Richard Nixon and Milton Friedman destroy sound money in the United States

Almost thirty years ago, David Stockman was taken to the woodshed for allegedly disturbing the Reagan doctrine on fiscal conservatism. His ‘mistake’ was pointing out that the Great Communicator’s  budget communications were – well disturbingly opaque.  Specifically, putting asterisks in place of numbers on politically sensitive social spending cuts looked a little like trying to fool the electorate. At that time, it was almost like the dumb leading the dumb, since neither the Great Communicator nor his fiscal vocal chords understood the difference between real and nominal values.

Whether President Reagan ever learned the difference is a matter of opinion. But once he was out of Reagan’s cabinet, David Stockman surely did. And on March 12, 2011, as part of his Henry Hazlitt Memorial Lecture, David Stockman places some very telling blows on a body politic and an economics sub-profession that has taken the United States down the road to unsound money and fiscal lunacy. In this column, I focus on Stockman’s organ-damaging punches, aimed at the solar plexi of US President Richard Nixon and  Chicago economics guru, Milton Friedman. And gut-busters they most surely are!

“That the demise of the gold standard should have been as destructive as it was of monetary probity can hardly be gainsaid.  Under the ancient regime of fixed exchange rates and currency convertibility, fiscal deficits without tears were simply not sustainable – no matter what errant economic doctrines lawmakers got into their heads. Back then, the machinery of honest money could be relied upon to trump bad policy.  Thus, if  budget deficits were monetized by the central bank, this weakened the currency and caused a damaging external drain on the monetary reserves; and if deficits were financed out of savings, interest rates were pushed up – thereby crowding out private domestic investment.” (Stockman, March 2011)

and

“During the four decades since the gold window was closed – the rules of the game have been profoundly altered.  Specifically, under Professor Friedman’s contraption of floating paper money, foreigners may accumulate dollar claims or exchange them for other paper monies. But there can never be a drain on US monetary reserves because dollar claims are not convertible. This infernal regime of fiat dollars, therefore,  has had numerous lamentable consequences but among the worst is that it has facilitated open-ended monetization of US government debt.” ibid.

and

“So at the end of the day, American lawmakers have been freed of the classic monetary constraints.  There is no monetary squeeze and there is no reserve asset drain.  The Fed always supplies enough reserves to the banking system to fund any and all private credit demand at policy rates that are invariably low. The notion of  fiscal  ‘crowding out’  thus belongs to the museum of monetary history.” ibid.

and

“In fact, the United States is clocking a 10-percent-of-GDP-deficit for the third year running because this latest budgetary fling is just another episode in the epochal collapse of US financial discipline that began 40 years ago at Camp David.” ibid.

Tricky Dick’s ghost  may may well not be entirely unhappy to absorb Stockman’s deadly body blow – for after all President Nixon was a compassionate progressive at heart. However, Milton Friedman’s ghost may well wince with pain.  For, like so many of his economic ideas – floating exchange rates and income tax withholding being the worst – what looks like good conservative economics from the blinkered perspective of the University of Chicago turns  out to be seriously bad political economy from the perspective of the Virginia School.

The continuing economic wisdom of John Kay

I have written before about the impressive economic insights offered by England’s John Kay, leading Oxford University economist, former Director of the Oxford Business School, and currently a columnist for The Financial Times.  Let me relay to you the essence of his thoughts regarding the break-down of economic models in predicting extreme outcomes, such as the financial crisis of September 2008.

“If the water in your glass turns to wine, you should consider more prosaic explanations before announcing a miracle.  If your coin comes up heads 10 times in a row – a one in a thousand probability – it may be your lucky day.  But the more likely reason is that the coin is biased, or the person who flips the penny or reports the result is cheating.  The source of most extreme outcomes is not the fulfillment of possible but improbable predictions within models, but events that are outside the scope of these models.” John Kay, ‘Don’t blame luck when your models misfire’, Financial Times, March 2, 2011

Some sixty years ago, a French economist, Maurice Allais described what would become known as the Allais Paradox.  This paradox is based on the discovery that most individuals treat very high probabilities quite differently from certainties.  According to John Kay, such individuals are right to make such a sharp distinction.  Why?  Because there are no 99 percent probabilities in the real world. 

