Waiting for the Death of the Chicago School, and the Keynesian School also

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 neccessity 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, wew 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.


  • Russ Wood says:

    David wrote:
    “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.”

    Well said. Sound money (the core of classical economics which is sadly ignored by Chicago and Keynesianism) eliminates the need for much of today’s regulations. But without out it, our financial system is prone to disruptions which participants will not tolerate (and thus will want regulated away).

  • F says:

    I love reading your website. It’s especially surreal because I think my instincts and beliefs are diametrically opposed to yours, but I agree with 90% of your analysis and suggested solutions, especially here. Just goes to show that you can’t argue with the facts. Thanks.

  • LetUsHavePeace says:

    Our seemingly ignorant ancestors – those who accepted the gold standard AND free banking – would be amused by our persistence in looking for a unified theory of money and credit. The Congress has a Constitutional obligation to “borrow Money on the credit of the United States” and “to coin Money and regulate the value thereof”. The representatives of the States who subscribed to Article I. Section 8. assumed that “Money” would be legal tender and would be specie. They took credit to something quite different – the willingness of people and other nations to trust the United States to pay Money in the future. Our most sensible ancestors – Washington and Franklin and Hamilton (in his less Royalist moments) – had no quarrel with unregulated merchant banking and open and free markets for credit. But they did assume that legal tender – the Money the country would offer for repayment of its debts and accept for payment of “Taxes, Duties, Imposts and Levies” – would be gold or a pledge of gold that could be trusted. They thought allowing anything else to be “Money” would be an invitation to official thievery.

    Our present monetary system refuses to accept or even understand the difference between Money and credit. The Federal Reserve Note itself is evidence of the deliberate obfuscation. The United States could reestablish tomorrow Money that was exchangeable with the national Treasury for a measure of gold IF Congress had the humility to allow the credit markets to determine its price. That is their actual charge under the Constitution; they are to certify the physical properties of our national Money “and of foreign coin, and to fix the Standard of Weights and Measures.” Free exchange would determine the relative prices of monies just as it determined the discounts for lending and the value of merchant and banking bills and notes.

    Intellectuals like Jefferson were furious at such a revolutionary idea. They still are. They reject the Constitutional premise that markets should control the price of money and people should be free to deposit and lend their Money as they choose. In the name of equality and authority, economists are, with rare exceptions, united in their belief that the government must determine the price of its own money AND the form and extent of credit for the good of all. That is why you, poor reader, must pay for your neighbor’s mortgage.

  • matt says:

    The proclivity of the government to attempt to manipulate asset prices must be taking its toll on the capital markets. I hesitate to make sensible investments right now–not because I’m afraid of the future outlook, but because I’m afraid that the government will affect some policy that harms my investment. Certainly, the shorts have been complaining about the government for the last 6 months, but longs have taken a few bites too. Also, the government aiding struggling companies can be harmful to their healthy competitors.

    I can’t be the only one hesitating because the government is actually creating uncertainty.

  • Tom Human says:

    I agree with everything except – what’s with that weird religious “gold standard”?

    Gold is no less “fiat” than any other currency. You can’t eat gold, it won’t make your car run. I own no gold and there hasn’t been a day in the last many decades where I’ve needed gold. (I might have wished to have more economic value and believed that I could have captured that by investing in gold – but that’s hardly the same is it?)

    A natural, healthy economy should be expanding in real terms by a few percent a year – because of the increasing population and the march of technology.

    But the supply of gold is finite and fixed.

    This means that the strategy of “hording gold”, something which actually generates no true economic value at all, becomes a very desirable strategy.

    An economic system that encourages people to do things that don’t actually profit anyone is badly designed. Luckily for us, the usually-stupid movers and shakers were sort of forced into the realization above about 50 years ago.

    A slowly but exponentially growing economic system that’s hitched to a fixed supply commodity like gold is rather like running an electric car with a long extension cord.

    If we’re going to be rational here, we have to realize that “the gold standard” is every bit as religious as “Christ” or “Communism” or “Capitalism” (or “free markets” but that’s another essay).

    Like it or not, a modern society will have a fiat currency. What you want is an honest currency, where liabilities are fully disclosed.

  • Tom Human says:


    I agree 100%. The government is a long-term force for preventing assets being correctly evaluated.

    Now, I actually believe that a correctly-run government would do this too – because I believe that stability is the most important thing that a government can bring, more important than growth or “prosperity” – because I believe that if you give me stability, I can make my own prosperity.

    So it’s perfectly reasonable to me that a government might actually reduce liquidity in order to increase stability.

