Are we now in danger of losing Milton Friedman’s legacy to the mindless adoption of a socialistic imperative?
"When Friedman’s Platonic ideas of free-market virtues are put into practice, they have too often generated a systemic orgy of competitive greed — whose remedies, ironically, entail countermeasures of nationalization,” Marshall Sahlins.
What do our readers think — has the devastating unraveling of our financial system during this past year changed any of your beliefs? – Ilene
Friedman Would Be Roiled as Chicago Disciples Rue Repudiation
By John Lippert, in Bloomberg
John Cochrane was steaming as word of U.S. Treasury Secretary Henry Paulson’s plan to buy $700 billion in troubled mortgage assets rippled across the University of Chicago in September. Cochrane had been teaching at the bastion of free-market economics for 14 years and this struck at everything that he — and the school — stood for.
“We all wandered the hallway thinking, How could this possibly make sense?” says Cochrane, 51, recalling his incredulity at Paulson’s attempt to prop up the mortgage industry and the banks that had precipitated the housing market’s boom and bust.
During a lunch held on a balcony with a view of Rockefeller Memorial Chapel, Cochrane, son-in-law of Chicago efficient-market theorist Eugene Fama, and some colleagues made their stand.
They wrote a petition attacking Paulson’s proposal, sent it to economists nationwide and collected 230 signatures. Republican Senator Richard Shelby of Alabama waved the document as he scorned the rescue. When Congress rejected it on Sept. 29, Cochrane fired off congratulatory e-mails.
The victory was short-lived. Lawmakers approved the plan four days later, swayed by what Cochrane calls a pinata of pork-barrel amendments.
“We should have a recession,” Cochrane said in November, speaking to students and investors in a conference room that looks out on Lake Michigan. “People who spend their lives pounding nails in Nevada need something else to do.”
Unusual Role
At the University of Chicago, 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.
By the end of November, the government had committed $8.5 trillion, or more than half the value of everything produced in the country in 2007, to save the financial system.
The European Union had ponied up more than $3 trillion to guarantee bank loans and provide capital to lenders. And China had unveiled a $586 billion stimulus plan and its biggest interest-rate cut in 11 years.
The intrusion is anathema to the so-called Chicago School of economics and its patriarch, the late Milton Friedman.
Nobel Dominance
For half a century, Chicago’s hands-off principles have permeated financial thinking and shaped global markets, earning the university 10 Nobel Memorial Prizes in Economic Sciences starting in 1969, more than double the four each won by Columbia University, Harvard University, Princeton University and the University of California, Berkeley.
Chicago’s laissez-faire imprint underpins everything from U.S. President Ronald Reagan’s 1981 tax cuts and the fall of communism that decade to quantitative investment strategies.
In 1972, Friedman helped persuade U.S. Treasury Secretary George Shultz, former dean of Chicago’s business school, to approve the first financial futures contracts in foreign currencies.
Such derivatives grew more complex after Chicago economists created the mathematical formulas to price them, helping spawn a $683 trillion market that’s proved to be a root of today’s financial system breakdown…
Free Market
Friedman, who died in 2006 at age 94, defined the Chicago School in 1974 as he spoke to a board of trustees dinner.
“‘Chicago’ stands for a belief in the efficacy of the free market as a means of organizing resources, for skepticism about government intervention into economic affairs,” he said.
Friedman was explaining a movement that had taken hold in the U.S. and was percolating in Europe and South America.
“By the mid-1970s, there was a whole generation in government and academia who’d trained at Chicago or places influenced by it,” says Ross Emmett, a Michigan State University professor who’s written three books on the school.
Today, 10 percent of Chicago undergraduates study economics. Alumni of Chicago’s graduate business school, now called the Booth School of Business, run states and companies…
Unlike Booth, 62, much of the academic world is reassessing Chicago School hallmarks. That’s true even in the limestone buildings on the 211-acre (85-hectare) Hyde Park campus in which professors teach Friedman’s theories.
‘Systemic Orgy’
On Oct. 14, about 250 students and professors debated an administration-backed plan for a $200 million research center to be named for Friedman. The protesters argued that the institute would enshrine policies that have brought economies near collapse.
