The Long FAQ on Liberalism
A Critique of the Chicago School of Economics:

INTRODUCTION



For most of the 20th century, the Chicago School of Economics has served as a hotbed of conservative economics. Whereas its counterpart, the Austrian School, is widely dismissed as crank science, the Chicago School has achieved considerable clout in the field. No less than eight Nobel-prize winners hail from the economics department at the University of Chicago: Milton Friedman, Robert Lucas, George Stigler, Gary Becker, Ronald Coase, Robert Fogel, Merton Miller and Theodore Schultz. The Chicago School has also been active in applying economic theory to other fields of science, most notably law, under Richard Epstein.

But although influence and awards are many, practical victories have been few. Their admittedly elegant theoretical models have failed when tried or tested in the real world. These theories first gained prominence in the 70s and early 80s, when the Chicago School dominated economic thought. It nearly caused the complete demise of Keynesianism, the school which held that government could manage the money supply to benefit the economy.

Yet by the late 80s, events in the real world had convinced mainstream economists that there were fundamental flaws in the Chicago School's theories. And subsequent advances in liberal economic theory brought Keynes back to life -- New Keynesianism is now the dominant theory in academia. Conservatives, if they are ever to reclaim the debate, must find new arguments to make their case -- the old ones clearly don't work. What these new arguments might be is a good question. All the obvious ones have already been tried.

The historical context of the Chicago School

A brief review of economic history is useful to place the Chicago School in its context. This review will also introduce several terms and concepts that will be used frequently in the following essays. Those already familiar with this history may wish to go on to the next section.

There have been nine major schools of economic thought. As you can see, many feature the same recurring themes, only updated with more modern arguments.

Mercantilism: This was the 16th and 17th century economic philosophy that nations were as rich as the amount of gold and silver they owned. Consequently, national leaders orchestrated economic policy to secure more gold, by imposing tariffs, subsidies, and other market interventions.

Physiocrats: This was a group of 18th century French merchants who protested the heavy regulations of mercantilism. They coined the term laissez-faire ("leave it alone"), referring to their favored national policy of minimal government intervention in the market.

Classical School: Adam Smith created this school in 1776 when he published one of the most famous economic works of all time, The Wealth of Nations. He updated the physiocrats' theories by identifying land, labor and capital as the necessary factors of production.

Smith also lent theoretical support to the policy of laissez-faire by introducing a concept called "the invisible hand." This term refers to all the social good incidentally caused by individuals seeking their own personal rewards. For example, a baker does his job only to receive a paycheck, but in the course of doing his job, he bakes bread for hundreds of people. Performing this greater good for society may not have been part of his original intention, but the market's "invisible hand" has led him to do so. Latter-day conservatives have latched onto the "invisible hand" as proof that greed is good, that markets are magical, and anything the market does is virtuous and optimal by definition. However, not even Adam Smith went that far, and part of the fun of being a liberal economist is citing all the Adam Smith quotes criticizing the greed of businessmen. (1)

An important question that classical economists struggled to answer was how land, labor and capital interacted to produce the low wages they observed among workers. David Ricardo argued that the growth of population and capital on a fixed amount of land was responsible for driving down wages. Thomas Malthus argued that low wages were the result of the population growing much faster than food production. John Stuart Mill broke tradition with the classicists, arguing that the market may be efficient at allocating resources, but not at determining wages, and that society might have to intervene to correct it.

Marginalism: Undoubtedly the most famous of the marginalists was Alfred Marshall, who published the "bible" of economics, Principles of Economics, in 1890. Whereas the classical economists had focused on production costs, Marshall argued that the demand for a product also affects its price. Thus, the concept of "supply and demand" was born. Marshall showed that when supply rises relative to demand, prices fall; when supply falls, prices rise. This allowed him to create an elegant mathematical model in which supply and demand curves glide about and intersect, showing businessmen the optimal points to set prices, wages, and allocate resources. With such mathematical models, economists could now determine if the economy was in a state of equilibrium or disequilibrium. If the latter, then resources were being wasted. This approach would eventually become known as equilibrium economics, a mainstay of the future neoclassical school.

Marginalists also sought to justify the existing inequality of wealth and wages, by arguing that the market returned exactly what was contributed to production.

Marxism: This school was a reaction to the injustices and inequities of laissez-faire economies -- indeed, Marxism has been called a "cry of pain" from workers suffering from sub-poverty wages. Its founder was Karl Marx, who described workers' plight in his labor theory of value. According to this theory, workers should own the means of production, because they produce everything of value in society. Marx argued that capitalism exploited workers by not returning a fair share of their production to them. He predicted that worker exploitation would become so great that one day they would rise in revolution and take the means of production for themselves.

