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Chicago Interviews

January 15, 2010

Interview with Raghuram Rajan

Posted by John Cassidy

This is the seventh in a series of interviews with Chicago School economists. Read “After the

Blowup,” John Cassidy’s story on Chicago economists and the financial crisis. (Subscribers

only.)

Interview with Raghuram Rajan

Posted by John Cassidy

This is the seventh in a series of interviews with Chicago School economists. Read “After the

Blowup,” John Cassidy’s story on Chicago economists and the financial crisis. (Subscribers

only.)

I met Rajan in his office at the Booth School of Business. I began by asking him about the

academic work he and several colleagues at the business school did in the years leading up to

2007 on banking and liquidity. In addition to exploring theoretical issues that turned out to be

important, Rajan, in the summer of 2005, issued a prescient warning about the dangers of a

financial blowup involving the credit markets. It was striking, I remarked, that despite Chicago‘s

image as a bastion of market efficiency, it was also home to much more questioning research in

the financial system.

Raghuram Rajan: Forget the public utterances: the research done at this place was, essentially,

right on the ball—issues of liquidity, the fact that liquidity might dry up, and who‘s there to

provide liquidity in those situations. One of my colleagues, Doug Diamond, is, in many ways,

the father of modern banking theory. He wrote the book on bank runs, literally. When he was

traveling around giving his talks, people used to say, ―Why are you working on history?‖

Unfortunately, this stuff is all too real these days.

The point is, research drives thinking, and there are all kinds of research being done here. People

at the extremes get a lot of press, people who say: ―Let‘s not do anything, let‘s liquidate‖—the

Andrew Mellon kind of view. There are people at Chicago who hold that view. There are others

who understand that the banking system is a lot more important than, and different from, most

corporations. Yes, you can close down some banks without a problem, but there are some banks

that are so intertwined you don‘t have an option.

There are some people who say, Simon Johnson [an M.I.T. economist who was formerly at the

International Monetary Fund] for instance, ―Oh, we know how to shut down these banks. We did

it at the I.M.F.‖ The I.M.F. never did anything of this size—not by any stretch of imagination.

The U.S. has closed down banks, such as Wachovia or Washington Mutual, or at least dissolved

them, which are really big banks. But when you come to Citigroup or Bank of America it is a

completely different kettle of fish. We have to figure out how to do it—without any question.

And we could have been much tougher on the banks than we have been. Even now, we could be

much tougher than we are. But to argue that it‘s a very simple thing to do—it‘s just a matter of

nationalizing them or shutting them down—there are a whole lot of issues that are raised there.

All I am saying is that there are no easy answers in this thing … and one doesn‘t have to be

corrupt or in the pay of the financial sector to say, hey, wait a minute: it‘s not as simple as letting

them all go under or taking them all over. That‘s my rant about the banking sector. By and large,

I think we‘ve done all the things that needed to be done. I think the downside of what we haven‘t

done is that we haven‘t made the banks face up to more pain. That would have made it politically

easier to do what needed to be done.

When you say, “make the banks face up to more pain,” what do you mean? Tougher regulation?

Big equity stakes for the government—along the British lines?

Equity stakes and other things. For example, even now [the government] can require all

compensation above a certain amount to be paid in equity, and equity that is real equity. The way

banks do it now is they pay people in shares, but they also buy back equal amounts of shares [in

the market]. So there is no increase in capital.

What we have right now is a situation where every saver in the country is, essentially, paying a

huge tax to bail out the banking system. We are all getting screwed on our money market

accounts—getting 0.25 per cent—and the banks are making a huge spread on nearly every asset

they hold, because they are financing them at pretty close to zero rates. Another way of doing

this—a way that would be nice to try—is to force the banks to load up on capital.

What is the point of all this? The point of all this is to get banks to lend. Well, they have been

doing everything else except lending. Now, it may be that there aren‘t that many profitable

lending opportunities at this point. But if there aren‘t, why are all the savers paying for this?

