The Long FAQ on Liberalism
A Critique of the Chicago School of Economics:
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
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
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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1. Here are two such quotes by Adam Smith from An Inquiry Into
the Nature and Causes of the Wealth of Nations:
"People of the same trade seldom meet together, even
for merriment and diversion, but the conversation ends in a conspiracy
against the public, or in some contrivance to raise prices."
Other anti-capitalist quotes from Adam Smith can be found at Favorite
Quotes -- economics.
"All for ourselves, and nothing for other people, seems,
in every age of the world, to have been the vile maxim of the
masters of mankind."