“When Friedman’s Platonic ideas of free-market virtues are put into practice, they have too often generated a systemic orgy of competitive greed — whose remedies, ironically, entail countermeasures of nationalization,” Marshall Sahlins, an emeritus professor of anthropology, said during the debate, speaking in a room adorned with murals of female students parading through the campus in medieval gowns.
Sahlins, 77, noted a few weeks later socialist and capitalist countries alike are regulating or nationalizing financial institutions in a rebuff to Friedman.
Off campus, the global meltdown is stirring anti-Chicago economists, who were voices in the wilderness during decades of lax government oversight of markets.
Joseph Stiglitz, who won one of Columbia’s economics Nobels, says the approach of Friedman and his followers helped cause today’s turmoil.
‘Bears the Blame’
“The Chicago School bears the blame for providing a seeming intellectual foundation for the idea that markets are self- adjusting and the best role for government is to do nothing,” says Stiglitz, 65, who received his Nobel in 2001.
University of Texas economist James Galbraith says Friedman’s ideology has run its course. He says hands-off policies were convenient for American capitalists after World War II as they vied with government-favored labor unions at home and Soviet expansion overseas.
“The inability of Friedman’s successors to say anything useful about what’s happening in financial markets today means their influence is finished,” he says.
Instead, Galbraith, 56, says policy-makers are rediscovering the ideas of his father, Harvard professor John Kenneth Galbraith, and economist John Maynard Keynes of the University of Cambridge.
Keynes, who died in 1946, argued that governments should spend to combat the unemployment that free markets tolerate. Galbraith, who died in 2006, rejected mathematical models and technical analyses as divorced from reality.
Obama’s Role
Barack Obama, who will referee the laissez-faire versus free- market debate as U.S. president, has pledged the largest spending on infrastructure since the 1950s to save or create 3 million jobs.
Obama, 47, has deep roots on the university’s campus in Hyde Park, a middle-class enclave 7 miles south of downtown Chicago. His Victorian house is a five-minute walk from the school’s northern edge. He taught constitutional law there for 12 years, stepping down when he was elected to the U.S. Senate in 2004.
Obama tapped fellow Chicago professor Austan Goolsbee as staff director of his President’s Economic Recovery Advisory Board, which will propose ways to revive growth.
Goolsbee, 39, who was Obama’s chief economist during the campaign, has taught at the business school since 1995. Goolsbee says Obama’s top priority is to prevent the crisis from spiraling into a depression. Yet he insists Obama won’t overregulate…
Goolsbee supports bigger capital requirements for banks and other institutions that can borrow from the Federal Reserve, and wants expanded monitoring of hedge fund firms and ratings companies. Derivatives may need to be traded through clearinghouses, like those used in Chicago wheat pits, which act as counterparties for each trade and can suspend traders with insufficient collateral…
Already, some of the university’s top economists have abandoned hard-line Friedmanism for the middle ground.
Douglas Diamond, a finance professor at Chicago since 1979, declined to sign Cochrane’s petition damning Paulson’s bailout. Diamond says he knew the Sept. 29 vote against the rescue would spur investors to pull assets from banks. He says governments have no choice but to provide safety nets for banks and tougher oversight.
‘Crazy Stuff’
“The vote was the beginning of people believing crazy stuff, like the U.S. might find it politically expedient to let its financial system go,” Diamond, 55, says.
Robert Lucas, a Chicago economist 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…
“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 believe that.”…
Keynesian Orthodoxy
Friedman’s parents were Jews who emigrated from what’s now Ukraine. When he joined the faculty in 1946, he allied with Friedrich Hayek, a London School of Economics professor who later transferred to Chicago. They sought to discredit Keynes, who argued that deficits in government budgets could revive demand in recessions. They viewed rising government power as a step toward left-wing totalitarianism and wanted to stop it, says Philip Mirowski, a University of Notre Dame economist…
‘Change My Mind’
Lucas, the 1995 Nobel laureate, recalls Friedman convincing him in a 90-minute undergraduate class in 1960 that labor was subject to the same economic laws as other commodities. Friedman argued that minimum wage laws, which Lucas saw as humanitarian, harm workers by reducing demand for their services.
“I never thought I could change my mind like that,” Lucas says.