Because you are not getting them to lend any more, and you are not getting more investment,

which was the whole point of having interest rates so low. In fact, what you are doing is setting

up a whole lot of other asset bubbles at this point.

Another way would be to put more direct pain on the banks. For example, if they were flush with

capital and found they couldn‘t pay bonuses, so all of this [money] went into increasing the

capital base, they would have an incentive to make loans to reduce the effective capital that they

had. What we have at the moment is that the citizenry is paying for the banks. Get the banks to

pay for themselves.

That gets away from the whole Chicago issue. But what I‘m arguing is in Chicago you have the

extreme, which says, ―Let the chips fall they may. What‘s the problem with letting a few banks

go under?‖ Whether you hold that view depends on how much you think the banks as an

institution matters. Doug Diamond and I think it does matter. There is a lot of organizational and

relationship capital embedded in the banks. If you let them go, it is very hard to start them up

[again].

What about the causes of the crisis?

Within the big tent of Chicago, again, there are [also] so many different explanations for why

this happened. Whether it was an agency problem in the banking system itself. Whether it was

markets going haywire—Dick Thaler would be in that camp—irrational exuberance of one kind

or another. Or whether it was government intervention—the story about pushing credit to the less

well off segments of the population. My sense is, if you think seriously about this, all parts of it

are important.

When you have a systemic crisis of this kind in a developed country … the whole point about

development is that you deal with some of these problems. You don‘t have populist extension of

credit. You don‘t have banks going haywire. There is reasonable supervision. That is what we

have always argued—you get good institutions. And all of it broke down. Which would suggest

it is not a small breakdown; it is not a small thing that went wrong. You can‘t pin it all on

Greenspan. It is a systemic breakdown, and we need to look more broadly at why it happened.

How long have you been in Chicago?

I came here in 1991.

When it was largely associated with the efficient-markets hypothesis?

I would guess…. When I came here, Merton Miller and Gene Fama were the leaders of the

finance group. Clearly, both of them were strongly persuaded of the old Chicago viewpoint.

Since then, I would say that Dick Thaler and Rob Vishny have been two important figures

arguing that there are some serious departures from fundamentals. The whole point about a

strong form of efficiency is this: If everybody knows things are going wrong why don‘t they

correct it? Vishny‘s arguments have been about why it doesn‘t get corrected—limits to arbitrage

and stuff like that. I think that is quite persuasive. Dick Thaler‘s [work] has been about how

people make mistakes of a certain kind. That by itself is not enough to explain major departures.

If somebody makes mistakes, why doesn‘t somebody else see those mistakes and try to take

advantage of them?

Who brought in Thaler and Vishny? Was a deliberate decision taken to try and broaden out the

Chicago approach?

Vishny evolved. He was a dyed-in-the-wool corporate-finance guy when he came in, and then he

got interested in market efficiency and things like that. He put his money where his mouth is. He

ran a very successful [investment] fund. And now he‘s come back. Vishny evolved and therefore

wasn‘t an import of the virus. Thaler was a direct import. I think Gene, to his credit, and Vishny

played a big role in bringing Dick in.

I want to tell you a story that I don‘t know if anybody else has told you. Dick Thaler used to

teach a course on market inefficiency. For nine weeks, he would pound the notion that markets

were inept in this way and that way. The tenth week he would invite Gene Fama in. And Gene

would demolish everything that Dick had taught the students over those nine weeks. It was

Chicago at its best—where you have a debate but you respect each other‘s viewpoint even

though it is diametrically opposed to yours…. It‘s not about people; it‘s about ideas.

Unfortunately, in too many departments, disagreements about ideas turns into personal

disagreement. That‘s an important difference in Chicago—that we criticize the idea, and we

criticize it very fiercely internally, but not the person.

Is there a big difference between the business school and the university economics department?

The economics department, as you know, has these giant personalities. I would say the business

school has fewer personalities…. Maybe there are fewer giants at the business school, but it may

also be that the culture here is one of greater give and take.

As an outside observer, it sometimes seems that the business school is starting to loom over the

economics department. Is that fair?