    But the government isn’t doing this. They’ve historically been pushing “growth” (which means growth for one or two percent of the population and more work for the rest) at the expense of stability. We lose!

    If the government cared about stability, they’d probably seize one or two dozen financial institutions that are “illiquid” right today.

    There’s nothing morally wrong with that. They are taking a good that’s worth less than zero and purchasing it for zero dollars. The government is actually taking a loss – too bad for the investors and principals but your company is worth *less than zero dollars*. They’d actually mark everything to market, revealing exactly what securities were owned and inviting an independent evaluation of their value.

    Now, a lot of rich people would lose a lot of money. But the “system” would continue to flourish. The big worry these days is that a lot of institutions will fail at once and then counterparties to a lot of “quantum” transactions like repurchase agreements (“repos”) will vanish and “the system” will simply grind to a halt.

    If the government seized the illiquid (== worth less than zero) companies and guaranteed that they’d continue to be reliable counterparties in transactions like repos, the markets would be safe (and yes, that is a good thing) but we’d be able to systematically resolve the uncertainty, at the unfortunate cost of bankrupting a few thousand very rich people, who, when it came down to it *invested in something that did something economically unsound and thus by the laws of economics “deserve” to lose all their money*.

  • LetUsHavePeace says:

    What Washington, Franklin, and Hamilton all accepted was the fact that all governments cheat. Marx – being at heart a journalist – was naive enough to want people to give infinite credit to official sources. Since the government cannot avoid having a monopoly on legal tender, the only way for the people to avoid being perpetually cheated was for the country to have a Money that it could not be counterfeited or have its value simply legislated by Congress. There had to be a check and balance of substance. There was no other way to have an “honest” currency. (The pound, when established by the Normans was literally a pound of silver.) With credit there was no comparable problem. Commerce existed precisely because people, using their independent judgment, decided whom to trust, for how long and for how much. Credit could expand as much as the People in their judgment thought best. This is why the Constitutionalists had no problem with “free” banking or any of the other supposedly modern horrors of fractional reserve lending that so offend Congressman Paul. If a merchant wanted to accept Money or other merchant’s bills and notes for deposit and then issue his or her own bills and notes, fine. The people’s own commerce would establish the value of those credits. Washington and Franklin found this self-evident. (So did Hamilton but, being a lawyer, he was reluctant to allow the people to decide things that could be made part of The Law – hence, his enthusiasm for a national bank).

    What Franklin as a printer and Washington as a surveyor both understood is that there had to reference point from which measurements were taken – otherwise prints would not register properly and surveys would be fictions. Money was the reference point. People would not be satisfied simply to hold money, to hoard. Their sense of enterprise would urge them to invest for gain. But, their sense of prudence would also urge them to hold a reserve. For those reserves only specie or a trusted certificate of deposit of specie could do because in panics only Money would do.

    Our present panic has its source in the belief that the government can, by manipulation of Money’s value, make credit freely available for itself and selected groups of citizens, that no real reserve is required. The present rescue plans are based on the assumption that, by endorsing existing quasi-government credit instruments (bank deposits, Fannie and Freddie bonds, etc.) as Money, commerce can be restored. I doubt it. We have reached the point where people wonder if their Money itself can be devalued or appropriated by the click of a key and the stroke of a Presidential pen.

  • Anthony Teamson says:

    You should read Von Mises, you would learn something about the real world of economics and probably get a better understanding of what acting rationally means. In addition, Keynesian are considered economists only because they articulate models of working class exploitation that sound compassionate and oh, so scientific. When in fact they are alchemists who have successfully moved from the lead into gold mantra to the paper into wealth cant. Their cant is accepted because it appears to ensures an steady cash flow to government at the expense of the buying power of worker’s wages.

  • Dakota says:

    I was very excited when I saw the title of this piece. I was very disheartened after reading the post.

    When you start putting nails in the coffin, use this title. We all know what happened when the little boy who would have grown up to be a CPA cried “wolfriedman.”

    (people stopped reading his blog)

  • Dakota — Interested in your view in a detailed way — how did I fail you? What would you have said to make the case?

  • joe riemer says:

    “PS — The Bible says that the borrower is servant to the lender. ”

    true enough, until the borrower becomes insolvent

    I like the Austrian perspective, however, I don’t think it gives sufficient weight to the idea of new credit preceding new money.

    • joe — yes, except that if the lender were entirely equity-funded, he could survive it. The system gets complex when A owes B, B owes C, C owes D, etc. Only the party that is debt free is a master. Everyone else is a slave, to some extent.