Archive for April, 2010

Hayek Evaluates Keynes as a Charlatan Economist

April 30, 2010

” Whatever one may think of Keynes as an economist, nobody who knew him will deny that he was one of the outstanding Englishmen of his generation.  Indeed, the magnitude of his influence as an economist is probably as much due to the impressiveness of the man, the universality of his interests, and the power and persuasive charm of his personality as to the originality or theoretical soundness of his contribution to economics… As a scholar he was incisive rather than profound and thorough, guided by strong intuition which would make him try to prove the same point again and again by different routes.” F.A. Hayek, ‘Review of Harrod’s Life of Keynes in The Journal of Modern History June 1952

“It may be doubted whether ‘his flair for global estimates which, not least due to his influence, has now become the fashion, and his general habit of thinking in terms of aggregates and averages, have been beneficial to the understanding of economic phenomena.  Economic activity is not guided by such totals but always by relations between different magnitudes, and the practice of always thinking in ‘global’ totals can be most misleading.” F.A. Hayek, ibid.

“The main reproach to which Keynes laid himself open was that he presented as a ‘General Theory’ what was essentially a tract for his times.  It was the successful one of repeated attempts he made to justify his practical inclinations by theoretical argument.  It succeeded partly because it provided a highly sophisticated support for demands which are always popular in times of depression and partly because it was expressed in a form congenial to the scientific fashions of the moment.  Yet it was based on assumptions even more unrealistic than those Keynes ascribed to what he called classical economics.  If it was a defect of the latter that it assumed for a first approach that there existed no reserves of unused resources, Keynes was even more unrealistic in assuming that there existed always ample reserves of all resources.  In short he assumed away that scarcity of resources which is the root of all our economic problems.” F.A. Hayek, ‘Symposium on Keynes: Why?’ The Christian Science Monitor, September 1959

“Keynes was not a highly trained or a very sophisticated economic theorist.  He started from a rather elementary Marshallian economics and what had been achieved by Walras and Pareto, the Austrians, the Swedes, was very much a closed book to him.  I have reason to doubt whether he ever fully mastered the theory of international trade; I don’t think he had ever thought systematically on the theory of capital, and even in the theory of the value of money his starting point – and later the object of his criticism – appears to have been a very simple, equation-of-exchange-type of the quantity theory rather than the much more sophisticated cash-balances approach of Alfred Marshall.” F.A. Hayek, ‘Personal Recollections of Keynes and the Keynesian Revolution’, The Oriental Economist, January 1966.

“He was so many-sided that when one came to estimate him as a man it seemed almost irrelevant that one thought his economics to be both false and dangerous.  If one considers how small a share of his time and energy he gave to economics, his influence on economics and the fact that he will be remembered chiefly as an economist is both miraculous and tragic.” F.A. Hayek, ibid.

“It will not be easy for future historians to account for the fact that, for a generation after the untimely death of Maynard Keynes, opinion was so completely under the sway of what was regarded as Keynesianism, in a way that no single man had ever before dominated economic policy and development.  Nor will it be easy to explain why these ideas rather suddenly went out of fashion, leaving behind a somewhat bewildered community of economists who had forgotten much that had been fairly well understood before the ‘Keynesian Revolution’.  There can be no doubt that it was in Keynes’ name and on the basis of his theoretical work that the modern world has experienced the longest period of general inflation, and has now again to pay for it by a widespread and severe depression.” F.A. Hayek, ‘The Keynes Centenary: The Austrian Critique’, The Economist, June 11, 1983

“I am afraid this obliges me to say frankly that I still have no doubt that Maynard Keynes was neither a full master of the body of economic theory then available, nor really cared to acquaint himself with any development which lay outside the Marshallian tradition which he had learnt during the second half of his undergraduate years at Cambridge.”  F.A.Hayek, ibid.

Maynard Keynes once again stalks the corridors of power both in the United Kingdom and in the United States. It is completely unsurprising, therefore,  that these two countries are the very last to stagger ouf of the financial crisis and economic contraction of 2008. I predict with considerable confidence that these two countries will also be the worst affected by significant stagflation throughout the coming decade. 

“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.  Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.  I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.  Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new ideas after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.” J.M. Keynes, The General Theory of Employment, Interest, and Money, 1936.

Give me Liberty, or give me Death!

April 29, 2010

“It is not now time to talk of aught

But chains or conquest, liberty or death”

Joseph Addison, Cato, A Tragedy, 1713

This play was a literary inspiration for the American Revolution, being well-known to many of the Founding Fathers.  George Washington had it performed for the Revolutionary Army while the Army was encamped at Valley Forge.

“Why stand we here idle?  What is it that gentlemen wish?  What would they have?  Is life so dear, or peace so sweet, as to be purchased at the price of chains and slavery?  Forbid it, Almighty God!  I know not what course others may take; but as for me, give me liberty or give me death!”

Patrick Henry, Speech to the Virginia Convention, March 23, 1775

This speech is credited with having swung the balance in convincing the Virginia House of Burgesses to pass a resolution delivering the Virginia troops to the Revolutionary War.  Among the delegates present on that occasion were future U.S. Presidents, George Washington and Thomas Jefferson.

“Our nation’s founding was a historical turning point.  The Founders embraced the inherent value of each person, adopted a Constitution that established the freedom to choose life’s path, and established a government that would only govern with the people’s consent…We are at another turning point.  President Obama is pursuing a socialist agenda based upon a demand for radical equality.  As embraced by modern-day liberals, this is not equal opportunity, but equality of outcomes.  By rejecting both success and failure, radical equality leads inexorably to a tyranny of shared misery. The Founders could have chosen this path.  The French did, and their Revolution led to anarchy, the guillotine and dictatorship.  Instead our Founders chose freedom, launching a remarkable period of liberty and prosperity.”

