Treasury Secretary

Copyright The Financial Times Limited 2012.

Egypt’s Unfinished Revolution Will Succeed

Mohamed A. El-Erian


NEWPORT BEACH – A year ago, Egyptians of all ages and religions took to the streets and, in just 18 days of relatively peaceful protests, removed a regime that had ruled over them with an iron fist for 30 years. Empowered by an impressive yet leaderless movementlargely of young people – the country’s citizens overcame decades of fear to reclaim a voice in their future.

While much has been achieved since those euphoric times, Egypt’s revolution today is, unfortunately, incomplete and imperfectso much so that some now doubt whether it will fully succeed. I believe that the doubters will be proven wrong.

Over the last year, Egyptians have voted in their first free and fair parliamentary elections. They have discovered and used freedom of expression in a way that, not so long ago, would have been deemed unthinkable. Participation in civic activities is on the rise. And Egyptians are learning a lot about who they are as a society, and what they can achieve collectively.

For the first time in decades, millions of Egyptians now feel that they “own” their country, and that they are directly responsible for its well-being, and for that of future generations. This is a priceless accomplishment for a country that had underachieved on so many fronts for so many years, in the process losing its self-confidence, failing to meet its considerable economic and social potential, and falling in international development rankings.

But greater ownership does not translate into full contentment. Dissatisfaction today is high and rising, and understandably so. Institutions are failing to adapt quickly enough. The legal system lacks sufficient legitimacy and agility. Everyday security, while improving, is still far from adequate.

Not surprisingly, the economy is struggling, and it will likely get worse in the months ahead. Growth is sluggish, amplifying alarmingly high youth unemployment. Shortages of some goods have started to appear, and the country is turning to the International Monetary Fund and other creditors for emergency financing.

So it is no less surprising that Egyptians now feel that, after an exhilarating start, their revolution has become stuck in a muddled purgatory. Moreover, many now believe that the future is as uncertain as ever, which is naturally fueling frustration with anyone deemed responsible for the lack of forward movement. Indeed, with increasing domestic tensions diverting energy from forward-looking initiatives, some Egyptians are even beginning to wonder whether it would not have been better to stick with the prior system.

What Egyptians are experiencing today is not new; it is familiar to many countries that have gone through a fundamental systemic change. After all, revolutions go far beyond popular uprisings and the overthrow of old regimes. They are dynamic processes that must navigate a number of critical pivot points, including, most importantly, the move from dismantling the past to establishing the basis for a better future.

Some contend that Egypt will not be able to undertake this shift. But, while I acknowledge their arguments, I think that they misunderstand what is fundamentally at play in the country today.

Doubters note that what remains of Egypt’s internal and external institutional anchors serve to retard the revolutionary process rather than to refine and accelerate it. They believe that the country’s growing economic malaise will strengthen the argument for sticking with what Egyptians know, rather than opting for a more uncertain future. Finally, they point to the wait-and-see attitude of Egypt’s friends and allies.

These are all valid and important considerations, but they are not overwhelming. Rather, they are headwinds that can and will be overcome, for they fail to capture a reality that is evident from the sentiments of a broad cross-section of society. Egyptians will not settle for an incomplete revolution not now, and especially not after all of the sacrifices that have been made.

Completing their revolution will be not an easy, quick, or smooth process, but it will happen. Egyptians’ collective determination will ensure that, in the revolution’s second year, the country will get a new constitution, hold proper presidential elections, and benefit from a functioning and representative parliament. Having completed the transition, the armed forces will return to their barracks and to safeguarding the country from foreign threats.

Any attempt to divert this legitimate process will be met by millions of Egyptians taking to the streets in protest. Make no mistake: Egyptians are committed to completing their impressive revolution, and they will.

Mohamed A. El-Erian is CEO and co-CIO of PIMCO, and author of When Markets Collide.