Bryan Caplan  

The Chicago School of Economics: What Went Wrong?

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Economics at the University of Chicago is no longer very different from economics at other top programs.  What happened?  The proximate cause was lack of a strong instinct of memetic self-preservation.  The ultimate cause, though, was that the Chicago School destroyed itself from within.  Or so I argue in the closest thing I've written to a history of thought piece:
Future historians of thought will be puzzled by the transformation of the Chicago School. How does one get from Milton Friedman to Donald Wittman? My answer: Step by step, and myopically. More than anyone else, Friedman cemented the Chicago view that the free market is under-rated. Since many market failure arguments assume that consumers or workers are irrational, Chicago economists eagerly joined the rational expectations revolution. Initially, their new outlook made their defense of free markets more truculent; government intervention seemed even more pointless than previously believed. But this position was unstable. If people have rational expectations, how can the free market be "under-rated"? And if the free market is not under-rated, then what reason is there to second-guess democratically-chosen policies? This pointed question gnawed away at the intellectual conscience of Chicago economists until enough were ready to hear Wittman's unconflicted answer: There is no reason to second-guess democratically-chosen policies.
I continue:
During this evolution, Chicago economists seemed to lose sight of a much more fundamental principle: the importance of empirical testing. Rational expectations is an empirical hypothesis. It could be true, it could be false, and it could be true for some applications and false for others. It is awfully rash to accept it as a universal truth without testing. Even if an hypothesis seems intuitively obvious, you should look for exceptions.

But at least for beliefs about economics, Chicago economists should have found rational expectations to be completely counter-intuitive. As teachers of economics, they must have noticed that students do not arrive as blank slates. In fact, students typically seem to believe the opposite of what you plan to teach. Yes, it is possible that economic educators have misread their students for centuries. But such an extraordinary claim needs compelling empirical evidence to command assent.

The Chicago School inexplicably waived this requirement. Empirical evidence that beliefs about economics are unbiased never surfaced. But the rational expectations hypothesis became de rigueur anyway. Now that a large body of empirical evidence confirms that the teachers of economics were right all along, we can justifiably say not only that Chicago economists should not have changed their minds, but that they should have known better.
The sad truth is that the Chicago School died around the time I entered grad school.  Bad timing on my part.  I really wish I could have saved Chicago from itself.  It had so much to live for.


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COMMENTS (10 to date)
Julien Couvreur writes:

Can you define "rational" in rational expectations?

Mises' definition of rationality may be tautological (and that is not necessarily bad), but at least he provides one.

david writes:

In the macro context, ratex only requires that agents value financial instruments in a von Neumann-Morgenstern-consistent fashion.

This has empirical content in the case of instruments because of an assumption that people only buy these instruments to liquidate them later, not because of innate preferences over the kind of instruments they buy. So we can test for consistency in attitudes toward risk and intertemporal discounting between different kinds of financial instruments.

david writes:

That, by the way, is why Larry Summers famously derided the EMH as

Nonetheless ketchup economists have an impressive research program, focusing on the scope for excess opportunities in the ketchup market. They have shown that two quart bottles of ketchup invariably sell for twice as much as one quart bottles of ketchup except for deviations traceable to transaction costs, and that one cannot get a bargain on ketchup by buying and combining ingredients once one takes account of transaction costs. Nor are there gains to be had from storing ketchup, or mixing together different quality ketchups and selling the resulting product. Indeed, most ketchup economists regard the efficiency of the ketchup market as the best established fact in empirical economics

Which is true: ratex means less than its proponents and critics talk as if it does, in political rhetoric. It's merely that the pre-ratex academic universe did not actually regard it as obvious.

R Richard Schweitzer writes:

This is fascinating stuff, to actually go back and read a 2005 critique of 1989 and 1995 thinking. Not exactly an Isaiah Berlin format, but analytical in character.

There is more than a faint possibility of the creation of a "straw man" in these lines of thought.

If democracy is a process and not a condition, is that not the process by which markets operate?

The Democratic process for the establishment of policy differs from the process of the market in that the market requires that the participants each bring something into the marketplace for purposes of exchange or mediation. There is no such requirement for the participants in the formation of policy.

That distinction rather than "free" or "open" markets, or policy intrusions into the otherwise Democratic process of markets is a matter for further examination.

Vangel writes:

I am sorry to ask this but isn't the Chicago School's decline rooted in its methodology? I am an engineer and not an economist but the red flags pop up when I read Friedman's statement, "The relevant question to ask about the "assumptions" of a theory is not whether they are descriptively "realistic," for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions."

Economics is not physics. It is the study of human activity and there are no experiments in which we can hold all variables other than the ones that we are interested in constant so that we can test a hypothesis. The Chicago School failed because it chose the use of unrealistic assumptions so that they could use math to create flawed models. And when I look at the Chicago School objectively I cannot see how I can say that it favours the free markets. From what I see the Chicago School economists favour central planning in monetary policy and has argued for a bigger state that engages in redistribution. That may be many things but free market is not one of them.

Jeff writes:

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Malcolm Kirkpatrick writes:

(Vangel): "the red flags pop up when I read Friedman's statement: 'The relevant question to ask about the "assumptions" of a theory is not whether they are descriptively "realistic," for they never are, but whether they are sufficiently good approximations for the purpose in hand ...' The Chicago School failed because it chose the use of unrealistic assumptions."

Friedman was right. Engineers are in no position to criticize the use of unrealistic assumptions. You use arithmetic, right? Continuity (Dedekind) and infinity (Euclid) are assumed. But they work well enough for government work.

Brian writes:

Isn't the simpler explanation for the supposed demise of the Chicago School that there never WAS a Chicago School? There was instead the Friedman School that happened to be at Chicago. He was sufficiently charismatic that other like-minded economists went to Chicago also. Once he left Chicago (and perhaps even before, since the field had moved on to new heroes), Chicago went back to recruiting the very best of everyone, which made them revert back to the profile of everyone.

It continually boggles my mind that a social science won't model expectations and preferences as being socially influenced.

Saveyourself writes:

Could it be that the Chicago-school is in Chicago and Chicago is one of the most socialistic cities in the world? To expect the Chicago-school to exist in Chicago and NOT lean towards central decision making models would be like asking a child whose parents and siblings use drugs and alcohol daily to grow up as a straight and sober adult.

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