The visible hand
of the recession
of the Chicago School of Economics.
Photography by Dan Dry
On a sunny day this spring, more than 1,000 people streamed into the Sheraton near the Gleacher Center for a conference on the Future of Markets. Its keynote panel, headlined by Nobel laureate Gary S. Becker, AM’53, PhD’55, featured six Chicago economists with differing viewpoints. The stock market was in the early part of a rally that would yield its best quarter since 1998. Stock-market turnarounds usually signal better times coming, but in an economy contracting 6 percent, better was relative.
A fierce skeptic of government and a Chicago School pillar, Milton Friedman remains a powerful presence in economic debates.
So the rally didn’t change the feeling among the free-market enthusiasts at the University of Chicago Booth School of Business management conference that market economics was on shaky ground: most of the financial industry, they felt, had been nationalized in all but name. Two of the three U.S. automakers looked like they would follow suit. The government was capping pay in the financial services. What in the name of the Chicago School was going on?
The central idea of the Chicago School of Economics holds that economies work best when markets operate freely, with limited government participation. The Chicago School, a phrase coined in the 1950s, championed an old idea: 1870s neoclassical economics. Yet in the wake of the Great Depression and World War II, it was a radical proposition. It went against the ideas of John Maynard Keynes, who believed government should play an important role across an economy. At the time, the U.S. government was viewed with reverence, as the force that beat the Depression, won World War II, and was girding to rebuild Europe. Keynesianism held “a virtual monopoly,” says James J. Heckman, the Henry Schultz distinguished service professor of economics and 2000 winner of the Nobel Memorial Prize in Economic Sciences. “People thought markets couldn’t work, incentives weren’t important.”
The Chicago School took almost the opposite tack, expressing near disdain for government. Some of that disdain was echoed during May’s Future of Markets keynote panel by Kevin Murphy, PhD’86, who holds an endowed chair named for 1982 Nobel laureate George J. Stigler, PhD’38, a pillar of the Chicago School, along with Milton Friedman, AM’33. Wearing his habitual baseball cap despite the suits and ties all round him, Murphy ticked off the challenges facing the nation. When he got to the problem of remaking General Motors, he paused. “Who in their right mind would put the government in charge of that task?” Titters came from the audience, then applause.
Another crowd might have booed—say, at Columbia University, current home of economist Joseph Stiglitz, who won the 2001 Nobel Prize for work on how markets misfire. Stiglitz threw this bomb via a Bloomberg News article last winter: “The Chicago School bears the blame for providing a seeming intellectual foundation for the idea that markets are self-adjusting and the best role for government is to do nothing.”
In his 2003 book The Roaring Nineties, Stiglitz recounts how, in the four-year period between 1997 to 2001, private companies and capital markets invested $65 billion into building telecom networks. They lost $61 billion of it. The episode is his version of Murphy’s question above: “Who in their right mind would put markets in charge of that task?”
Salon commentator Andrew Leonard also called out the Chicago School, writing in an April 29 column, “The direction in economic thought pioneered by Milton Friedman and enthusiastically adopted by Ronald Reagan and his Republican successors helped to get us where we are today—in the worst economic contraction in 50 years, characterized by an increasing concentration of wealth in the top tiers of society.”
“Who in their right mind,” Kevin Murphy asks, “would put the government in charge” of remaking General Motors?
The 2008 market collapse shocked the global economy like nothing since the Great Depression. Given the breadth of the failures involved, casting blame at a single school of thought may seem overly simplistic. But the Chicago School’s ardent championing of market forces, says Ross Emmett, a Michigan State University economist who studies the Chicago School and heads an oral history of it, makes it “a convenient locus” for anger.
Chicago’s market focus developed as the original Frank Knight/Jacob Viner Chicago School—also anti-Keynesian but skeptical of markets’ efficiency and mathematical models—waned along with World War II. The government’s influence on the University’s scientific-research funding disturbed then-president Robert Maynard Hutchins, according to Philip Mirowski, professor of economics and the history and philosophy of science at Notre Dame, and coeditor of the new book The Road from Mont Pelerin. (The Mont Pelerin Society was a Friedrich Hayek–led debating organization dedicated to advancing free-market ideals, including markets’ ability to efficiently show information.)