Institutionalism: This little-known movement has actually grown over the 20th century to become a major school of economic thought. Its founder was Yale economist Thorstein Veblen, best known for his 1899 book, The Theory of the Leisure Class. Veblen argued that the goal of a businessman is not to produce goods according to the best interests of society, but to make a profit -- hardly a synonymous activity, and quite often harmful.

Institutionalists argue that individual economic behavior is largely explained by the society they belong to, and in particular the institutions they belong to. These include business firms, churches, families, governments, charities -- any institution that prescribes behavior, tradition or knowledge. Individuals can create new institutions, of course, or change the traditions within existing ones, but historically institutions have been resistant to change. Only in modern times has the pace of change accelerated. Institutionalists believe that the engine of all change is technology (broadly defined here to include science and other knowledge).

Institutionalism was partly a reaction to the equilibrium economics of Alfred Marshall. His mathematical models described an economy in static equilibrium, which simply did not describe reality. The real world is constantly in flux; in fact, institutionalists often use evolutionary theory to describe the workings of the economy.

As for policy, institutionalists favor democracy, equality and government regulation of the market. They reject the idea that individuals are motivated purely by profit or self-interest, but are endowed with a measure of genuine altruism.

Keynesianism: This school of thought is named after British economist John Maynard Keynes, also known as the "father of modern economics." His 1936 book, The General Theory of Employment, Interest and Money, is probably the most important economic work of all time.

Keynes main contribution was to business cycle theory, or the recurring pattern of recessions and recoveries. Keynes argued that a recession could be cut short by expanding the money supply. Likewise, if a recovery started "overheating" -- that is, developing a bad case of inflation -- then restricting the money supply would reign inflation back in. Thus, government control of the money supply would reduce the severity of the swings in the business cycle.

For especially deep recessions, or depressions, Keynes suggested an even more drastic solution to expanding the money supply: heavy government borrowing and spending. Indeed, most economists believe that the Great Depression only ended in each nation around the world as it began borrowing and spending on defense, in preparation for World War II.

In the six decades since, there has not been one depression in any nation around the world that has adopted Keynesian monetary policies. That the greatest scourge of laissez-faire economies could be solved by government has been a body-blow to economists on the right, and most of their work since World War II has been intended to refute Keynesianism.

Neoclassical School: This school of thought has been an attempt to restore credibility to the laissez-faire policies of the classical school, by rebutting the schools that overtook it: Keynesianism, institutionalism and Marxism. And, in the 70s and early 80s, they came tantalizingly close to succeeding.

The Chicago School has been on the cutting edge of this effort. Although its conservative tradition extends back before World War II, it was only after the war that the school gained fame and emerged as a highly political and ideological force in right-wing economics. Milton Friedman started the trend with his attack on Keynesianism, and his promotion of an alternate policy: monetarism. In the 1970s, Robert Lucas would advance the theory of Rational Expectations, which purported to show how businessmen could anticipate Keynesian policy and therefore render it ineffective or even harmful. Others, like Ronald Coase, would show how the market could solve even pollution if only society would adopt strong property rights.

But most of these theoretical advances were due to the use of an unrealistic methodology. The Chicago School's emphasis has been on mathematical models based on perfect starting assumptions, such as the assumption that people have perfect knowledge and are perfectly rational. These models also show an economy in static equilibrium. In this respect, the Chicagoans are the descendants of Alfred Marshall. These models are theoretically impressive, but they have no meaning in the real world. Indeed, the events of the 80s were to prove that these models have little predictive or explanatory power. When economists looked around for what worked best in the practical world, they were led right back to Keynes.

New Keynesianism: The realization that people are not perfectly rational, but nearly rational, has served as the cornerstone for New Keynesianism. Current economic models are essentially Keynesian, although they are steadily being refined, even including improvements made by the Chicago School. But today there is a backlash in economics against the over-use of mathematical models and perfect starting assumptions. They will continue to be part of the economist's toolbox, of course, but the current trend has been to integrate other sciences into economics, such as evolutionary theory, psychology and chaos theory. If history is any guide, such integration should result in a flourishing of research and discovery.

In sum, the history of economic thought allows us to draw a revealing generalization. The most extreme schools appeared early on in economic science: the extreme individualism of laissez-faire, or the extreme central planning of Marxism and mercantilism. None of these extremes has fared well in modern academia. Over time, new schools of thought have advocated a more moderate position: a balance between the private and public sector. Keynesianism is the prime example. It is also interesting to note that the real world has followed this trend as well: both laissez-faire and centrally-planned economies have disappeared from the world, and all that are left are highly functioning mixed economies, most of them Keynesian.

Next Section: The Methodology of the Chicago School
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Endnotes:

1. Here are two such quotes by Adam Smith from An Inquiry Into the Nature and Causes of the Wealth of Nations: Other anti-capitalist quotes from Adam Smith can be found at Favorite Quotes -- economics.