Waiting for the Death of the Chicago and Keynesian Schools

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, there are potentially profitable arbitrages that are going begging.

Barry did a post Wednesday 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, it 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 transit 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.

Comments

[investor88:]

The point is made ie deleveraging must continue until the economy is in equilibrium at a lower level of debt. This will take some years probably.

2008 Dec 24 11:41 AM

[Dan7256:]

The ride was bumpy before the government got involed! and this is not a "moderate bump" It is a mega-bump!


On Dec 24 11:41 AM investor88 wrote:

> The point is made ie deleveraging must continue until the economy
> is in equilibrium at a lower level of debt. This will take some
> years probably.

2008 Dec 24 12:46 PM

[bobace:]

R eturn of the gold standard, as James Grant also prefers, is an admission that modern governments are not capable of regulating money supply. The current crisis was preceeded by a lack of regulation and over-sight. Adherence to a Gold Standard would not have any effect on the outcome - i.e., they are mutually exclusive concepts. I disagree with your opinion that the Keynesians will fail this time. I also disagree that the remedy is continued deleveraging of assets. (I agree that bad debts from insolvent debtors will need to be settled using the normal bankruptcy laws but this is normal course relief similar to the Resolution Trust liquidations in a prior Epoch.) The massive deficit financing and printing of money focused on retraining, public infrastructure and green initiatives, as Obama policy indicate, will increase consumer confidence and demand. Inflation will reduce real assets values - effective deleveraging. I base my view on the momentum of an Obama rally and a renewed focus on financial regulation and real-economy reorganization to reduce US reliance on foreign energy.

2008 Dec 24 12:57 PM

[jimmy46:]

Tax deductions for residential real estate, including the home sale capital gains exclusion."""""""

You think the gov. should tax what is only an inflationary adjustment?

My parents just sold the house they lived in for 53 years,
a big capital "gain",
but mostly due to the dollar losing over 90% of its value in that time.

The fed gov. profits too much from inflation as it is,
give us a break.

2008 Dec 24 02:24 PM

[Tony Petroski:]

You should read Hayek and the "Road to Serfdom." Summarizing: Socialist systems are dominated by the most ruthless and dishonest people in a society (think Blago and the Chicago gang now taking over) and that socialism of the type we are now blundering into conditioned the Germans for National Socialism.

2008 Dec 24 04:24 PM

[Anthony Alfidi:]

The Chicago and Keynesian schools will survive as long as their main adherents have academic tenure and mentor younger scholars. Note that Marxist thought is still alive and well in university poli-sci departments.

2008 Dec 24 05:25 PM

[Steven Hansen:]

i am beginning to wonder is a slightly inflating fiat currency is also the problem. what happens if this is the root cause of the bubbles. it allows for the over expansion of credit, and bad decisions being covered up by inflation.

2008 Dec 24 08:10 PM

[Alan von Al...:]

GSEs and government guarantees so badly deformed the market, you can scarcely say the Chicago school was discredited. What has been plainly discredited is phony "flow of funds" national accts and off balance sheet SIVs.

2008 Dec 25 04:56 AM

[morph366:]

The real world fits neither of the requirement for eithr of the economic ideologies discussed i.e. Keynesianism or monetarism.
Too many fudges and band aids have been stuck on to the global financial system. If you take human empathy and well intentioned altruism out of the equation - which surely we shouldn't do, especially at Christmas time -:) - then we should be looking at a Darwinian solution to the world of making money.
As it is we will have to muddle our way through the current "difficulties" with more invocations of hope and the ingenuity of human nature to overcome adversity.

2008 Dec 25 08:10 AM

[Sigmund:]

You should read von Mises and Hayek. You should recognize that they and the Chicago School and Keynesianism are voices in the dialogue. Each brings a view point and rationale that assists us in understanding our current predicament; namely, that we have spent more than we can reasonably repay. The reliance on econometrics to predict the direction of the economy is a serious error. The arithmetic is precise, the world we live in is imprecise. Models are instantaineous in their calculation, occurance requires time. It is a political economy, rife with the foibles of man. While I favor free market capitalism, I also assert that absolute freedom is anarchy, rules keep free markets free. So let us not hasten to bury all that has gone before, let us learn from it and adjust the lessons of history to our current circumstance.