In 1946 Chicago already had a neoclassical presence: the Cowles Commission for Research in Economics, funded by Alfred E. Cowles III, scion of one of the Chicago Tribune’s owners. Cowles’s postwar staff at Chicago included nine future Nobel laureates, among them Kenneth Arrow and Tjalling Koopmans, who won Nobels in economics before Friedman. Cowles promoted an economics more scientific than the theoretical type that dominated the field at the time. But he was left-leaning. Hutchins wanted specifically anti-statist thinkers, Mirowski says, enlisting help from the now-defunct libertarian William Volker Fund to hire, among others, Aaron Director at the Law School, Friedman (Director’s brother-in-law) in economics, and Hayek at the Committee on Social Thought (the economics department nixed Hayek). Cowles would decamp to Yale in 1955.
The new group created a whole new Chicago School, focused more strongly on markets and more skeptical of government. Over the next two decades their research would spearhead a revolution in economic thought.
The University community has never been of one mind about the Chicago School of Economics. Witness the ruckus last year over the creation of a Milton Friedman Institute for Research in Economics. Protesters argued, in part, that in choosing to name the research institute after Friedman, the planners were ignoring how in the 1970s the Chicago School’s free-market ideas went awry in developing nations when the Chicago Boys—a group of Chicago-trained Chilean economists—worked for the brutal dictator Augusto Pinochet.
Despite its controversial side, the Chicago School’s faith in markets gained wide influence in both public opinion and fiscal policy. Current government behavior in the United States and elsewhere, however, shows fewer signs of that influence. Beginning in fall 2008, world leaders moved quickly to intervene in markets, prop up banks, lend money to struggling firms, assemble stimulus packages. The U.S. government, in many economists’ opinions, has effectively nationalized the banking system, a no-no in Chicago School thinking.
Becker, the University professor in economics and sociology, concedes that the market collapse has damaged the Chicago School’s influence. But it didn’t, he argues, undermine the school’s principles. “I don’t think any of the major ideas were wrong,” he says in an interview. “If you look at the role of markets and competition in promoting economic growth over the last 25 years, things look very well, even if you factor in this serious recession.”
Robert Lucas devised the standard model for studying economic systems.
In those 25 years, Becker says, market forces have lifted many people out of poverty in places like China, India, and Brazil. Markets make mistakes, but “you have to take some of the bad with by far the good.” Even if we’ve lost wealth during the recession, he says, most people remain better off than they were a quarter century ago. It’s the same with the Chicago Boys: their policies did create greater income inequality in Chile, but they also, Becker has argued, helped spur economic and political change across Latin America.
Becker is willing to withhold judgment on the Chicago School’s role in the current crisis. We may not know for a few years if it deserves blame, he says. Yet true purists hold that the Chicago School has nothing to apologize for.
Fellow Nobelist Heckman, for example, absolves it of wrongdoing. He takes issue with critics like Stiglitz who suggest that Chicago, in effect, worships markets: “‘Markets are perfect’ is the vulgar view of Chicago economics.” In fact, the collapse was caused by the government regulators and Wall Street traders ignoring Chicago School principles, he argues, and forgetting that markets are about how people respond to incentives. “If I put a pot of gold out on the Midway and said, ‘Help yourself,’ most people would take it.” Deregulation created “perverse incentives” for Wall Street, rewarding traders richly for greedy, “privately rational” behavior that would ultimately come close to bringing down the system itself. “The Chicago School never said we wanted blind deregulation,” Heckman argues. “We should really ask who were the people in 2000 who decided markets don’t need regulating. Those were not Chicago economists. Some of them were Clinton officials, and some of them are now advising Obama.”
Indeed, by the 1990s the idea that markets—both financial and industry—work was part of economic orthodoxy. Chicago’s business school is a center of research on markets, most famously Eugene Fama’s efficient-market hypothesis, which holds that markets have the information they need to price stocks correctly. In effect, Fama argues, you can’t beat the market.
