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Saturday, July 1,2000

The Adoption of Hayekian Economic Infrastructure
as a Foundation for Sustained Prosperity

Remarks by
Jerry L. Jordan
President and Chief Executive Officer
Federal Reserve Bank of Cleveland

75th Annual Conference
Western Economic Association International
Vancouver, B. C., Canada
July 1,2000

The media abounds with assertions concerning the emergence of a new economy.
The pundits contend that we need a new paradigm to understand how this new economy
works. Not surprisingly, some old economic models have come under attack for not
being able to reconcile the low inflation, high growth, and quite low unemployment rates
we have witnessed over the past decade.
Let me suggest that there is no new economy. I admit there is something new, but
it isn’t the economy. Certainly, computers and information technology have sped up the
flow of acquiring or disseminating knowledge: knowledge about prices; knowledge
about production techniques. But, it doesn’t necessarily follow that we need a new
paradigm because of this technological progress. And, the reason that the old models are
not performing well is not due to bandwidth or megahertz, but, instead, it might be that
they never were very useful. Using statistical correlations, such as the relationship
between inflation and unemployment to determine policy, can be dangerous. In Hayek’s
words, but in a different context, it is the difference between knowing that and knowing
In my remarks today, I want to talk about some ideas concerning economic
performance and progress that are old and yet still highly relevant to the world we are
living in today. These ideas will not help anyone predict real GDP growth for next year
or instruct the FOMC on what to do with the federal funds rate at its next meeting. But,
they should help our thinking about a more important question: How do we design
monetary and fiscal institutions so that we maximize social welfare over time? The
theme of my remarks today is that the key to sustainable prosperity is the strength of the
underlying economic infrastructure.

Elements of Growth

One thing that has not changed over the last millennium or two is that each and
every day new businesses are bom, and each and every day other businesses fail. Along
with this turnover, we see churning in the labor market as new jobs are bom and older,
less productive jobs cease to exist. The same can be said of other productive resources,
such as physical and entrepreneurial capital. Individuals and firms must respond to the
various shocks hitting the economy. They must rethink not only the way they do

business, but also the way labor and capital are put together to produce final
consumption. Technological progress necessitates obsolescence. But, this observation is
just as valid today as it was in 1900, or 1800, or even much earlier.
Some shocks are large. Movable-type printing was every bit as revolutionary as
the computer. Gutenberg’s invention in the 1430s allowed information to be massproduced. In fact, the printing press is an apt analogy to today’s technology revolution:
they are both about information. Thirty years after the introduction of movable-type
printing, there were print shops in every comer of the European continent. It is believed
that more books were produced in the 50 years following Gutenberg’s invention than in
the 1,000 years before it.
The Industrial Revolution was obviously another large shock. The steam engine,
for example, increased horsepower by several orders of magnitude. With the added
power, not only could some products be made more quickly, but new products could also
be produced that would have been much more costly with manual labor alone.
Today we may very well be in the midst of another large shock: The information
technology revolution. Indeed, computers and the Internet allow us to obtain information
instantaneously from almost anywhere in the world, twenty-four hours a day, while
sitting at our desks, and at very little cost.
So, what do I mean when I say there is no new economy? I mean that the
fundamental determinants of healthy economies are the same as they ever were. So long
as the right environment exists, markets will flourish and in that environment individuals
and markets will adapt to shocks. And as they adapt, the face of the economy changes.
But the conditions that determine the right environment haven’t changed, and the
mechanisms by which the economy operates are the same as they always were. Only the
outward appearance has changed: the names of the businesses, the products
manufactured, the skills used, or the efficiency with which trade is conducted. Keep in
mind that in such an environment, the changes that occur are the result of the actors being
allowed to respond optimally to the shocks that confront them, making everyone better
off as a result.
How does such an environment arise? I contend that it is the product of
government laying the appropriate infrastructure. In the United States, as well as in more