James Bopp, ‘Freedom manifesto key to Republican comeback’, The Washington Times, April 28, 2010.  James Bopp is a vice-chairman of the Republican National Committee.

I have referred on several occasions in these columns to the fundamental difference between negative and positive freedom and the crucial importance of understanding this distinction.

Negative freedom – the freedom of any individual from arbitrary coercion by any other – was the ideal that inspired the Roman Republican Statesman Cato to address his army, following its defeat by Julius Caesar at Thapsus, and immediately prior to  his own consequential suicide  (46 BC)).  Negative freedom was also the ideal that inspired Patrick Henry to make his famous address before he spectacularly simulated his own death on the  floor of the Virginia Convention.

Positive freedom is the bastard notion that now flows through the veins of  too many Americans – Democrat and Republican alike – and that stresses regulated egalitarian outcomes, rather than equality of opportunity, as the basis for  man’s freedom. Positive freedom is the road to serfdom clearly identified by Friedrich von Hayek in his justly famous 1944 monograph by that name.

Over the period 2000-2006, the reins of political power were entirely in Republican hands, with the presidency, both houses of Congress and the US Supreme Court under Republican control. What followed was a massive surge in support for positive freedom,  driven by surging federal expenditures, socialist expansions in the public financing of health care, burgeoning foreign wars, invasive transportation policies, and the like.  The Republican majorities never saw an invasion of negative freedom that they did not like.  The Republican motto throughout this period is well-characterized by replacing ‘tax and tax’ with ‘borrow and borrow’  from Harry Hopkins’ infamous defense of FDR New Deal policies:

“We will spend and spend, and borrow and borrow, and elect and elect” (Karl Rove, do you think, Dear Readers?)

Well, the Republicans failed signally in the latter prediction.  A sufficient number of Americans became so addicted to the methadone that they raided the clinic for the real heroin.  By 2007, the Republicans had lost control over Congress. In January 2009, the Democrats controlled the White House and both houses of  Congress.  Since then, positive freedom reigns supreme, and negative freedom is retreating on all fronts across the United States.

So let us watch closely as the Republican Party girds its loins for the 2010 and 2012 elections. What exactly does James Bopp mean when he talks about a Freedom Manifesto?  His words surely leave open the implication that negative freedom is his goal. They also leave open the alternative implication.  Republican politicians, no less than Democrats, love the sound of all that Amazing Grace softly lining their campaign coffers. Will they have the courage and the self-restraint to ignore the Sirens and to strap themselves to the ship’s  mast as they set sail for the long-lost waters of negative freedom?

Or is this thought merely wishful thinking, yet another triumph of hope over experience?

Hat Tip to Black Flag


September 15, 2008: The Day of Judgment for Chicago Economics

April 27, 2010

On September 15, 2008 Lehman Brothers Holdings Inc., a global financial services firm, headquartered in New York, with regional headquarters in London and Tokyo, and with offices located throughout the world, filed for Chapter 11 bankruptcy protection following a massive exodus of most of its clients, drastic losses in its stock, and devaluation of its assets by credit rating agencies.  The filing marked the largest bankruptcy in the history of the United States.  As a classical liberal political economist, I experienced sadness for those adversely affected, but qualified optimism for laissez-faire capitalism.  After all, this is how markets are meant to work, with bankruptcy serving as a cleansing agent in the process of creative destruction that underpins wealth creation under competitive conditions. My qualifications concerned only the robustness of this outcome. Would government, in a state capitalist system driven by special interest politics,  actually allow Lehman to go down?  My public choice instincts correctly told me that the story had only just begun.

Well, the demise of Lehman surely was only the early beginnings of a fascinating  journey that would descend into the lowest depths of special interest politics, that would challenge the most fundamental precepts of individual freedom under the rule of law, and that would confirm my judgment on the validity both of  the Virginia political economy program and of the Austrian economics perspective on the nature of the business cycle.  For many post-Hayek, post-Friedman  Chicago economists, however, September 15, 2008 and its aftershocks were viewed in an entirely different manner;  as ‘The End of Days’, or as ‘The Day of Judgment’.

Chicago economists, for the most part, had long abandoned Friedrich von Hayek’s focus on the limitations of knowledge and the associated coordination problem in market process and the inevitability (and value) of periodic booms and busts in a market economy. Under the unsophisticated leadership of Robert Lucas, they now adhered to the nostrum that all business cycles are real, that all are caused by supply shocks, and that economies proceed at full Pareto-optimality through the short-term adjustments that follow outside shocks. They had rewritten the histories both of the Great Depression and of the 1981-83 recession to fit the fable that the American workforce had simply  enjoyed extended vacations while searching for the best available deals among a fully satisfactory range of job opportunities.  Soup kitchens, what were soup kitchens, other than as opportunities for recreational meetings?

Chicago economists, for the most part, had long abandoned Milton Friedman’s love of liberty, replacing it with George Stigler’s and Richard Posner’s love of wealth as the highest ethical value of mankind. They had re-written recent history to embrace the growth of the giant  corporation and to rejoice in the growing inter-relationships  between  corporations and governments in a wealth-creating symbiosis.  How they had rejoiced in the 1999 dismantling of the Glass-Steagall Act, legislation that had unnecessarily impeded the merging of retail banking with casino investment banking to the detriment of  Wall Street profit-making!   ‘Accumulate, accumulate!  That is Moses, and all the Prophets!’  Karl Marx, Das Kapital

Chicago economists, for the most part, had long forgotten the deep suspicion of the coercive power of government written into the genetic codes of Hayek and Friedman. Instead, they had imbibed deeply from the hallucinogic potions of George Stigler, Gary Becker and Donald Wittman that imbued them with Panglossian visions of  the wealth-maximizing qualities of democratic politics and of the wondrous healing nature of Ricardian- equivalence with respect to accumulating budget deficits.