Today Fama, MBA’63, PhD’64, is also a target for critics. Time magazine economics writer Justin Fox argues in his 2009 book The Myth of The Rational Market that efficient-market theory led finance scholars, and then Wall Street, to a “conviction that [the market] is perfect.” Obviously, a market perfect at pricing should avoid rapid repricing events, such as crashes. Outside the University of Chicago, Fox argues, the efficient-market theory is often regarded with skepticism. In the book Fox contends that Fama himself concedes his theory is flawed, citing his 2007 paper, written with Dartmouth economist Kenneth French, showing that knowledgeable traders can’t offset all the damage done by “misinformed investors.”
At the May conference, Chicago Booth Dean Edward A. Snyder, AM’78, PhD’84, held a forum with Fama, who showed no signs of thinking his theory had failed. He did allow that it had problems explaining phenomena such as momentum trading, the tendency for a stock to continue rising or falling. But even Fox acknowledges the basic premise of the efficient-market theory, that investors cannot consistently outperform the broad stock-market indices.
Like Fama, Anna J. Schwartz, Friedman’s collaborator on the massive 1963 book A Monetary History of the United States, 1867–1960, makes no apologies. “There have been business cycles for centuries, some mild, some even severe,” she wrote in an e-mail. “Why should the current one be expected to alter the views of the Chicago School?”
The Chicago School philosophy under attack today is no longer a radical one. The general free-market principle won out and is now common practice. Critics use the term as shorthand for libertarian free-market ideology, which is what they actually oppose. Friedman and Stigler in fact were fiercely skeptical of much government action. Stigler’s research showing that government regulation of electricity often fails to achieve its goals came out just before Friedman and Schwartz’s book, blaming the Depression’s depth not on the markets but on mistakes by the Federal Reserve. But Friedman was not some Ayn Rand acolyte yelling that the Federal Reserve should be abolished. He thought government had a role to play, in particular as a setter and enforcer of rules and controller of the money supply.
In the 1960s using empirical data and mathematical models were radical methods in economics. Chicago’s economics department and later its business school adopted those methods early, and they are now standard. Likewise, the standard model for studying economic systems was devised by Chicago economist Robert E. Lucas Jr., AB’59, PhD’64.
Today’s scholars at Chicago still use those methods, but they have varied views on government intervention. The faculty includes behaviorists such as Richard Thaler, whose research suggests that markets actually need a helping hand, sometimes from government. At the moment Chicago’s best-known economist is probably Steven Levitt, who doesn’t even study macroeconomic phenomena. His 2005 Freakonomics sold millions of copies and has some accusing him of damaging the profession (see “Sumo wrestlers are big, but are they a Big Question?”). Yet even Levitt knows his Chicago School dogma. If the recession lingers, he quips, “as Chicago economists, we’d have to start blaming the government for that.”
That the Chicago School still gets invoked serves as a testament to Friedman’s power as an economist and writer. His Capitalism and Freedom (1962) called for the end of the fixed-currency exchange-rate system established at the 1944 Bretton Woods conference, for school vouchers, for a flat tax, and for the end of state licenses for professionals like doctors. The book has sold hundreds of thousands of copies and is still in print almost half a century later. Retiring from Chicago in 1977, in 1980 Friedman and his wife, Rose, PhB’32—who died this past August—created the ten-part PBS series Free to Choose, celebrating the power of markets and individual freedoms. Conservative politicians like Richard Nixon, Ronald Reagan, and Margaret Thatcher championed Friedman’s ideas, including abolishing the draft and privatizing industries, to a public increasingly inclined to distrust government in the wake of the Vietnam War, Watergate, and the emergence of stagflation.
Acceptance of the Chicago School was thus “somewhat of a historical accident,” says William T. Niskanen, PhD’62, former chief economist of Ford Motor Co. and chair emeritus of the Cato Institute, a libertarian think tank. Conservatives weren’t the only ones adopting those ideas—both Jimmy Carter and Bill Clinton loosened regulations, for instance. Yet even at their 1980s height of influence, Chicago School ideals took a back seat to political need—the first U.S. bank considered too big to fail was Continental Illinois in 1984. And since 2003, Niskanen says, when George W. Bush’s administration began increasing government’s role in public life through, for instance, the Patriot Act, Chicago School ideas have been on the wane in Washington.