and more countries throughout the world, an infrastructure exists that allows a large
proportion of resources to be spent on research and development. The infrastructure
ensures that we will be able to reap the rewards from a successful outcome, and, of
course, that we will have to pay the price for an unsuccessful one. Certainly, more
people “online” means ideas can spread faster and new techniques and processes can spill
over into other sectors of the economy. Nevertheless, there really isn’t anything new
here. The printing press, the telegraph, and the telephone each had the same effect. In
fact, so much attention has been devoted to the so-called new economy that we have
overlooked the importance of the infrastructure that has allowed a freer flow of
information, products, capital, and labor—all of which have enabled us to fully exploit
those new technologies.
To understand better how an infrastructure can foster the increase in output, and
concomitantly wealth, in the economy, it is instructive to glance back at another “new
economy”—the Industrial Revolution. What made the capital accumulation, innovation,
and industrial enterprise of that economic transformation possible over a century and a
half ago? The appropriate institutions and enforcement mechanisms had to be in place.
In contrast, the technical preconditions for such a revolution almost certainly existed in
China between the seventh and twelfth centuries AD. While most know that Gutenberg
invented his printing press in the 1430s, a similar press was invented by Pi Sheng some
400 years earlier in China. However, for various reasons, his invention did not spread to
the West.
Institutions—those that were in place and the way they were structured— have
also been mentioned as the proximate cause of the Industrial Revolution. Because of its
institutions, Great Britain was able to combine innovation and resources to create greater
wealth and set the revolution in motion. While the leaders of countries across the globe
at that time may not have been particularly different in their attitudes toward their
citizenry, the European fiefdoms were small and open, allowing individuals to move
across jurisdictions easily if the conditions in one were not conducive to their skills, or if
the particular area was governed in an arbitrary manner. Individuals with the foresight to
realize that gains in the standard of living could be made by enforcing property rights,


establishing individual autonomy to make contracts, and so on, were able to capture such
gains to the benefit of the citizenry.
Still, trading between jurisdictions was problematic, because the laws or rules
between them were often idiosyncratic. The merchants took it upon themselves to
impose and enforce their own rules, known as medieval lex mercatoria (Custom of
Merchants). These rules basically established property rights and enforcement
mechanisms for breaches of those rights, enabling a freer flow of both goods and ideas,
leading to higher levels of prosperity. One should not be under the illusion that that was
a peculiar time or a singular event. It is easy to point to many such cases where
institutions can be singled out as encouraging or discouraging growth. For instance, we
can point to the “Asian Tigers” over the past couple of decades compared to China or
North Korea. In economics it is usually not possible to “see how things would have
turned out” had we imposed a different assumption on the model. Occasionally,
however, we are provided natural experiments. Countries divided by some arbitrary
border, as East and West Germany were, or North and South Korea are, give us keen
insight into the important role institutions play in determining economic growth. It seems
doubtful that explanations other than the underlying infrastructure can adequately explain
the disparate patterns of growth between such politically divided regions.

It’s the Institutions, not the Macropolicies
If we ask a simple question like, “Why are some economies rich and others
poor?” or “Why do economies grow at different rates?” we get a simple answer: Rich
economies have greater resources per capita—more capital, both human and nonhuman,
and better technology connecting the two. But this answer only begs another question:
“Why do some economies have high levels of capital and technology, while others do
I believe it is a nation’s choice of institutions—the totality of which we call the
economic infrastructure—that determines wealth and development. What separates
economic “haves” from “have-nots” is whether the role of an economy’s institutions—
particularly its public institutions—is to facilitate production, or to confiscate it.


We can describe an economy’s infrastructure as the climate created by institutions
that serve as conduits of commerce. Some of these institutions are private; others are
public. In either case, an institution’s role can be that of conversion—helping to
transform resources into output—or diversion—transferring resources to nonproducers.
Most private institutions are sustained by the value they add—either they produce, or
they fail. But the same cannot be said of public institutions that are sustained by the
power of the state.
Implicit governmental guarantees, without adequate market oversight, create the
potential for a nation’s asset values to be determined by things other than the
investment’s underlying contribution to the world economy.

The Role of the State Institutions
At the most basic level, there can be only two rationalizations for the state’s
participation in an economy. The first is as a social equalizer, redistributing the fruits of
a nation’s production under the presumption that a particular social need takes
precedence over private desires. The second justification for government participation is
the assertion that markets fail to produce an efficient outcome.
Where equity issues are concerned, the role of the state is unambiguous. Society
chooses to accept a lower average level of wealth in exchange for some presumably
higher social objective.
It is the state’s role as a promoter of market efficiency that raises the most
complex questions. Even if the objective is to overcome a particular market failure, once
the state has involved itself in the economy, its influence will have wide-ranging and
unanticipated consequences. And state institutions, which are not bound to obey market
forces, exert influence long after their usefulness has passed.
While I doubt that market failures are as common as activist policymakers
presume, it is clear that they do occur. The most frequently cited example is “public
goods,” where providing a good for anyone makes it possible to provide it for everyone
with no additional costs. But, precisely because it is difficult to exclude individuals from
receiving the benefits of such goods, the private sector would produce too little of that
good. A legal system and national defense are such public goods. Another, though not