So, when the Day of Judgment finally arrived, Chicago economists, for the most part, were shocked and ill-prepared. Slowly it began to dawn upon them  that the corporatist  lunch to which their tastes had become so well -adjusted might be high cost rather than free, that the grass really might be greener on the laissez-faire side of the street, and that individuals really might behave better under conditions of competitive capitalism than under conditions of a social market economy.  But these were merely feelings; and emotion should play no role in a discipline that was dedicated to the primacy of rational choice.  What to do, what to do?

Well, Robert Lucas, perhaps wisely, decided to head for cover, and to avoid potentially embarrassing interviews with aggressive journalists, now loaded for Chicago bear. Eight others allowed themselves the mixed blessing of  interviews with John Cassidy, an ‘American Idol’ exposure to the progressive-leftist columns of  The New Yorker.  Let me close the discussion with a balanced and representiative set of statements emanating from two of these interviews, one with Richard Posner, the other with Gary Becker, identifying the far left and the moderate right positions on the Chicago faculty:

Cassidy to Posner: ‘Has your critique of the efficient markets hypothesis made you rethink your view of markets outside of finance?

Posner to Cassidy: ‘Even before this, I had become less doctrinaire about markets.  For example, one of the topics Gary Becker and I debated on our blog was New York City’s ban on transfats. I supported that. The country has an obesity problem.  I didn’t think that just listing the amount of transfats on a menu would deal with it – people don’t know this stuff.  I thought a ban, even though it violated  freedom of contract, made sense.’ (my italics)

Cassidy to Posner: ‘What about Chicago economics in particular?  At this stage, what is left of the Chicago School?

Posner to Cassidy: ‘Well, the Chicago School had already lost its distinctiveness.  When I started in academia – in those days Chicago was very distinctive.  It was distinctive for its conservatism, for its 1968 fidelity to price theory, for its empirical studies, but not so much for formal modeling.  We used to say the difference between Chicago and Berkeley was Chicago was economics without models, and Berkeley was models without economics. But over the years, Chicago became more formal, and the other schools became more oriented towards price theory, towards micro. So, now there really isn’t a great deal of difference….I’m not sure there’s a distinctive Chicago School anymore.’

Cassidy to Becker:  ‘Posner says that the government’s interventions have staved off another Great Depression.’

Becker to Cassidy: ‘it’s been long recognized that there are situations when you need very strong, temporary government intervention. [Policy-makers] did come in here, and they did help.  It was a very mixed bag of different policies.  I don’t blame them too much for that.  It was a novel situation and they were experimenting a lot.  I definitely think they helped, though, overall, in averting a much more serious recession.’

Cassidy to Becker: ‘Two of the big theories associated with Chicago are the efficient-markets hypothesis and the rational-expectations hypothesis, both of which, some say, have been called into question.  How do you react to that?

Becker to Cassidy: ‘Yeah, markets aren’t fully efficient. Expectations go wrong.  We’ve seen many other episodes in the past where expectations have gone wrong, where it looks like there were bubbles that happened.  Certainly, in the housing market it did look like there was a bubble going on, and people were anticipating prices still going up. Nevertheless, the notion that people are forward looking and try to get things right, and often they do get things right – I still think that comes through O.K. You just have to be more qualified and more careful how you state it.’

Cassidy to Becker:  ‘Lots has changed at Chicago in recent years.  What if anything is distinctive about Chicago economics these days?

Becker to Cassidy: ‘It’s not as distinctive as it was when I graduated with my Ph.D from Chicago.  In those days, there was a great belief in the price system, in people’s incentives, and in linking theoretical research to empirical research.  That wasn’t common at most of our competitors.  Both in micro and in macro, there were major differences.  Chicago was hostile to Keynesian economics when I was in graduate school.  Now there’s been a lot of convergence, particularly on the micro side of things. Chicago is less unique than it used to be.’

Cassidy to Becker:  ‘How do you think that the financial crisis will change economics? The nineteen-thirties revolutionized economics. Do you see that sort of change?’

Becker to Cassidy:  ‘No, not of that magnitude.  If this recession had got a lot worse, we would have seen two major changes: much more government intervention in the economy and a lot more concentration in economics in trying to understand what went wrong.  Assuming I’m right and, fundamentally, the recession is over – a severe recession but maybe not much greater than the 1981 recession, or those in the nineteen-seventies – I think you are not going to see a huge increase in the role of government in the economy. I’m more and more confident of that.  And economists will be struggling to understand how this crisis happened and what you can do to head another one off in the future, but it will be nothing like the revolution in the role of government and in thinking that dominated the economics profession for decades after the Great Depression.’

Cassidy to Becker: ‘Some people in Chicago don’t accept the too-big-to-fail doctrine. They say, “Let them go.”‘

Becker to Cassidy:  ‘I think in this crisis we had to do it (bail them out).  I don’t accept the view that in this crisis we should just have let everything fall where it may. Yeah – the economy would have picked itself up, but I think it would have been a much more severe recession.’

‘And we’ll tak a cup o’ kindness yet, for auld lang syne.’  Robert Burns, A Scottish Poem, 1788

The Demise of Chicago Economics 3: World-Class Technique Alone Does Not Cut the Mustard

April 26, 2010

The Chicago School of Economics did not arrive fully grown in 1946 and 1950 with the arrivals of Milton Friedman and Friedrich von Hayek.  Strong foundations had been laid during the inter-war years by the deep-thinking  Frank Knight and the analytically brilliant  Jacob Viner, together with the strong (though not unequivocal) support of Paul Douglas and Henry Simons.  The soil was fertile for Hayek and Friedman to carry the baton of free market economics on its second lap.