Before the current collapse some University economists tried to warn that the financial system was dangerously flawed. Raghuram G. Rajan, the Eric J. Gleacher distinguished service professor of finance, was the International Monetary Fund’s chief economist in 2005, when he warned at the Kansas City Federal Reserve Bank’s annual Jackson Hole Symposium that the financial system was poised for collapse. Rajan said lack of regulation and excessive compensation, especially fat bonuses, were driving unsustainable levels of risk. He was flayed by a number of economists there, including then-Harvard president Lawrence Summers, now director of Obama’s National Economic Council, for being anti-market.
Rajan, who in fact favors markets, at least well-regulated ones, notes that he was not the lone Chicago voice in the wilderness. Thaler and fellow behavioral economist Rob Vishny also warned of system perils.
It may not be their Chicago School anymore, but the spirits of Friedman and Stigler remain. Last September, at the height of the crisis, Chicago Booth’s John Cochrane led a petition drive that challenged the Bush administration for using taxpayer money to rescue financial institutions, for creating an ambiguous plan, and for weakening the “private capital markets [that] have brought the nation unparalleled prosperity.” In effect, the petitioners wanted the government to stop intervening in markets by trying to prop up financial firms. They wanted it, in short, to stop acting so Keynesian. Among its 230 signatories were 45 members of the Chicago faculty.
But by May, none of the Future of Markets panelists—not Becker, not Murphy, not Rajan, not Marianne Bertrand, Steven Kaplan, or even petition cosigner Anil Kashyap—said the government was wrong to step in and unfreeze the financial markets. Instead they debated how long the recession would last and how strong the recovery would be. Most were skeptical that the recovery would be robust because the government had gotten sucked into long-term economic intervention.
Becker is right. We can’t yet know what the downturn will do to the ideas of the Chicago School. It took decades for Keynesian principles to ebb. Now they flow again as Stiglitz and like-minded theorists regain popularity. Some other mode of thought could also rise. Alan Kirman, professor of economics and director of studies at France’s Paul Cézanne University (Aix-Marseilles III), coauthored the February 2009 Dahlem Report, which critiqued contemporary economics. Kirman, who went to graduate school at Princeton with Heckman, thinks economics was already undergoing a slow transition away from the neoclassical model before the crash and the current wave of anti–Chicago School critics.
Perhaps the crisis will indeed prompt a mutation. Otherwise, “we don’t have an alternative to markets for most things,” says Harvard economist Edward Glaeser, PhD’92. In other words, markets are like Churchill’s view of democracy: a flawed way to run an economy, except for all the others ways we know.
Despite the vogue for neo-Keynesianism, says Sam Peltzman, PhD’65, the Ralph and Dorothy Keller distinguished service professor emeritus of economics, outside of finance the Obama administration still adheres to market principles. “They’re not bringing back the draft or bringing back [industry] regulation. We’re not going back to the gold standard.” Peltzman, wearing a shirt covered in hot-sauce bottles, turns up the heat. “This experience is going to seal the tomb on socialism for all time,” he says. “If this can’t bring it back, it’s hard to think about what could.” A burst of Keynesianism should surprise no one, he argues. Of course we hope the government can step in and save the economy. In a crisis people “become infantilized and go back to what’s comforting to you as a child.”
The Keynesian burst, Peltzman insists, will wane. “It’s clear already it’s not working,” he says. “There are two possible reactions to that: ‘Well, it’s not big enough,’ from the left. The other, from people like me, is it’ll make it still worse if you go down that road.”
At the Future of Markets conference, the keynote panel ended with the six Chicago economists discussing the government’s role in the marketplace. All were concerned about the potential—or the likelihood—that bad market behavior would spawn even worse regulation. What we need most, as Rajan put it, “is cleverer regulation, so that perhaps next time around we might get it right.” Friedman and Stigler would probably agree.
Friedrich Hayek’s 1944 book The Road to Serfdom, with its sweeping theme that any form of collective government leads to tyranny, laid the groundwork for the Chicago School of Economics. Will another book lead to its unraveling?