often mentioned in economics textbooks, is that of a stable currency. These functions
become part of the economic infrastructure called “the protection of property rights,”
which means, more or less, that individuals can expect to receive the product of their
labor. Although people could privately undertake actions to prevent diversion of their
output (by burglary, for example), it is widely accepted that a social institution (such as a
police force) is a less costly means of protection. Let us be clear, however. In order to
pay for the police, courts, or jails, resources must be diverted to the state from private
persons in the form of taxes.
Indeed, once the state is introduced into the economic infrastructure, it cannot
help but tax the system’s productive capacity. Sometimes, these taxes are direct and
sustain the government activity. But direct taxes are probably only a small part of the
overall cost to the economy. Also important are the costs borne by private agents who
invest resources to minimize their tax burdens, either through tax-avoidance schemes or
through attempts to influence the taxing authorities.
This is the paradox of any state enterprise. While the state may be the most
effective instrument for minimizing resource diversions (for example, by protecting
property rights and enforcing contracts), it simultaneously introduces the potential for the
debilitating diversion of resources for the state’s own account. This, I think is where the
differences between economies are grossly understated.
A recent article in the Wall Street Journal,1written by Hillel Halkin, comments
on a well-known Egyptian writer’s impressions of the recent corruption scandals in
Israel. The chief of police resigned after it was revealed that he spent several nights as a
nonpaying guest at a beachfront hotel. The Egyptian writer was shocked at the
resignation of the chief of police, saying that Israel must have a “.. .terribly childish fear
of corruption if you make an important official lose his job over an idiotic trifle like that.”
Mr. Halkin points out that “.. .the country that does not hold its elected officials to the
highest standards will end up getting the lowest.”

1“The Virtues of a ‘Childish Fear of Corruption,’” Wall Street Journal, March 29,2000, p. A22.


The rule of law must be universal; and these universal rules should be general and
abstract. These abstract rules, according to Hayek, must be “applicable to an unknown
and indeterminable number of persons and circumstances.”
As is well known, such rules must protect private property and create
predictability in interactions with others. The rules should be easily accessible so that all
can take advantage of them and all will know the sanctions for malfeasance. Also
important is that the rules must allow actors in the economy to spontaneously respond to
new technologies and new methods brought on by technological progress. Innovators
need access to well-functioning capital markets. Firms need to be able to hire or fire
workers as market conditions warrant. Enterprises not willing or able to embrace new
technologies—and therefore not able to compete with those that do—should be allowed
to fail.
What are the elements, then, that the state must put in place to allow an economy
to be able to take full advantage of possible gains from trade? A market economy
requires a foundation of enforceable property rights, generally accepted accounting
principles, sound financial institutions, and a stable currency.
Quoting Hayek:
“The orderliness of social activity shows itself in the fact that the individuals
can carry out a consistent plan of action, that at almost every stage, rests on the
expectations of certain contributions from his fellows.”3

Where public contracts are not honored and private contracts not enforced,
markets are impaired. Where title to property is not certain, normal banking is not
possible. Where financial statements are not reliable, investment opportunities are
obscured. Where the purchasing power of money is not stable, resources are wasted in
costly information gathering or in producing or consuming the wrong things.
Additionally, the rules governing individual interactions are inherently not any
different than those we would want governing interactions between individuals and
institutions. It is essential that we trust that those we interact with will act in predictable

2 Law, Legislation and Liberty, Volume I: Rules and Order (Chicago University Press), 1973.
3 The Constitution of Liberty, London: Routledge & Kegan Paul, 1960.


ways, will fulfill promises, and so on. If this were not the case, transactions’ costs might
exclude possible gains from trade. It seems remarkable, when you think about it, that we
often take substantial amounts of money to our bank and hand it over to people we have
never met before. Or, that securities traders can send millions of dollars to people they
don’t know in countries they have never been in. Yet this occurs all the time. I trust that
the infrastructure is set in place that allows me not to worry that the person at the bank
who takes my money doesn’t just pocket it. Or that when I use my credit card to buy a
new CD or tennis racquet over the Internet, from a business that is located in some other
state or country, I am confident I will get my merchandise, and they are confident they
will get paid.