Very low and very high probabilities are artifices of models. The probability that any model perfectly describes the world is much less than one. Once the probabilities delivered by the model are compounded with the unknown, but large, probability of model failure, the reassurance provided by any model simply disappears. This is especially true when models are relied upon to predict extreme events.

Armed with this insight, John Kay lays into the observable failure of ‘value at risk’ modelers to learn from past  experience.  For example, the European Union is ploughing ahead with its Solvency II directive for insurers – which is explicitly modeled on the failed Basel II agreements for monitoring bank solvency.  Solvency II requires that businesses develop models that show the probability of imminent collapse as being below 0.5 percent.

In John Kay’s judgment, insurance companies do not fail for the reasons described in such models.  They fail because of events that were unanticipated or ignored.  They fail because underwriters misunderstand the risk characteristics of their policies, as at AIG or because of fraud, as at Equitable Life Fundings.

Huge standard deviations – or multiple sigma – events simply do not occur in real life.  Economists, financial analysts and statisticians, who purport to provide objective means of controlling for such  risks are frauds, much of a piece with the practitioners of alchemy and quack medicine. Such fraudsters incite gullible outsiders to believe that they are dealing with professionals blessed with genuine expertise. For this reason, they wreak havok on an unsuspecting world.

“We will succeed in managing financial risk better only when we come to recognize the limitations of formal modeling. Control of risk is almost entirely a matter of management competence, well-crafted incentives, robust structures and systems, and simplicity and transparency of design.”  John Kay, ibid.

Never Let A Good Crisis Go To Waste

 

Readers who have been following my daily weblogs may be interested in my new book: Charles K. Rowley, Never Let A Good Crisis Go To Waste.  This book is published today by The Locke Institute. It  contains the best of my columns, carefully edited and organized by themes, in a 250 page paperback book.  The book sells at $10 plus postage from www.amazon.com and (by check only at $12.50 inclusive of postage ) from The Locke Institute, 5188 Dungannon Road, Fairfax, Virginia 22030, USA.

The book consists of 93 columns presented under the following themes: Part One – Political Philosophy, Part Two, – Public Choice, Part Three – The Long Shadow of John Maynard Keynes, Part Four –  The Burden of the Public Debt, Part Five – Valley of the Dolls: Stimulants and Depressants, Part Six – Money Mischief, Part Seven – Dry Rot in the United States Housing Market, Part Eight – Hot Air Creates Global Warming, Part Nine – U.S. Health Care in the I.C.U. and Part Ten – Progressive Socialism in the United States.

Readers will note that the Front Cover portrays the Three Villains who publicly agreed to take advantage of the recent Economic Crisis : President Barack Obama,  Chief of Staff,  Rahm Emanuel and Secretary of State,  Hillary Clinton.

Richard A. Posner meddles with other people’s preferences

“Even before this (financial crisis), 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.”  Richard Posner, ‘Interview with John Cassidy’ The New Yorker 2009

“Taxing fattening foods has its advocates, but they tend to overlook the fact that consumers can overeat otherwise healthy foods, and that taxes are regressive because they raise the food budget of poor individuals who do not overeat.  It would be desirable, but infeasible, to tax just overconsumption of food.”  Tomas J. Philipson and Richard A. Posner, ‘Fat New World’, The Wall Street Journal, July 31, 2010

“But if most of the adverse health consequences of obesity were eliminated  (the authors favor government sponsored research and development programs to achieve such an outcome), obesity would cease to be an issue, except perhaps from an aesthetic or emotional standpoint.” Philipson and Posner, ibid.

So there we have it, folks.  Richard Posner is aesthetically and emotionally disturbed by the existence of fatness in this world.  He believes that fat individuals do not have sufficient incentives to slim down, and that they do not have sufficient knowledge to know how to do so, even if the desire was there. Note that nowhere in his discussion is there any concern for health care costs arising as a consequence of obesity, other than those that individuals impose upon themselves. So the arguments that he advances are not driven by conventional third-party externality considerations, other than those of aesthetics and emotions.