We have a lot more younger people—just because of the size. We have an economics group, a

behavioral group, a finance group. I think in the numbers we are bigger. Also, business schools

typically have substantial resources, and so on. All those things help. But I would say it is still a

formidable economics department.

Have there been a lot of in-house debates about the crisis? Seminars, that sort of thing?

Oh yes, when the crisis started getting worse and worse we had a whole bunch of seminars

across the school. And our lunchroom is full of debate about this, all the time—again, because

we differ internally about what the causes and remedies may be. It boils down to two or three

things.

One: the extent to which it was animal spirits and mistakes versus distorted incentives.

Two: the importance of the banking system. If you let them all collapse, can they regenerate

immediately, or is there a difficulty in rebuilding organizations once they collapse? Some people

say liquidate and from the ashes you will see the phoenixes rising. Other say no—ashes are ashes

and you get nothing from that.

Three: there is also some argument about the extent of the financial center-political system

nexus. Those on the left and the right basically think they are in bed with each other. Those at the

center think that [policymakers] are in a difficult situation.

So you have some sympathy for Tim Geithner, Larry Summers, and others in the Obama

Administration who are being attacked for being too soft on Wall Street? After all, people tend to

forget how dire things seemed at the end of 2008 and the start of 2009.

(Nods) Here‘s the thing. A lot of people were saying the only way out was to nationalize the

banks, and now they are not revisiting what they talked about then. And what about the guys

who said, ―Let them all fail‖? They aren‘t going back to what they said either…. Maybe if we

had let them fail we would have had a better outcome—who knows? But I think you have to give

the authorities credit for at least putting a floor under the panic. And I think [Hank] Paulson

deserves some of the credit. This Administration followed some of what he did.

Now, they were playing in an environment where they really were making it up as they went

along, so I have a lot of sympathy for what they did. But I do think in hindsight, and even at the

time, that they could have been a lot tougher. Their fear was that if they were a lot tougher they

would have taken the bottom out. I think even at that time they could have been tougher.

You mean when they were handing out debt guarantees and equity injections and so on?

Yes. At that time, they could have asked for more [in return], but I don‘t think they were

focussed on it. The problem now is the banks act as if there was never a problem. It‘s the ex post

rationale: we paid you back with profits. Well, nobody was willing to lend to you then. The

effective interest rate the government should have charged would have been infinity. When there

is no quantity available, the price was infinity. (Laughs) So to argue that it wasn‘t a subsidized

loan just because you paid it back is ridiculous. They know it, but, obviously, it‘s harder to make

the case to the public.

Where do we go from here?

The real problem is that the United States has, in many ways, been encouraging too much

consumption as a palliative for other things that haven‘t been solved. So we muddle along

because the crisis wasn‘t deep enough [to force big changes]. We used all our bullets. We don‘t

have any bullets left, and we are in the process of encouraging risk-taking all over again. I‘m not

saying we are necessarily going to have another crisis soon. But what do we have in reserve if

we haven‘t dealt with the fundamental problems? That‘s my worry—that we will emerge without

a serious sense that there are problems we need to fix. We will have identified bonuses as an

issue, or something like that, and imposed some constraints. But we won‘t have dealt with the

underlying deep problems.

Back to your own research on banking: Did you encounter any opposition to it internally?

No, we weren‘t raising any hackles. Our research was about liquidity and the possibility of it

drying up. It wasn‘t about market efficiency, or anything of that sort. It was technical and a bit

obscure. In a sense what we did was we added some institutional detail to the traditional theory.

Were there are precursors at Chicago to your line of work?

Well, there is Ronald Coase. Coase is an important figure at Chicago, and he started this whole

thing about worrying about organization.

We have talked about the efficient-markets theory. What about the other big modern theory

associated with Chicago—the rational-expectations hypothesis? What’s left of that one?