2008 Dec 25 09:51 AM

[Ferdinand E...:]

Now that we have a nice meltdown in many countries, I sometimes ask myself why I stopped teaching macroeconomics. When I read this article, and some of these comments, I know why. Check out the following: "a critic of their methods through behavioral economics and nonlinear dynamics...." Some kind of behavoral economist visited my university ten years ago, and I informed him in front of a hundred or so students that he was not welcome, and if he were to attempt to run e.g a seminar on that topic, I would make him wish that he never heard the term. I don't think the students or my colleagues appreciated my remarks, but they knew enough to keep their mouths shut.

As for nonlinear dynamics, this isn't even gobbledygook. Incidentally, Hayek received his Nobel as the same time as Gunnar Myrdal, and when he got up to talk, Myrdal said at the top of his voice: Remember, you don't speak for me. He said a lot of other things too before Hayek left town.

The people doing the complaining should listen to themselves, Many of them voted for George Bush instead of Kerry, and so to my way of thinking they asked for what they are getting.

2008 Dec 25 11:59 AM

[1RuleNoRules:]

The market have been self-regulating. It is government interference in the markets that has caused this problem. Namely, Fannie Mae & Freddie Mac. My understanding is in the Chicago School of thought, government would be much smaller, taxes would be lower on corporations and businesses and there there would be no Fannie and Freddie. Keynesian thought dominates Government, education and economics. You my friend are blaming the hangover on not having enough to drink. Wait until we try the Chicago school of thought before we blame it for anything. I suspect it will be blamed for prosperity.

2008 Dec 25 02:39 PM

[maedchen:]

I think capitalism finally has failed, thanks to GS and the other criminals.
We really should try a more human and social form of democracy.
We should care more of the people without a job or health-insurance, than the bonusses for Wall-Street, the jets for CEO's etc.
Obama is not only the hope for change, he is our last chance.

2008 Dec 25 09:15 PM

[JohnL:]

David,

I love your writings already; I can't wait to read them after you have read von Mises and von Hayek! Armed with their insights, the last of the fog will clear.

2008 Dec 26 02:41 PM

[Smarty_Pants:]

"we eventually have to give our currency some backing and get the government out of the money business."

This is the crux of our problems. The gub'mint runs the money business. Name one program run by the gub'mint that has worked as expected without side effects worse than the original problem (answer: none). Until the market can be certain that the medium of exchange is trustworthy (ie. not manipulated by gub'mint or banks), we will continue to have problems.

Fully backing the money supply and eliminating fractional reserve banking would return our economy to sustained health. Sure, there will still be bumps in the road, but they would be much smaller and less painful than the current Keynesian regime where small bumps are pushed into the future until a cumulative disaster occurs.

2008 Dec 29 09:18 AM

[kungfucraig:]

Aye. I second that. Read Human Action by Ludwig von Mises.


On Dec 25 09:51 AM Sigmund wrote:

> You should read von Mises and Hayek. You should recognize that they
> and the Chicago School and Keynesianism are voices in the dialogue.
> Each brings a view point and rationale that assists us in understanding
> our current predicament; namely, that we have spent more than we
> can reasonably repay. The reliance on econometrics to predict the
> direction of the economy is a serious error. The arithmetic is precise,
> the world we live in is imprecise. Models are instantaineous in
> their calculation, occurance requires time. It is a political economy,
> rife with the foibles of man. While I favor free market capitalism,
> I also assert that absolute freedom is anarchy, rules keep free markets
> free. So let us not hasten to bury all that has gone before, let
> us learn from it and adjust the lessons of history to our current
> circumstance.

2008 Dec 29 02:29 PM