A Reputable Monetary Authority
We must require from our government institutions the same features we require
from our private ones—predictable behavior, trustworthiness, and commitment. People
would like to expect that if taxes are taken from them to provide for their retirement, the
government will honor its obligation and return the funds with interest when they are old.
We should expect that the dollars issued by the government are subject to the same level
of trust, and that their value will not be eroded by arbitrary policies.
It is important to emphasize that these rules should apply at all levels and to all
institutions, including the monetary authority. Economic exchange involves information
and transaction costs that require real resources. These costs, which influence the extent
of trade, the degree of specialization of labor, and the economic benefit derived from
goods, stem primarily from the difficulty of acquiring information about the quality of the
goods—their true worth, as opposed to their money worth. The lower the information
and transactions costs, the greater the opportunities for individuals to undertake
exchanges that maximize mutual welfare. When we find ways to conserve productive
resources that had been devoted to gathering information and conducting exchange, we
liberate them and make them available for creating consumable output. In this way,
sound money promotes prosperity.
Of course, a nation must be concerned not only about the integrity of its money,
but also about the stability and reliability of its financial system. The condition of a


nation’s financial intermediaries and financial (asset) markets may influence a monetary
authority’s policy actions, but need not compromise its objectives. Unsound financial
institutions and inefficient financial markets may impede, but do not preclude, the
achievement and maintenance of a stable currency. Nevertheless, if ex ante concerns
about, or ex post responses to, the condition of financial intermediaries or markets, divert
monetary authorities from a disciplined, sound policy stance, then overall financial
instability can result. While the adverse effects of shocks to the financial sector can
never be eliminated, their disruptive influence can be minimized if monetary authorities
continue to provide a stable monetary unit.
Economists are accustomed to talking about the quantity of money; I suggest
thinking more deeply about its quality. A society will choose to use as money something
that enables people to gather information and conduct transactions with a minimum of
resources. Indeed, the worldwide use of the U.S. dollar alongside local currencies
illustrates the point that currencies do compete along the quality dimension.
While central banks around the world have begun to understand the long-term
efficiencies that stable money can provide, they are also part of a fiscal regime that
includes strong incentives to violate the public’s trust by generating unanticipated
inflation. Through unanticipated expansions of fiat money, central banks can levy an
unlegislated tax, reduce the real value of the government’s outstanding debts, or attempt
to exploit a short-term trade-off between growth and inflation. Governments, especially
those that heavily discount the future, will always be tempted to instruct or pressure their
central banks to issue excessive amounts of money.
The beneficial effects of such short-sighted government policies are transitory at
best. As people alter their behavior in the face of inflation, the cost of conducting
exchanges increases. The additional resources expended on gathering information and
protecting the real value of wealth would otherwise have been available for growthenhancing activities.
Governments lacking the willpower to maintain price stability may attempt to
ensure the quality of their monetary unit by adopting institutional arrangements that
restrict their own monetary discretion. Certain types of rules can enhance a central
bank’s reputation by signaling that the government intends to maintain the quality of its


currency. Examples include explicit price-level targets or other legal imperatives that
place monetary stability above other objectives. Such arrangements may be particularly
important because a reputation for monetary integrity is built very slowly.

Some Practical Examples
Several examples of the importance of infrastructure in fostering long-run growth
are worth noting. The first concerns the decline in the value of the euro relative to the
U.S. dollar and the British pound, which occurred shortly after its initial offering. The
euro recently was trading at about 95 cents, far below its January 1999 starting level.
Many have put the blame for the euro’s weakness on the outflow of long-term capital.4
Indeed, there are still many uncertainties when it comes to trying to reconcile the
structural differences among the countries in the euro-zone. Countries entered the Union
with over- or undervalued real exchange rates, different debt-to-GDP ratios, different
rules concerning the hiring and firing of workers, and so on. Recent comments from the
European Central Bank suggest that allowing Greece into the Union may exacerbate the
euro’s slide. Greece is the poorest country in the European Union, its per capita
production is a third below the EU average, and its debt of 104 percent of GDP is
substantially above the EU target of 60 percent. Many are concerned that the problem
with the euro stems partly from not having adhered strictly to the standards originally
proposed. For example, Italy was allowed to join, although it lacked several proposed
EU standards for admission.
What needs to be done to reverse the capital flight? I am not the first to provide
the answer: Significant structural reform. Namely, privatization, deregulation, and tax
and pension reform.
With no constraints on capital flows, the euro, the dollar, or any other currency
will migrate to earn its highest expected return. After all, there is worldwide competition
for capital and labor. Institutions that restrict capital movement, or lower its return
through excessive taxation, will not be able to compete with those countries whose
policies help foster economic growth. And this is becoming more evident as the speed of
information increases.
4 See, for example, Martin W olfs April 25,2000 article in the Financial Times.