For an economist to make a real impact, in my opinion, four ingredients are necessary.  The first ingredient is genius, the ability to see through the fog of a complex world and identify new insights of true significance for the discipline. The second ingredient is an understanding that economics is about economizing, and that economizing requires that economic models themselves must be economical: they must produce a lot from a little, not a little from a lot. The third ingredient is communication skills. Writing in simple clear sentences is the art of good communication. If an economist uses mathematics and econometrics as a crutch rather than as a tool, he is lost in translation, just as an attorney is lost before a jury if he has to resort to a blackboard to make his point. The fourth ingredient is relevance. Great economists do not waste their talents on the third order of smalls. They direct their energies exclusively to issues of the highest contemporary importance.

Hayek was endowed in full measure with these four ingredients, and used them well. Hayek’s early career focused on the role of knowledge and discovery in market processes and on the methodological underpinnings of  Austrian economics, notably subjectivism and methodological individualism. Throughout a long career, Hayek  focused attention on economics as a coordination problem, and on the role of markets as spontaneous orders  that, to a greater or a lesser degree,  resolve that problem of coordination, not least by signaling inconsistency among the plans of individuals and by providing incentives for the resolution of such inconsistencies.  Hayek was no Utopian.  He fully recognized that market economies periodically experience profound failures of coordination, that panics and recessions, even depressions do occur. He explained, better than anyone else, just how those failures occur, who and what is primarily responsible, and how the process of regeneration can and will occur in a well-functioning market economy.  How much his wisdom would be missed in September 2008 by the fatal conceit of an economics profession that rushed to constructivist rationalist solutions that he had long abjured!

Friedman also was well-endowed with those four ingredients, though in a different balance.  Friedman was less philosophical  than Hayek, better trained in advanced economic theory and econometrics, more narrowly focused on economics, and much more aggressively brilliant in debate. In my judgment, Hayek ranks first, and Friedman second, as the two most influential economists of the second half of the twentieth century. Friedman had a wonderful sense of what was important in the debate between mercantilism and free markets. His work on the consumption function embraced the economics of Keynes while invalidating the Keynesian theory of a powerful fiscal multiplier.  His reformulation of the quantity theory of money and his rigorous testing of its predictions,  laid the foundations for the 1980s re-emergence of monetary policy from its long dangerous sleep throughout the Western World.  His insights on flexible exchange rates provided a crucial basis for the worldwide globalization that surely followed its implementation.  His influential critique of the military draft saved countless Americans from temporary enslavement by the state. Most important of all, his consistent application of high-quality price theory to an understanding of economic issues provided a beacon of light to the economics profession thus transforming the discipline world-wide.

Inevitably, the presence of two such towering intellects drew the brightest and the most ambitious young  (and older)economists to Chicago like moths to the flame. Those economists, for a time,  at least, inspired by what they believed to be the ‘fire of truth’, worked wonders on economics, literally forcing back the powerful divisions of progressive socialism that swamped out the US economics profession during the middle years of the century. Among these eager scholars, were Ronald Coase, Harold Demsetz,  Harry Johnson, Gary Becker, Sam Peltzman, Reuben Kessel, Richard Epstein, Richard Posner and William Landes, names that are now renowned (if not always revered) for the contributions that they made to free market economic thinking.

Unfortunately, this beautiful program would not last, in fact would not long survive the departure of Milton Friedman from Chicago. Some attrition came through premature deaths, some through departures to sunnier climes, some through eventual changes in economic philosophy. Most important, however, was the fault-line that developed when Chicago faculty determined to emulate their Saltwater rivals and to substitute high technology for human capital, complex modeling for simple modeling, impressive incoherence for simple communication skills, and third order of smalls for relevance, in order to attract mathematicians to the doctoral program and to publish in journals whose editors had lost all sense of what is important and what is not. As one renowned faculty member listed above advised me just a few years ago:  ‘Charles, I would never have graduated through the Chicago program as it now is. I am not a world-class mathematician, and I do not emanate  from the People’s Republic of China.’

When an economist substitutes technique for quality-thinking, writes in jargon rather than in good prose, directs his attention to problems where data sets exist for mining, rather than because the problems are of substantive importance, and focuses attention on making marginal contributions to a well-researched field rather than redirecting economic research through discrete innovative steps, he downgrades his impact and renders himself vulnerable to irrelevance when a crisis truly emerges. Too many Chicago economists fell for such low-hanging fruit over the past quarter century.  As I shall demonstrate in tomorrow’s column, this would cost them dearly in September 2008.

The Demise of Chicago Economics 2: Political Naivety Wipes Out the Lessons of History

April 25, 2010

Throughout the third quarter of the twentieth century, Friedrich von Hayek (especially) and Milton Friedman (to a certain degree) ensured that the Chicago economics program did not ignore political economy, thus guaranteeing that a suitably cautious and suspicious judgment about the behavior of political markets influenced the overall research agenda of the Chicago School. In this respect, Chicago clearly distinguished itself from all the major Saltwater economics programs where the Keynesian, Arrovian nostrum that government is the impartial servant of the public good was the sine qua non of all economic discourse. 

In saying this, by no means do I infer that Chicago’s understanding of the political process was ever close to being sound.  Neither Hayek nor Friedman kept abreast of the public choice revolution that emanated from Britain during the late 1940s (Duncan Black), and spread slowly across the United States during the late 1950s and 1960s (Anthony Downs, James Buchanan, Gordon Tullock and Mancur Olson). The concept of Homo Politicus was far from center-stage in their scholarship.  Essentially, neither maestro  had a theory of government behavior comparable to their excellent theories of private market behavior. And that always constituted a serious fault-line in Chicago economics, significantly weakening the School’s  defense of free markets against the all-but universal challenge from the Saltwater academies that private markets typically fail.