Freakonomics, the 2005 book by Chicago economist Steven Levitt and journalist Stephen Dubner, uses economic techniques to study questions nontraditional in the world of economics, such as whether Japanese sumo wrestlers cheat and whether legalizing abortion led to less crime. The book has sold 3 million copies, inspiring lots of talk about economics and a regular New York Times blog by the authors. But it also brought out critics, including from within Chicago’s economics department. The New Republic’s Noam Scheiber took aim at the Freakonomics phenomenon in his April 2007 article “Freaks and Geeks: How Freakonomics is Ruining the Dismal Science.” Heavily quoted in the piece: Chicago Nobel laureate James J. Heckman.
Heckman doesn’t cite Levitt by name, but he does complain about a trend that finds economists going after only small, manageable questions and discouraging them from pursuing problems they can’t solve quickly or easily, such as the nature of business cycles. Scheiber connects the dots for those who didn’t get it: “Heckman’s allusion to a certain pedagogical technique is almost surely a shot at his Chicago colleague, Steve Levitt.”
Heckman has nothing against Levitt, he says in an interview. “What I’m concerned about is not him personally; he’s fine.” But he disdains Levitt’s approach: “Freakonomics is an exercise in triviality. It’s intellectual escapism. It substitutes cuteness for substance. And the style of research that suggests that you need to somehow produce a paper every two months that’s cute and catches the eyes of the New Yorker reader damages the kind of long-term research that economists do and still do at Chicago.”
Questions that macroeconomists, at least, could be tackling involve economic growth, the effect of regulation, and how financial markets work. Heckman cites Milton Friedman, AM’33, and Anna J. Schwartz, who spent ten years studying the relationship between money and the economy, resulting in their 1963 Monetary History of the United States, 1867–1960. He admires former Chicago economist Robert M. Townsend (now at MIT, though still a research professor at Chicago), who spent a decade assembling a database supporting his work on Thailand’s economy. “I don’t want to single Levitt out,” he says. “The ethos of a lot of modern young economists is, ‘I’d rather have it methodologically right than be a dirty question.’”
In an interview, Levitt agrees, almost deferentially (in Scheiber’s New Republic piece, he referred to himself as “a dilettante”). He pursued his course of research because, he says, “I’m just not that good an economist; I’m just not that talented. I had to find ground that no other economist had traversed.”
Then Levitt works in a bit of verbal jiu jitsu, comparing his work on crime and abortion to Gary Becker’s (AM’53, PhD’55) once-unappreciated studies of discrimination and families. Sounding tired of the debate, he jabs back at his critics. “There are a lot of economists out there who’ve been tilling the same ground for the last 30 or 40 years. I think there’s some value in going out to define new ground to tackle.”
Levitt’s peers in academic economics seem to agree. He won the 2003 John Bates Clark Medal, given to an outstanding American economist under 40. Among the previous medal recipients: Friedman, Becker—and Heckman.
From the rhetoric, one might think that the Heckman/Levitt debate was an insider’s struggle, a battle between a macroeconomist who looks at broad systems and a microeconomist who examines individuals within those systems. But Heckman and Levitt are both microeconomists. Heckman won his Nobel for his use of microeconometrics, or statistics-driven studies, to examine topics like creating incentives for workers. Levitt looks at what motivates people.
Weighing in on the Scheiber article, Alex Tabarrok, an economist at George Mason University, wrote: “The truth is that even today most of economics is a wasteland of boring papers on profoundly uninteresting questions. The choice is not Levitt v. Heckman; it’s Levitt and Heckman...versus a huge number of nonentities (many highly paid and famous) who answer trivial questions poorly and do it without even the courtesy of offering some entertainment on the side.” Perhaps Levitt brings a little levity to a field desperately in need of it.
As he puts it, Levitt believes he represents a broader trend in economics of asking new questions about new areas. “Would I say that I’ve distracted the profession of microeconomics? Well, I hope so,” he says. “That’d be a great compliment.”
But to Heckman, Levitt’s distraction does a disservice. “Basic research on the economy is ugly,” he says. “It’s hard, and it’s unrewarding.”
It is Socrates v. the Sophists, the Impressionists v. the Academy, quantum mechanics v. classical dynamics. Hayek’s Road to Serfdom hasn’t been paved, and it’s unlikely economics’ road to ruin runs through Steven Levitt’s office.—M.F.