The Chicago School v. The Rest of UsPosted: April 28, 2009
There’s a very big debate between economists that’s beginning to spill on to the pages of major newspapers. Suddenly, people that I usually only read in scholarly articles are attending conferences where they give papers in what passes off more as the lessons of theory and empirical evidence instead of the theory and evidence itself. So many folks are coming down out of the ivory towers these days that I think some kind of tipping point about the financial crisis has been reached. The only thing I can think that may have caused this escalation is the back and forth that is now the blogosphere and the financial crisis which is making a lot of folks defend their models.
Many, many academic economists keep blogs now. The readership of these blogs was originally every one’s students or the adopters of your textbook. It then became a way to pass your working papers and pubs back and forth to avoid the journals. Even a few folks have actually put their databases up for use by doctorate students. Believe me, both a blessing and a curse having been in the position of having to reproduce a bunch of stuff I’d rather have not. Many finance folks keep blogs because they make money giving advice to Wall Street Types and investors. But their blogs have taken an interesting twist too. Maybe it’s because I live blocks from the Mississippi and a few miles from a salt water lake but watching this back and forth is like watching the world’s longest intellectual and philosophical tennis match. Do we really have to repeat the Great Depression for the Chicago School to get it this time?
As more of these folks have begin to link to each other, respond to each other, and especially attract an audience of noneconomists, we’ve see more and more debates between the “fresh water” and the “salt water” macroeconomists. Here’s a bit of an explanation of that from Angry Bear back when the discussion started.
In the field of macroeconomics there is a much deeper division between macroeconomics as practiced at universities closer to the great lakes than to an Ocean (Fresh water economics) and that practiced at universities closer to Oceans (Salt water economics). The geography has shifted some as Fresh water economics has been exported. I’d consider Professor Robert Barro at Harvard to be brackish (with, he reports, noticed salty contamination in the first 6 months after he moved from U. Rochester) and the economics department at the University of Pompeu Fabra (in Barcelona) seems to be distilled. It is a little difficult to explain the disagreement to non economists. Frankly, I think this is because non-economists have difficulty believing that any sane person would take fresh water economics seriously.
Roughly Fresh water economists consider general equilibrium models with complete markets and symmetric information to be decent approximations to reality. Unless they are specifically studying bounded rationality they assume rational expectations, that everyone knows and has always known every conceivable conditional probability. I’ve only met one economists who claims to believe that people actually do have rational expectations (and I suspect he was joking). However, the fresh water view is that it usually must be assumed that people have rational expectations.
Over near the Great Lakes there is considerable investigation of models in which the market outcome is Pareto efficient, that is, it is asserted that recessions are optimal and that, if they could be prevented, it would be a mistake to prevent them.
Salt water macroeconomics is basically everything else with huge differences between people who attempt to conduct useful empirical research without using formal economic theory and people who note the fundamental theoretical importance of incomplete markets and of asymmetric information and of imperfect competition (as in everything you think you know about general equilibrium theory is known to be false if markets are incomplete or there is asymmetric information or there is imperfect competition – Market outcomes are generically constrained Pareto inefficient which means that everyone can be made better off by regulations imposed by regulators who don’t know anything not known to market participants who also just restrict economic activity and don’t introduce innovations like, say, unemployment insurance).
Leading fresh water macroeconomists include Robert Lucas, Ed Prescott Thomas Sargent, Lars Hansen, John Cochrane, Larry Jones, Robert Barro (mostly), and Kevin Murphy (usually). Leading salt water economists include Paul Samuelson, Edmund Malinvaud, Jacques Dreze, Joseph Stiglitz, Robert Solow, Paul Krugman, Andrei Shliefer, Olivier Blanchard, George Akerlof, Robert Hall, Ben Bernanke, N. Gregory Mankiw, Christina Romer, David Romer and, and Lawrence Summers. Brad DeLong is also a salt water economist and he is very very smart, but last I knew, he was a little too far out there to be really a member of the economists club. I can’t classify Paul Romer.
Notably all of the above have made important contributions to fields other than macroeconomics.
A blog war started early this year between Barro and Fama and Krugman and DeLong that was intriguing to theoretical economists but not really something I’d bring up at any place other than a department cocktail party. Fama made a really elementary mistake so Krugman got the high ground, but he achieved an even higher ground when he walked off with the Noble Prize. It was for his contribution to International Trade Models, not the same thing, but still a blow to the ‘fresh water’ krewe. However, as I said, it’s spilling into the popular press, so I thought I’d share this with you because it’s really about philosophical differences and approaches to the current Financial Crisis.
This article is from Salon and is entitled “The Great Crash of the Chicago School of Economics”. It basically talks about how all the Nobel prizes and medals in economics (like the John Bates Clark award) are not going to the Chicago School the way they used to in the 70s and 80s. As I’ve mentioned before, Eugene Fama has been clawing for one for as long as I’ve been both in and out and back in academia. What is at heart here is the debate between the last of the laissez faire, neoclassical economists and the neokeynesians who have been out in the cold for some time. Andrew Leonard throws a punch line for you:
I’m not going to cut it too fine: I think you can very well blame the Chicago school for the fiasco of growing income inequality in the U.S. Nice triumph for deregulated capitalism, boys! Ronald Reagan listened closely to Milton Friedman and the Chicago school godfather’s disciples have been rife in the Republican administrations that have dominated the White House ever since the Californian swept into Washington and started blaming government for our problems. Well guess what? It didn’t work so well. The rich got richer and then screwed the pooch.
Perhaps the shining moment, that I’ve mentioned before, is when Dr. Allen Greenspan sat in front of a congressional committee and said his entire world view went upside down this last year when the markets didn’t self-correct. Perhaps we’re doomed to repeat the past because many of the Fresh Water Macroeconomists and their philosophical cronies in the talking head set continue to revise the history of the Great Depression so that we can’t learn or teach the lessons learned. This article appeared in the Financial Times and is by Henry Kaufman, one of the greats. It’s called “How Libertarian Doctrine Led the Fed Astray”.