Yet, scholars of such experience and erudition could not be unaware of  the dangerous reach of politics. Hayek had fled central Europe for the comparative  safety of England during the 1930s as national socialism, fascism and communism marched across that benighted Continent. His seminal book, The Road to Serfdom (1944) drew upon his own experiences of those dreadful doctrines, to warn the West where not to go in the aftermath of World War II.  Friedman,  the son of Russian Jews who had fled Tsarist pograms to reposition themselves in the New World  by the good fortune and  grace of sweatshops, had no instinctive love of government. Friedman’s own experience advised him that government (not the private market-place)  is always the principal source of discrimination against immigrant minorities, even in a country that is almost entirely composed of immigrants. Ban the sweatshops, and commit penniless new immigrants to begging on the streets, or to death by pestilence and/or starvation.

Two quotes, one from each, underline their instinctive distrust of the state:

“The principle that whatever government does should be agreed to by the majority does not therefore necessarily require that the majority be morally entitled to do what it likes.  There can clearly be no moral justification for any majority granting its members privileges by laying down rules which discriminate in their favour.  Democracy is not necessarily unlimited government.  Nor is a democratic government any less in need of built-in safeguards of individual liberty than any other.  It was, indeed, at a comparatively late stage in the history of modern democracy that great demagogues began to argue that since the power was now in the hands of the people, there was no longer any need for limiting that power.  It is when it is contended that ‘in a democracy right is what the majority makes it to be’  that democracy degenerates into demagoguery”  F.A. Hayek, The Constitution of Liberty, 1960

“The preservation and expansion of freedom are today threatened from two directions. The one threat is obvious and clear.  It is the external threat coming from the evil men in the Kremlin who promise to bury us.  The other threat is far more subtle.  It is the internal threat coming from men of good intentions and good will who wish to reform us.  Impatient with the slowness of persuasion and example to achieve the great social changes they envision, they are anxious to use the power of the state to achieve their ends and confident of their own ability to do so.  Yet if they gained the power, they would fail to achieve their immediate aims and, in addition, would produce a collective state from which they would recoil in horror and of which they would be among the first victims.  Concentrated power is not rendered harmless by the good intentions of those who create it.” M. Friedman, Capitalism and Freedom, 1962.

And then the great Men were gone.  Knowledge coupled with wisdom about politics blew out, and ignorance coupled with naivety about politics swept in, through the corridors of the Chicago School.  Inevitably, the rot started with Stigler, who had maintained a cautious disrespect for government and regulation while working under the vigilant classical liberal eyes of Friedman. Stigler’s 1962 and his 1971 papers on regulatory failure constituted the basis for major intellectual  advances by Sam Peltzman and others. 

Stigler’s tendency towards deconstruction, however, began to embrace the political system as the 1980s advanced, and as he became increasingly unwilling to envisage any role whatsoever for economists in the process of policy reform. Ultimately, Stigler became a caricature of himself, advancing the notion that what is is efficient in increasingly unacceptable formulations. Surely his final thoughts on this matter, published postumously in 1992 in The Journal of Law and Economics, must rank high in the pantheons of stupidity published by any top-ranked journal of economics:

” Tested institutions and practices found wanting will not survive in a world of rational people.  To believe the opposite is to assume that the goals are not desirable: who would defend a costly practice that produces nothing?  So I would argue that all durable social institutions, including common and statute laws, must be efficient.” G.J. Stigler, ‘Law or Economics’, Journal of Law  and Economics , October 1992   

Inevitably where Stigler regressed, Gary Becker was sure to follow. And Becker surely lived down to expectations, producing in 1983 and 1985 two articles on interest groups that challenged one of the best established tenets of public choice, namely the generally supported hypothesis of Mancur Olson  that interest groups, plagued by problems of collective action, distort the political process by their interventions and contribute greatly to the decline and fall of nations.  Not so, says Becker, as the following quotation clearly indicates:

“Policies that raise efficiency are likely to win out in the competition for influence because they produce gains rather than deadweight costs, so that groups benefited have the intrinsic advantage compared to groups harmed.  Consequently, this analysis unifies the view that governments correct market failures with the view that they favor the politically powerful by showing that both are produced by competition among pressure groups for political favors.”  G.S. Becker, ‘A theory of Competition Among Pressure Groups for Political Influence’, Quarterly Journal of Economics August 1983

With intellectual leadership of such low calibre,  it is not surprising that Chicago political economy took a downward spiral throughout the final quarter of the twentieth century. With new and younger faculty members increasingly naive about politics – Robert Lucas and Lars Hansen barely allow government to enter into their models except as some abstract G variable, and Richard Posner remains a complete naif about the workings of political markets –  it was inevitable that Chicago economics would stand idly in the wings as the 2008 financial crisis unfolded and that most of its faculty would run for cover as the political storm unfolded.  Not everyone, of course, as I shall outline in tomorrow’s column. A disappearingly few Remnants still remain. And the odd Benedict Arnold still wanders up and down the corridors of a once-great free market economics program.

The Demise of Chicago Economics 1: Philosophical Fault-Lines Evolve

April 24, 2010

A primary reason why the Chicago School played such an effective role in promoting laissez-faire capitalism throughout the third quarter of the twentieth century was the philosophical  leadership provided by Friedrich von Hayek from the Committee on Social Thought and by Milton Friedman from the Department of Economics.  These deep-thinking, widely-read scholars imbued the entire Chicago School program with a sound normative basis from which to direct their influential positive economic analyses. 

