Bloomberg wrote a piece over the puzzlement that many in the Chicago School of Economics feel at the present time with all of the distress in the markets.? After all, don’t markets self-correct?? Sadly, no, not all the time, or, at least not with high speed during credit crunches.? (All of the econometric studies I have done note a weak tendency to mean reversion in financial markets, even excluding periods where there are credit difficulties.)

For markets to self-correct, it requires that economic agents have enough access to capital in order to make the investments necessary to arbitrage the differences between the markets that are in disarray.? It should be no surprise that during a time where credit is hard to come by, that there are potentially profitable arbitrages that are going begging.

Barry did a post today off of the Bloomberg piece, suggesting the death of the Chicago School.? I think that prediction is too early.

I am not a Chicago School economist.? I don’t like the neoclassical synthesis.? It posits human rationality in ways that make us robots, both individually and collectively.? I have been a critic of their methods through both behavioral economics and nonlinear dynamics, a la the Santa Fe Institute.? We need a new paradigm to replace the neoclassical synthesis.? It does not adequately describe how mankind behaves (and we have known that for 25 years — the models don’t predict well, either in micro or macro).

But the answer is not Keynesian policy, in my opinion.? Just because markets are unstable, that doesn’t mean that government action can stabilize them over the long run.? In the short-run, while credit is still easily available, yes, government action can work, whether through the Fed, subsidies, or tax incentives.? But Keynesian remedies don’t work when the government can’t easily tax or borrow in order to provide the stimulus.? We will face borrowing problems soon enough.

The answers are not to be found by asking the Chicago School or the Keynesians.? We need an economic theory that accepts the necessity of moderate booms and busts, where the government does little to try to correct the imbalances.? Moderate imbalances are normal, and if we try to eliminate the moderate busts, we get a series of small busts, followed by one humongous one.? We experienced easy money in the 20s, and in the 1990-2000s.? Easy money cured the moderate busts, but at a price.

A quick excursus: I agree that tight regulation of financial institutions is necessary if there is fiat money.? Controlling the money supply means controlling credit.? I don’t like fiat money, and would rather have a gold standard, but if we must have fiat money, then make life tough for the banks.? Restrict what they can invest in.? Regulate lending practices.

The present distress stems from both a lack of regulation and too much regulation.

Lack of regulation:

• Lack of enforcement on bad lending
• Leverage limits on commercial and investment banks were too loose.
• Modest limits on the banks dealings with the non-regulated financials.
• Regulatory arbitrage allowed depositary financial to choose weak regulators.
• Failure to disallow investment in areas the regulators did not fully understand.

Too much regulation:

• Lack of limits on Fed stimulus action (our “independent” central bank was/is compromised)
• Tax deductions for residential real estate, including the home sale capital gains exclusion.
• Limiting the number of rating agencies.

My view is that we eventually have to give our currency some backing and get the government out of the money business.? Until we get there the ride will be bumpy.? We need to transist back to an economy where credit is not easy, but not non-existent, and where total leverage declines.? Saving has to become a virtue again, which our present monetary policies will not encourage.

It is too early to declare the demise of the Chicago School, much as it should disappear.? But now we will get the test of the Keynesian School and I predict failure there; they will not solve our crisis.? The crisis will end when enough bad debts have been liquidated, and the financial system can begin lending normally again.? Call it unrealistic; call it the Austrian School if you like (I have not read and von Mises or Hayek), but it is what restores the financial sector, which cannot live with too much leverage once assets are deflating.

PS — The Bible says that the borrower is servant to the lender.? True enough, but if the lender is himself a borrower, like most of our banks, the proverb does not hold.? The only lenders that are truly soverign are those that control their own destinies, because they have no debt.