The fault of the macroeconomics profession was not so much rational expectations, which is a

convenient and useful device. It was to ignore the plumbing. Economists could afford to do that

for a long time because the plumbing didn‘t back up. Now that the plumbing has backed up you

find that loans aren‘t really made in a pristine, pure market. Things can break down. There can

be quantity constraints, when nobody is willing to lend to anybody at any price.

It‘s not so much rational expectations, which I think was an important advance. The mistake was

that we thought the economy works reasonably well, and we could ignore the institutional

details. We learned that was wrong.

Read more: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-

raghuram-rajan.html#ixzz0d3bikuTT

nterview with Kevin Murphy

Posted by John Cassidy

This is the sixth in a series of interviews with Chicago School economists. Read “After the

Blowup,” John Cassidy’s story on Chicago economists and the financial crisis. (Subscribers

only.)

Kevin Murphy is one of the best-known Chicago economists from the post-Lucas, post-Fama

generation. In 1997, he was the recipient of the John Bates Clark Medal, which is presented to

the best American economist under forty. Although he is primarily a microeconomist, Murphy

has published articles on a wide range of subjects, including income inequality, the value of

medical research, economic growth, and unemployment. He wasn‘t available to see me when I

was in Chicago, but I subsequently talked to him on the telephone, and these are the notes of our

conversation.

To what extent has the financial crisis and subsequent recession damaged the prestige of

Chicago economics?

The Chicago straw man has taken a beating. The Chicago economist who says that markets

always get things right and financial markets always work efficiently, he has taken a beating—no

doubt. But the Chicago economist who I think about when I hear that phrase, he‘s in the same

place that he was in a year ago.

So what is Chicago economics, if it isn’t its media image?

I‘ve always thought of Chicago economics as an approach to the subject—a way of doing

economics. It‘s based on the belief that the tools of economic analysis are really useful for

explaining things in the real world. When you approach problems in the real world, you use the

same tools you use in doing economic theory. That has always been the test—a guy would give

the same answer in a seminar to a question about the economy that he would give if somebody

stopped him in the street. He wouldn‘t say, the theory is this but the actual answer is something

else.

Is that attitude reflected in your own research and teaching? [Murphy teaches graduate courses

on economic theory, with Gary Becker, and on the economic analysis of policy issues.]

Yes. [Murphy explained that he sometimes teaches summer camps in price theory for Ph.D.

students from other universities.] Many of them say they have never been taught in that way, or

done a course like ours. In tying theory to data when studying a range of phenomena in the real

world, you are always trying to give an example. If you can‘t give one it is a problem.

It is also true in seminars. If you present a paper in Chicago, you don‘t get much of a chance to

present. You have to defend. The type of paper where the presenter says, ―Well, this assumption

clearly isn‘t realistic, but I‘m just going to ignore that for now and derive some results‖—there

isn‘t a whole lot of sympathy for that approach here in Chicago. You‘ve got to be telling us

something that is valuable and applicable to the real world. People like Friedman and Stigler

really instilled that tradition in this place.

What about skepticism toward the government: Isn’t that also a key part of the Chicago

tradition?

Sure. You have to ask why would the government get it right. You can‘t just say, here‘s a market

failure and the government needs to step in and address it. You have to look in detail at what the

government might do, and compare the relative effectiveness of the two.

What about the efficient-markets hypothesis and the idea that speculative bubbles are very rare,

or might not even exist? Is that the Chicago view?

I teach economics a lot. I teach in the economics department; I teach in the business school. I talk

about house prices, and I think I‘ve always raised the possibility that prices might get too high.

[Murphy cited the example of the Japanese real estate bubble in the late nineteen-eighties and

early nineteen-nineties.]

I was looking at that, and I was thinking, ―Geez, these prices are assuming that the returns from

housing—the rental cost of housing capital—is going to be really high in the future. How

realistic is that? Boy, it‘s really hard to justify these prices.‖ During the Internet stock bubble,

same thing. I looked at those prices and said, ―Geez, can I rule out the possibility that investors

are being irrational?‖ I think we believe that prices can depart from economic reality. The

problem is that you can‘t see it in advance.

