CHICAGOITES AS CONFUSED AS EVER* (Print Version)
by Martin Masse**
Le Québécois Libre, January 15, 2009, No 263.
Bloomberg ran a long and
interesting report on December 23, 2008, on the disarray that
Chicago school economists finds themselves in as a result of the current
The article explains that "For half a century, Chicago's hands-off
principles have permeated financial thinking and shaped global markets."
But today, "once ascendant free-market acolytes are finding themselves
in an unusual role: They're battling a wave of government intervention
more sweeping than any since the Great Depression as the U.S. struggles
with the worst recession in seven decades." So much so that many
Chicagoites are now rediscovering the virtues of government regulation
and bailouts and are parting with their "free-market" colleagues. Or is
this really what's going on?
The piece begins with the story of economics professor John Cochrane,
who was so infuriated by Henry Paulson's first $700-billion bailout
proposal in September that he launched a petition attacking it that
eventually collected the signatures of 230 economists from across the
Cochrane explains that "a rash of bailouts will expand government and
kill entrepreneurship." True enough. But that's the "fiscal stimulus"
aspect of all the government intervention that has been taking place for
the past couple of months. What about the "monetary stimulus" side of it?
That's where the free-market principles go out the window in typical
Cochrane says he was
encouraged by the Fed's Dec. 16 rate cut and its plan to buy
mortgage-backed securities, saying these moves will help
unfreeze capital markets.
"This is exactly the right thing for a central bank to be doing
in the midst of a credit crunch," he says.
So, from the perspective of what we could call the
"right wing" of the Chicago school, it's bad economics when the
executive and legislative branches of the governement throw money at
failing sectors. But when it's bureaucrats from a governement monetary
planning agency who do it with counterfeit money, no problem, that's the
right free-market thing to do!
This stance is not very surprising of course, considering that Milton
Friedman supported government control over money (albeit under the helm
of the Treasury instead of the Fed, which he wanted abolished) and
inflationary policies (he wanted a stable and modest increase of fiat
money in normal times, and big increases during periods of crisis).
That's still too much free market for some Chicagoites who now find
themselves on the "left wing" of the school. Robert Lucas, who
won a Nobel in 1995
for a theory that argued against governments trying to fine-tune
consumer demand, says deregulation may have gone too far.
Depression-era laws that separated commercial and investment
banks helped depositors decide if they wanted secure accounts or
riskier investments. Today, without these distinctions, people
can't be sure if their investments, or those of their customers,
"I'm changing my views on bank regulation every week," Lucas,
71, says. "It was an area I saw as under control. Now I don't
Let's ignore the fact that a 71-year-old economist who
won the Nobel Prize can still change his views every week on bank
regulation. One would think he would have found a stable theoretical
framework to think this through by this time? monetarism has obviously
not been very helpful. Note instead the interesting reason he gives for
his new scepticism: when they put their money in a bank, depositors
cannot know if their money is in a secure account or in a risky
Isn't this one of the fundamental problems with the current banking
system, that is, fractional reserves? You think your money is there and
you can retrieve it at any time, but the bank only keeps a fraction of
it in its vaults and has lent most of it to someone else. Austrians and
others before them have been saying for centuries that this was a sort
of fraud that led to unsustainable leveraging and to booms and busts.
Mr. Lucas is right to see that there is something wrong here. He just
hasn't found a good explanation of why and what should be done about it,
and so he adopts the default position of confused free-marketeers, which
is that more regulation must be the answer.
The article tells us about another left-wing Chicagoite, Douglas Diamond,
who refused to sign the petition against Paulson's bailout because he
believes governments have no choice but to provide safety nets for banks
and tougher oversight. Again, the explanation given by the finance
professor for parting with his colleagues is quite interesting:
studying bank failures when he was a doctoral student at Yale in
the 1970s. The 1963 book that Friedman wrote with Anna Schwartz,
"A Monetary History of the United States, 1867- 1960," provided
the foundation. A copy, held together by Scotch tape, sits on
Diamond's desk, even though he concluded at Yale that a main
premise was wrong.
Diamond rejects Friedman's view that banks failed in the 1930s
because the U.S. money supply contracted as panicky Americans
started hoarding cash and the Fed reacted too slowly. Diamond
sees the money supply as less significant than Friedman did.
Banks failed, he says, because their assets weren't readily
converted into the cash that depositors were demanding.
Is it just me or do I see a pattern here? There is no
explicit mention of it, but just like Mr. Lucas, Mr. Diamond seems to
have realized that the fractional reserve system (that's what the last
sentence is referring to) is a crucial part of the problem. His solution
however (if his views are correctly reported in the article) is to have
governments impose even more regulation on the banking system and to
intervene to save it when it is on the verge of collapse. When it's
precisely because governments control the monetary system, condone
banking fraud and constantly save banks from the consequences of their
fraudulent practices that we have this problem.
Chicago school economics is in such a mess that it's hard to decide who
we, as Austrians, should sympathize with: the inflationists who are
still claiming to defend free-market principles, or those going over all
the way to the interventionist side but who may be doing it on the basis
of a legitimate preoccupation with the fractional reserve system.
One can't help but agree with arch-Keynesian James Galbraith, who is
quoted in this article as saying that "The inability of Friedman's
successors to say anything useful about what's happening in financial
markets today means their influence is finished."
* This article was first published on the
Mises Economic Blog on December 23, 2008. **Martin Masse is publisher of