The philosophy that drove Hayek and Friedman forward in their attack on statism and socialism in the professing of economics was not primarily a desire to maximize the wealth of a society – though that was never very far from their thinking.  The fundamental driving force was a belief that individual freedom (or individual liberty) is the most highly-valued ethical goal, and an understanding that individual freedom was under severe threat from the progressive socialist agenda that was then advancing across the Western World.

Both Hayek and Friedman prized individual freedom in its negative sense, as the absence of  arbitrary coercion of any individual by any other individual or group of individuals in society.  Such freedom offers no individual any specified outcome in society, but rather provides each individual with the opportunity to carve for himself such achievements as he can, in so doing enhancing his human fruitfulness.  Negative freedom, they clearly recognized, is the direct enemy of positive freedom, the philosophy of progressive socialists that insists that individuals have the right to certain categories of attainment that require coercive interventions by the state and its agencies. Yet, neither Hayek nor Friedman was an anarchist.  Both endorsed significant roles for the state, albeit roles that minimize invasions of negative freedom.  The rule of law was crucial for such a minimization of coercion of some by others:

“Whether he is free or not does not depend on the range of choice but on whether he can expect to shape his course of action in accordance with his present intentions, or whether somebody else has power so to manipulate the conditions as to make him act according to that person’s will rather than his own.  Freedom thus presupposes that the individual has some assured private sphere, that there is some set of circumstances in his environment with which others cannot interfere.”  F.A. Hayek, The Constitution of Liberty, 1960

“The free man will ask neither what his country can do for him nor what he can do for his country.  He will ask rather ‘What can I and my compatriots do through government’  to help us discharge our individual responsibilities, to achieve our several goals and purposes, and above all, to protect our freedom?  How can we keep the government we create from becoming a Frankenstein that will destroy the very freedom we establish it to protect?  Freedom is a rare and delicate plant.  Our minds tell us, and history confirms, that the great threat to freedom is the concentration of power.  Government is necessary to preserve our freedom, it is an instrument through which we can exercise our freedom; yet by concentrating power in political hands, it is also a threat to freedom.” M. Friedman, Capitalism and Freedom, 1962

These normative beliefs provided the fulcrum from which Harold Demsetz would develop the economic case for preserving private property rights, from which Ronald Coase would develop the case for allowing private bargaining to take care of externalities under conditions of low transaction costs, from which the young George Stigler and Sam Peltzman would develop economic arguments in favor of deregulation, and  from which Harry Johnson would advocate the case for free trade.  These were the arguments, of course, from which Hayek argued the case for constitutional constrants on government and for the spontaneous evolution of the Law of Nomos over the legislated  expansion of  the Law of Thesis. These were the arguments from which Milton Friedman wrote Capitalism and Freedom and from which he and his students launched the monetary workshop, that eventually would transform governance throughout the Western World.

Friedrich von Hayek  remained at Chicago only for the relatively short period, 1950 to 1962, when he moved to Freiburg.  Friedman joined the Chicago faculty in 1946 and retired in 1977.  The period 1950 to 1975  is  indisputably the  truly productive era of the Chicago School. 

As early as 1978, however, just one year after Friedman’s departure, the philosophy of individual freedom was under aggressive attack from within the Chicago School. In 1978, George Stigler published a paper in The Journal of Legal Studies under the ominous title: ‘Wealth, and Possibly Liberty’. In that fateful paper, Stigler outlined, for the first time, a radical moral agnosticism that led him to deny any distinction between coerced and free choices, licit and illicit acts, robbery and commerce, as long as they are equally utility-enhancing.  Finding the concept of coercion to be baseless, Stigler identified liberty with wealth.  The only ends that matter are all included in a single maximand, wealth, tempered by proximity-altruism. Led by Stigler and his most loyal disciple, Gary Becker, all but a very few remaining Chicago Remnants fell in line with the Stigler Doctrine.

The rest, as they say is history, at least for the Chicago School. My next two columns will outline the inevitable consequences of such shallow thinking for the decline and fall of  Chicago Economics, and for the entirely unnecessary nightmare that engulfed the School in September 2008.

The Decline and Fall of Chicago Economics

April 23, 2010

Throughout the third quarter of the twentieth century, the Chicago School played an indispensable  intellectual role in defending laissez-faire capitalism from the predations of state capitalism and socialism. As a by-product, the Chicago School also became a foremost defender of economic liberty. The Chicago School advanced this innovative program of ideas through reliance on a sensible rational choice approach, the pre-eminence of private  property rights and the rule of law for sustainable economic development, sound microeconomics, and macroeconomics reflective of classical political economy insights adjusted for the adverse  experience of the Great Depression. Under the indisputed  intellectual leadership of Friedrich von Hayek and Milton Friedman, with the support of Ronald Coase, Harold Demsetz, William Landes, Sam Peltzman, Harry Gordon Johnson, Richard Epstein, Al Harberger, and many younger rising stars, Freshwater Economics engaged and defeated Saltwater Economics in a bloody battle for the soul of the discipline.

Even during that crucial quarter of a century, however, Chicago was spawning the seeds of its ultimate demise, with the hiring of less subtle thinkers such as George Stigler, Eugene Fama, Gary Becker, Robert Lucas, and Richard Posner, each of whom seized eagerly upon the new ideas of their more creative  colleagues and progressed within the economics profession by pushing those ideas too far. George Stigler forgot his own important insights on the limits of knowledge and ended up by deconstructing  political economy into a near-tautology that ‘what is is efficient’.  Eugene Fama became so impressed with the quality of his own mind that he forgot reality and advanced the notion that capital markets are strong-form efficient. Gary Becker became so enamored with his mentor George Stigler that he joined him in the new Chicago Political Economy program by analysing interest group behavior as welfare-enhancing agents of the public good.  Robert Lucas carved out a Nobel niche for himself by pushing rational expectations thinking to insane limits. And Richard Posner –  well how can I describe the contributions of Richard Posner in a column designed for family readership?