So what are Posner’s recommended solutions to his personal dilemma?  First, ban fat-producing ingredients like transfats, where such can be identified,  from all non-domestic consumption.  Oh! and if only Posner could get inside the refrigerators and cupboards of all those offensive  fat-saturated households!  Second, tax the hell out of fat-producing ingredients where one can do so without adversely impacting on the budgets of the non-fat poor.  Third, investigate ways in which overconsumption of food might feasibly be taxed.  Fourth, roll out a major government subsidy to support basic research designed to end the world-wide obesity problem and its adverse consequences.

All this sounds like meddlesomeness, not to say progressive socialism,  to me. Way back in the early 1970s, when I was promoting law-and-economics in England along the lines then apparently set out by Richard Posner, somehow I missed out on the underlying premise that this program was designed to tell individuals how to live their lives, to tax and regulate them when they did not cut Richard Posner’s mustard, and to promote government programs to relieve individuals of the inferred bad consequences of their intemperate lifestyles. Somehow, I mis-understood his Chicago message to be concerned about enhancing individual freedom, and allowing individuals to effect rational choices to achieve overall wealth maximization.

Richard Posner, to my knowledge, remains a member of The Mont Pelerin Society at this time.  Friedrich von Hayek, Ludwig von Mises, and Milton Friedman, together with many other founding fathers of that freedom-loving society,  must be turning in their graves at the meddlesome messages that he now purveys.

Hayek’s First and Last Sermon

“The economist knows that a single error in his field may do more harm than almost all the sciences taken together can do good – even more, that a mistake in the choice of a social order, quite apart from the immediate effect, may profoundly affect the prospects for generations.  Even if he believes that he is himself in possession of the full truth – which he believes less the older he grows – he cannot be sure that it will be used.  And he cannot even be sure that his own activities will not produce, because they are mishandled by others, the opposite of what he was aiming at.”  F.A. Hayek, ‘On Being An Economist’  Address to the Student’s Union of the London School of Economics, February 23, 1944

Hayek’s sermon is especially significant in that it was delivered not in London but in Cambridge, where the LSE faculty and students located themselves during World War II because of the devastating bombing raids and later rocket attacks emanating from a barbaric nation  whose Prussian leaders worshipped at the Pagan shrine of intellectual elitism. His sermon was not only for his time.  It was for all time.  This column shares with you some of the most pregnant words of that sermon, which surely is  for our time.

“The reason why I think that too deliberate striving for immediate usefulness is so likely to corrupt the intellectual integrity of the economist is that immediate usefulness depends almost entirely on influence, and influence is gained most easily by concessions to popular prejudice and adherence to existing political groups.  I seriously believe that any such striving for popularity – at least until you have very definitely settled your own convictions, is fatal to the economist and that above everything he must have the courage to be unpopular.” F.A. Hayek, ibid.

“It is the desire to gain influence in order to do good which is one of the main sources of intellectual concessions by the economist.  I do not mean, and do not wish to argue, that the economist should entirely refrain from making value judgements or from speaking frankly on political questions.  I do not believe that the former is possible or the latter desirable.  But I think he ought to avoid committing himself to a party – or even devoting himself predominantly to some one good cause. That not only warps his judgement – but the influence it gives him is almost certainly bought at the price of intellectual independence.”  F.A. Hayek, ibid.

“There can be no question that in resisting the inclination to join in with some popular movement one deliberately excludes oneself from much that is pleasant, profitable and flattering.  Yet I believe that in our field more than in any other this is really essential: if anyone, the economist must keep free not to believe things which it would be useful and pleasant to believe, must not allow himself to encourage wish-dreams in himself or others.  I don’t think the work of the politician and the true student of society are compatible.  Indeed, it seems to me that in order to be  successful as a politician, to become a political leader, it is almost essential that you have no original ideas on social matters but just express what the majority feels.”  F.A. Hayek, ibid.

“I believe this duty to face and think through unpleasant facts is the hardest task of the economist and the reason why, if he fulfills it, he must not look for public approval or sympathy for his efforts.  If he does he will soon cease to be an economist and become a politician – a very honourable and useful calling, but a different one, and not one which gives the kind of satisfaction we expect when we embark on an intellectual pursuit.”  F.A. Hayek, ibid.

These words of wisdom from a master are worthy of serious consideration by all aspiring economists at this time, when all the incentives signal them to embrace social agendas of one stripe or another;  agendas that inevitably must compromise their intellectual independence and search for truth.

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

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

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

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

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

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.