One of the Fed’s biggest blind spots has been its failure to recognise the problems that huge financial conglomerates would pose for financial stability – including their key role in the current debt overload. The Fed allowed the Glass-Steagall Act to succumb without appreciating the negative consequences of allowing investment and commercial banks to be put together. Within two decades or so, financial conglomerates have come to utterly dominate financial markets and financial behaviour. But monetary policymakers failed to recognise that these behemoths were honeycombed with conflicts of interest that interfered with effective credit allocation.
Nor did the Fed recognise the crucial role that the large financial conglomerates have played in changing the public’s perception of liquidity. Traditionally, liquidity was an asset-based concept. But this shifted to the liability side, as liquidity came to be virtually synonymous with easy borrowing. That would not have happened without the marketing efforts of large institutions.
My second major concern about the conduct of monetary policy is the Fed’s prevailing economic libertarianism. At the heart of this economic dogma is the belief that markets know best and that those who compete well will prosper, while those who do not will fail.
It is amazing to me that we go back and forth on this same territory over and over again. This brings me to a current conference and two papers that are completely readable, I promise, and reflect the two view points. This week , we have the Milken Institute Global Conference. You can actually read the articles and view some of the panel discussions on line and I would suggest you do that. It is more than just a Finance/Economics conference. However, I’d like to point you to in the Finance Track where we still have the same old same old, coming from the same old same old, including Mohamed El-Erian, CEO and Co-Chief Investment Officer, Pacific Investment Management Co. (PIMCO), Steve Forbes, Chairman and CEO, Forbes Inc.; Editor-in-Chief, Forbes, Kenneth Griffin, Founder, President and CEO, Citadel Investment Group LLC, John Micklethwait, Editor-in-Chief, The Economist, Moderator and Michael Klowden, President and CEO, Milken Institute
University of Oregon (salt water macroeconomist) Mark Thoma points out the debate happening at this conference in his thread “Government is always the Scapegoat” which concerns the first session. You can view that first session here.
I was curious to see how the attitudes had changed relative to last year, if they had changed at all, e.g. whether there would be any self-reflection, acceptance that the financial sector would have to change. But, nope, not from this panel anyway. There was a lot of talk and worry about the growing role of government in the economy, that was viewed as the main cause of all the problems in the past, and of problems yet to come. There was very little about the financial sector must change in order to stabilize the system going forward, very little about what needs to be done to clean up their own houses.
So the game so far this year, if one session is any indication, is to blame the government for the problems we have, and to point to the government as the biggest potential impediment to the recovery. I don’t know if this is a conscious strategy or not, but it seems clear that blame the government is the defense against more regulation.
There are two papers that I’d like to point to that interested me in particular. Both are very readable. One is by Rene Stultz from Ohio State who insists that financial derivatives really don’t need to be regulated, much, because they are, after all, wonderful, financial innovations in “Financial Derivatives: Lessons from the Subprime Crisis”. The other is by Lawrence White of NYU who makes a very clear case for renewed financial regulation ala Glass-Stegall in “Financial Regualtion an Agenda for Reform.”
Both of these papers are about a dozen pages long, written for a nontechnical audience and should give you some good information from experts on credit default swaps and some of the more obscure derivatives at the center of the global meltdown as well as some really good idea of the debate for more or less regulation of these markets. Here’s just a few take away lines, that again show you the debate still howls between the salt water and fresh water macroeconomists.
I think the case for pinning the blame on these poorly understood financial tools is based on a misunderstanding. There would never have been a subprime crisis if the housing bubble had not burst. Consequently, for derivatives to be the proximate cause of the crisis, they would have to have influenced the path of housing prices.
To the contrary: I would argue that a well developed market for housing-price derivatives might have tempered the boom-bust cycle by allowing big market players to signal their growing concerns about escalating prices, and by giving homeowners a means of hedging against the loss of wealth when the housing market headed south. There is, in fact, a market for housing-price derivatives – specifically, for futures contracts on housing price indexes. But this market was small and illiquid, and there is no reason to believe that it had much impact on events.
We’ve just witnessed a record boom in housing prices – they doubled from 1998 to 2006. That run-up was
fed by progressively looser lending standards that allowed households with marginal credit to borrow excessive amounts for mortgages. These loans were often bundled into securities that were blessed with solid ratings by the credit-rating agencies, then sold to blithe institutional investors from Singapore to Norway. And in many cases, these securities became collateral for yet other securities, generating more fees for Wall Street and further distancing investors from the unwelcome reality of the risks they bore.
Much of this happened because the market participants – from the borrower to the mortgage broker to the securities packager to the ratings agency – chose to assume that what went up would never come down. Today we earn big bonuses. Tomorrow … well, tomorrow is another day.
This is not the whole story; outright fraud played a part. But it was only a footnote to what amounted to the greatest pyramid scheme in history. The taste for flying high was infectious: normally cautious banks made loans to highly leveraged private equity firms and failed to insist on the close oversight that would have been de rigueur a few years earlier. Similarly, bond investors, who had long demanded an interest premium of five to six percentage points above the rate on Treasury securities on loans to corporations with iffy credit, were doling out cash to borrowers for less than half that premium.
In sum, the combination of a humongous housing boom and a surprising disregard for risk on the part of investors conspired to create an environment in which slipshod practices remained profitable way too long. When housing prices ceased to rise, the housing finance system imploded, dragging much of the overleveraged and under-vigilant financial sector down with it.
From Dakinikat: C’mon guys, I only have two hands and I have to teach this stuff.