So the seeds for decline and fall were well-embedded into the Chicago economics program by the mid-1970s, awaiting  only the exodus of Hayek and Friedman in order to explode into dominance.  By the mid-1980s, the new Chicago was in full flood, now dominated by Stigler, Becker, Lucas, Posner and Fama.  Democratic political markets were not just politically efficient, but wealth maximizing for society. Interest groups were agents of the public good. Capital markets were universally strong-form efficient. Western macroeconomies were Pareto-optimal throughout the real business cycle.   The common law had evolved (in the United States at least)  into a wealth maximizing agent of economic development.  Think about the  Hubris of such shallow thinking, Dear Readers, and just  know that Nemesis  was out there waiting in the wings.  

Well, Nemesis moved center-stage in September 2008.  In tomorrow’s column I shall begin to address just where those Chicago over-achievers and their new accolytes have ended up,  following the shattering of their ill-founded fantasies.

Rent Seeking versus Rent Extraction in the Market-Place of Politics

April 22, 2010

Some economists view lobbying outlays in political markets as a manifestation of free speech – and that is just fine if one is prepared to stretch the meaning of a word or two.  Surely the sweet sound of large dollar bills moving from the coffers of well-endowed  interest groups into the coffers of  well-endowed  political parties and well-endowed individual policians is a manifestation of Amazing Grace:

Amazing grace!  how sweet the sound,

that saved a wretch like me!

I once was lost but now am found,

was blind but now I see.

Through many dangers, tolls, and snares,

I have already come;

’tis grace hath brought me safe thus far,

and grace will lead me home.

(John Newton, 1779)

Well grace, surely lubricates the wheels of politics, ensuring that those who give also shall receive the fruitful  bounty of political harvests. Grace, of course, has nothing in common with the free lunch, even though it manifests itself on many a breakfast, luncheon or dinner table across this generous land.  Grace has something to do with markets, but it surely does not make them free. Grace is the dirty oil that introduces grit into the free market process, grit that builds up and builds up until eventually it transforms laissez-faire into state capitalism and destroys the wealth of a nation.

Grace comes to politics in two forms – rent seeking and rent extraction -the former marginally less malign than the latter. Neither form is in any way beneficial to those who strive to  make their living outside the Forbidden City. Let me explain.

Rent seeking is a concept introduced into economics in 1967 by Gordon Tullock, and named for what it is by Anne Krueger in 1974. Rent seeking is the rationale for the emergence and existence of special interests – organizations designed to generate, via  politics,  concentrated benefits for their constituents  while  imposing  dispersed costs on the wider community.  The concentrated benefits are viewed as rents because they are returns in excess of opportunity cost, available only through politically-imposed monopolies, rather than through free competitive markets. These rents are purchased through lobbying outlays.

Rent seeking is socially undesirable because it wastes scarce resources in pursuing redistributive outcomes that are themselves destructive of wealth.  In the limit, when the market in rent seeking is sufficiently competitive, rent seeking may well dissipate the total expected value of the monopoly rent that is sought through wasteful lobbying competition. The winner’s rents will be exactly offset by the negative rents of those who lose out in the competitive battle.

How can such a negative activity survive under conditions of democracy, you may well ask?  Why would it not be eliminated by political market competition?  The answer to that question, in a nutshell, is that political markets do not work like private markets.  Political markets are handicapped by high levels of rational ignorance among  the electorate that stem from the irrelevance of the individual vote. It simply does not pay voters to inform themselves about destructive political behavior because, individually, voters  are helpless to do anything about it.

So when you notice the movement of grace from Wall Street behemoths like Goldman Sachs into the coffers of Democratic members of the Senate Financial Committee, do expect that that grace will be returned in a multiplied form to such donors, even if in plain brown envelopes slipped under the table by faceless  Democratic Party bagmen. Rent seeking is an X-rated movie, unsuited to the eyes of innocents. For those old enough to watch, the game can be tracked. Simply follow the money, and the political responses to the movement of that money, and you understand the  charade.

Rent extraction is the hard core pornographic movie of  political life, much more difficult to discern, sometimes impossible to follow. Rent extraction defines an activity that, at first sight, is simply unbelievable: the movement of grace from special interests in return for nothing!  As Fred McChesney demonstrated in 1987, however, money for nothing is a  widespread phenomenon in political markets. Even when the political waters appear to be still, powerful forces are at work beneath the surface.  The fact that a dog does not bark in the night may well be worthy of investigation.

Consider, for example, Citicorp, one of the country’s largest banking institutions, whose registered lobbyists spend most of their time and money heading off legislation that could harm any one of its multiple financial service operations.  Even to the keenest eye, such outlays induce no political response. Indeed, that is the precise intent.

Rent extraction is the political equivalent of protection racketeering on the part of Cosa Nostra. ‘We are really worried that your house might burn down. If you are willing to remunerate us appropriately, we can ensure that such an event does not come to pass.’   Politicians, desirous of loading up campaign coffers, threaten to legislate against the interests of a target unless said target persuades them not so to do.  Bills of this kind are referred to among the cognoscenti as Milker Bills.  The milk in question is not the healthy opaque white liquid produced by mammals.  Rather, it is that old-time unhealthy grace that we have just been talking about: the mother’s milk of politics.