Deirdre McCloskey, now an economist at the University of Illinois, Chicago, remembers laughing with fellow Harvard undergraduates in 1963 at Friedman’s claim that free markets allocate resources better than governments. She says Harvard-trained bureaucrats enjoyed prestige following World War II. She switched her support to Friedman after the Vietnam War destroyed her faith that such bureaucrats knew what they were doing.
Friedman, who stood 5 feet 3 inches (160 centimeters), was a fierce debater, McCloskey recalls.
“He always asks, persistently, ‘How do you know?’” McCloskey, now 66, wrote in the Eastern Economic Review in 2003. “It’s a terrifying question, because most of the time we can’t say.”…
Black-Scholes
While wrapping up his Hyde Park career, he reviewed the early research of professors Fischer Black and Myron Scholes, who gave Chicago theories a bigger and more direct role in financial markets.
The pair provided a foundation for trading call options on stocks by creating a formula to link the value of the options to share price and volatility, time remaining on the option and interest rates.
The Black-Scholes model helped spark the global derivatives market.
At the time, Fama was positing that securities prices reflect the collective wisdom of all participants. This “efficient market” theory helped make him the No. 1 scholarly business writer, with 250,828 downloads of academic papers as of Dec. 22, according to Social Science Research Network.
Fama’s theory helped pave the way for the recent economic crisis by sanctioning limited government, Notre Dame’s Mirowski says.
“Fama taught that no human being knows enough to understand how resources should be allocated,” he says. “All you can do is let the market have greater and greater ability to repackage information and risk. The result is, people bought mortgage-backed securities with no idea whether borrowers could repay.”
AIG’s Long Position
Fama, 69, who favors casual shirts and chinos on campus, joined the Chicago faculty in 1963. When he opened his financial theory class on Sept. 29, the day Congress voted down Paulson’s bailout, he placed efficient-market equations from his 1976 textbook on an overhead projector.
Fama says he never denied the possibility of unexpected events even though he’d spent a lifetime showing that markets effectively digest information. He was stunned that American International Group Inc., once the world’s largest insurer, sold $441 billion in unhedged and undercapitalized insurance on securitized debt, much of it tied to mortgage values.
“No one expected a player like AIG to take a long position and not hedge themselves,” Fama says. He says the government may have been able to stabilize the U.S. financial system at a lower cost by letting AIG collapse.
Bailout Mania
Bailing out Detroit automakers will simply postpone their demise as they reel from expenses promised for employee retirement plans, he says.
Cochrane, who circulated the anti-rescue petition, says a rash of bailouts will expand government and kill entrepreneurship…
…Cochrane says he now represents a minority viewpoint among Chicago’s business faculty. He says Diamond, who declined to sign the petition, holds a majority view, which posits financial institutions must be rescued and regulated.
Bank Failures
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.
During the 1980s, Diamond’s research was similar to that of Fed Chairman Ben S. Bernanke, 55, whom he calls a good friend. The two postulated that because bankers accumulate experience in assessing risk, they play a key role in the economy.
In the past decade, bankers failed to properly grasp risk because of a “witch’s brew” of mistakes, Diamond says.
Real-Life Experiment
Former Fed Chairman Alan Greenspan’s 1 percent interest rate in 2003 — a 45-year low — flooded Wall Street with so much cash that banks could increase profits with short-term borrowing to service long-term liabilities, Diamond says. The mismatch grew more dangerous as Greenspan resisted regulation of off-balance-sheet structured investment vehicles, which banks used to circumvent capital requirements.
Reagan’s $4.5 billion rescue of Continental Illinois National Bank & Trust Co. in 1984 convinced bankers that bailouts would come if things turned bad, Diamond says.
By 2007, a quarter of assets held by big U.S. investment banks came from short-term borrowing, up from 12 percent three years earlier.
Goolsbee describes the plan Obama is formulating — tax relief for workers, investment in technology and infrastructure and more oversight of financial markets — as pragmatic and data-driven. He says Friedman would approve of Obama’s determination to keep policy making rooted in the economic methodologies developed at Chicago…
With his inauguration on Jan. 20, Obama faces a real-life experiment in organizing financial markets amid turmoil few presidents have navigated.
His success will be measured partly by how he uses the University of Chicago as an intellectual anchor — and whether he can meld its free-market heritage with today’s nonstop intervention to bring order to uncharted times.
Full article here.