This problem is not specific to the European Union. In Peru, the recent
presidential challenger, Alejandro Toledo, established his platform on exactly these
points. Privatization and restructuring of debt were his major priorities. He viewed
establishing credibility with investors and encouraging long-term investment projects as
crucial to ensuring economic growth.
Another example that illustrates the importance of appropriately structured
institutions in fostering long-term growth is the trend toward dollarization in some
developing countries. While it may be tempting for the monetary authority to tax money
holders by expanding the money supply, as a long-run strategy this is usually
counterproductive. An important role of fiat money is to increase standards of living by
decreasing the costs of transactions. As inflation rises, actors in the economy will be less
willing to accept the inflating currency as payment. Sometimes the actors will act on
their own devices and find a substitute medium of exchange in times of acute inflation.
Lately, governments of some economies, attempting to establish credibility and
attract capital, have discussed adopting the U.S. dollar as currency. This is a way to
begin to build an infrastructure for an economy that is unable to maintain a constant
purchasing power of its own fiat money. In a recent conference on this topic held at the
Federal Reserve Bank of Cleveland, it was surprising how many contemporary
international economists spoke about dollarization as an issue arising in countries
characterized by an absence of strong institutions to protect property rights.
One final example of the role of institutions in providing an infrastructure
conducive to fostering long-run growth, and one that I am intimately involved with, is
openness regarding how decisions by the Fed are made with respect to monetary policy.
My goal for monetary policy is neither new nor a secret. I have said many times that it is
imperative that we maintain the purchasing power of the dollar. Not minute by minute,
not necessarily at the frequency at which the FOMC meets, but over some longer time
horizon, maybe three to five years. The rules I set out for institutions earlier apply
equally well here. Predictability is an important component. If the rules are transparent
enough, people know with some amount of certainty how the monetary authorities will
respond. If they know that policymakers have a three- to five-year horizon, then seeing
an uptick in price statistics in one quarter will not cause them to alter their behavior.


I would like it to become clearer that the Federal Reserve is focussed on one goal,
the long-run stability of the purchasing power of the dollar. There should be no
perception that the central bank is “antigrowth” as has often been portrayed in the media,
or that it pursuing some sort of “countercyclical stabilization policy.” If an economy’s
monetary unit is known to be a stable standard of value, then changes in money prices
will accurately reflect changes in the relative values of goods and assets. This is the best
that can be done. While the monetary authorities are focussed on this one intermediate
goal, there is no sacrifice of output or employment. The notion of a social/political trade­
off between prosperity and price stability is a mischievous myth. When monetary
stability is certain, substantial resources are preserved since people do not have to solve a
complicated signal extraction problem, trying to decide if the price changes they observe
are relative or more general. Resources will not be wasted searching for and using near­
The monetary authority of any country has an important role in the ideal
infrastructure envisioned by Hayek. Therefore, it is imperative that we understand, in a
structural sense, how money fits into a dynamic, equilibrium economy.

I began my remarks today with a simple premise—that the economic
infrastructure plays a major role in determining economic prosperity. I attempted to
show that infrastructure depends crucially on the culture of the institutions that are
supported by the state. The best economic performance occurs where the state has
fostered an infrastructure that functions as, in the words of Vaclav Klaus, the former
prime minister of the Czech Republic, a “market economy without adjectives.”
Protections often taken for granted—patents, copyrights, and other intellectual
property rights—are largely unknown or are ineffective in many places in the world
today. Without such protections, incentives for creative talents to design and develop
new products and services are substantially weakened.
Finally, let me say that while we are fortunate to be in the midst of what appears
to be a new technological revolution, we should keep in sharp focus the environment that


encourages such great leaps forward. And it would be false hope for countries or regions
without such an environment to think that adopting the new technologies will allow them
to achieve the tremendous gains experienced by those with a more conducive
infrastructure in place.