So as we cast our sights from rent seeking to rent extraction, we  re-focus our analysis from politicians as dishonest agents who broker policies in return for money to politicians who engage in a much more distasteful process:  issuing threats to cause harm in order to be ‘persuaded’ not to implement said threats. Well, few people now argue that the process of politics is pleasant. I suspect that few really understand just how filthy the process has become. Maybe attending the current public hearings of House and Senate Committees on the regulation of financial markets would open eyes and ears.  Of course such meetings are unsuited to the eyes and ears of those under the age of  eighteen years.  The meetings that go on behind closed doors  are suited only to the irremediably  depraved. 

Even Amazing Grace cannot save such lost wretches.

Gordon Tullock, ‘The Welfare Costs of  Tariffs, Monopoly and Theft’. Western Economic Journal (1967)

Anne Krueger, ‘The Political Economy of the Rent-Seeking Society’, American Economic Review (1974)

Fred McChesney, ‘Rent-Extraction and Rent Creation in the Economic Theory of Regulation’, Journal of Legal Studies (1987)


Goldman Sachs: Harbinger of the State Capitalist Firm

April 21, 2010

In earlier columns, I have warned about the potential threat to  freedom and  wealth in any nation that drifts away from laissez-faire capitalism under the rule of law towards state capitalism under rule by men.  The European Union succumbed to such drift several decades ago, with predictable consequences. Since 2001, the United States has followed suit, with the September 2008 financial crisis an entirely predictable consequence. Lessons have not been learned since then.  Currently, the United States is on track to drift  beyond the limits of  state capitalism to progressive socialism or  liberal fascism –  two closely- related, ultimately autocratic movements.

Goldman Sachs, is no  exception to, but rather is the epitome of the corporate form best adapted to conditions of state capitalism, progressive socialism, and liberal fascism.  Goldman Sachs, indeed, is the harbinger of America’s corporate future in the absence of some unlikely reversal of political economic direction.  Goldman Sachs is the perfectly designed two-way sewer,  pumping excrement in and out of privately-networked  political markets  and in and out of  politically-networked private markets. Goldman Sachs, to put it more bluntly, is designed to work the sewer system, extracting all valued protein  for itself, while discharging the residuals into any waste dump corrupt enough, or foolish enough to provide access to its  pipes.

Let us briefly outline the complex nature of Goldman Sachs’ linkages between political and private markets within the United States (without forgetting that the corporation is multi-national and that what we see in the United States is at least equally apparent in other countries).

Brody Mullins and Jean Spencer ( ‘Goldman Links Cut Both Ways’,  The Wall Street Journal, April 20, 2010) trace the pattern of Goldman Sach’s direct infiltration into the US political system. This  infiltration started under the administration of FDR when Sidney J. Weinberg, a Senior Partner of GS, 1930-1969,  became Vice Chairman of the War Production Board , remaining there through the ensuing two Truman administrations.  It has manifested itself with increasing force since 1995.  Robert Rubin, Co-Chairman and Co-Senior Partner of GS, 1990-1992, served as Treasury Secretary under President Clinton, 1995-1999.  Joshua Bolten, Executive Director for Legal and Government Affairs in London for GS, 1994-1999, served as Chief of Staff to President George W. Bush 2006-2009.  Henry Paulson, Chairman and CEO of GS 1999-2006, served as Treasury Secretary under President George W. Bush, 2006-2009.

The GS sewer pipes extend more deeply into the regulatory process. Reuben Jeffery III, Managing Partner of the GS Paris office, 1997-2001, served as Chairman of the Commodity Futures Trading  Commission, 2005-2007.  Stephen Friedman, Co-Chairman of GS, 1990-1994, served as Chairman of the Federal Reserve Bank of New York in 2008 and 2009.  Neel Kashkari, Head of IT Security Investment Banking Practice at GS, 2002-2006, ran the $700 billion Troubled Asset Relief Program until May 2009.  Gary Gensler, Co-Head of Finance at GS, 1995-1997, has served as Chairman of the Commodity Futures Trading Commission since May 2009.  Bill Dudley, Partner and Managing Director at GS until 2007, has served as President of the Federal Reserve Bank of New York since January 2009.

Money, of course, is the mother’s milk of politics, and politicians, Republican and Democrat alike, drink deeply from the GS pales.  According to the nonpartisan Center for Responsive Politics, the GS political action committee and its employees, since 1989, has ranked second among corporate donors (to AT&T Corporation)  in total campaign donations – $31.6 million.  Almost two-thirds of the money has gone to Democrats, making GS their largest single donor.  GS is the fourth largest corporate donor to Republicans.  Barack Obama scooped up nearly $1 million from GS employees during his 2008 presidential campaign. The next largest recipient of GS-related contributions was Hillary Clinton, at $500,000.

Undoubtedly, the infiltration of GS personnel and GS monies into US politics has provided opportunity and cover for their dirty dealings in private markets. As I have outlined in earlier columns, GS is currently under investigation by financial regulators around the world, in addition to the US Securities and Exchange Commission’s fraud charges over tts mis-selling of derivatives. GS has now been named in a court filing seeking information about short-selling Lehman shares in September 2008. In a further potential legal case, AIG is considering suing Goldman over $2 billion of losses it incurred when it was forced to pay protection to buyers of credit-default swaps when collateralised debt obligations (CDOs) in GS’s Abacus program lost their value.

It is sometimes claimed that when thieves fall out, honest men come into their own. Unfortunately, in the world inhabited by Goldman  Sachs, the number of honest men appears to be vanishingly small. I am sure that anyone who lived under Benito Mussolini’s Fascist Italy, or Adolf  Hitler’s National Socialist Germany would immediately identify with this depressing  and truly dangerous phenomenon.