So is the efficient-markets hypothesis consistent with that idea—that prices sometimes depart

from fundamentals?

It could be.

[Echoing what John Cochrane had told me, Murphy explained that there were two rival

explanations for big movements in asset prices: attitudes to risk that vary over time, which are

consistent with an efficient-market equilibrium, or irrational exuberance and bubbles, which

aren’t.]

Empirically, I don‘t see how you can distinguish between the two. It‘s become almost a matter of

semantics. Do you call it time varying risk premiums or irrational exuberance?

But the fact is that much of the variation in the market is unpredictable. In finance research, it‘s a

major victory if you can explain half of one per cent of the price variation with your model. The

idea that you can‘t beat the market, or predict it—that part of the efficient-markets hypothesis is

very much alive and well.

What about the rational-expectations hypothesis and the work of Robert Lucas? How does that

fit in with your idea of Chicago economics, and the idea of tying theory to data? Surely the data

rejected much of that work early on.

Well, I think that work does have empirical implications, but it is certainly a larger distance back

from the theory to the data.

[At this point, Murphy defended Lucas’s work, saying that it helped fill in an important gap in

Keynesian economics, which couldn’t explain the inflation of the nineteen-seventies. Going back

to the nineteen-sixties, Milton Friedman and Columbia’s Edmund Phelps had put forward the

idea that, contrary to Keynesian ideas of the time, there was no long-run trade-off between

inflation and unemployment—in the jargon of economics, the “Phillips Curve” was vertical.

Lucas added a lot of rigor to that idea, Murphy said. He also brought up Lucas’s work on the

causes of economic growth, which date back to the nineteen-eighties.]

That side of his contribution is probably even more important, because it says that the questions

of what we can do to keep creating growth is really critical. That gets us back to physical capital,

human capital, and technical progress—and those are the things that really matter in the end.

How do we do a better job of promoting physical investment, human capital investment, and

technological progress? When you think that way, you have to always consider the long-run

implications of short-term actions.

That takes us neatly back to the current situation. You have written skeptically about the Obama

administration’s stimulus package. Why are you so critical?

[Murphy referred me to a January 2009 presentation of his (pdf). The presentation analyzes the

likely impact of the stimulus and concludes that it wouldn’t do much good. The key to his

negative result, Murphy explained, was two assertions: 1) that the taxes necessary to pay for the

stimulus would act as a significant disincentive for people to work and for businesses to invest,

and 2) that the government wouldn’t spend the stimulus money wisely, and that much of it would

be wasted.]

The reason I think it‘s neat is that it makes clear what really matters. You can say it‘s Keynes

versus Friedman, but it‘s really a debate about bigger government versus smaller government.

The whole question of what size the [fiscal] multipliers are—that‘s just part of the question.

Read more: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-kevin-

murphy.html#ixzz0d3bxH167

Interview with James Heckman

Posted by John Cassidy

This is the fifth in a series of interviews with Chicago School economists. Read “After the

Blowup,” John Cassidy’s story on Chicago economists and the financial crisis. (Subscribers

only.)

I interviewed Heckman by telephone in late October. I began by referring to a piece in the

University of Chicago Magazine in which he appeared to absolve Chicago economics of any

blame in causing the financial crisis. How did he react, then, to the recent criticisms of Chicago

School economics from Joseph Stiglitz, Paul Krugman, and others?

James Heckman: Well, I want to distinguish between two different ideas. The Chicago School

incorporates many different ideas. I think the part of the Chicago School that has been justified is

the claim that people react to incentives, and that incentives are important. Nothing in what has

happened invalidates that idea. People did react to incentives—clearly they did. It turned out that

the incentives they were reacting to weren‘t socially beneficial, but they definitely reacted to

them. The other part of the Chicago School, which Stiglitz and Krugman have criticized, is the

efficient-market hypothesis. That is something completely different.

I think it is important to put it into historical perspective. In the late nineteen-forties and

nineteen-fifties, when Keynesianism was really dominant, that sort of Keynesianism—so-called

hydraulic Keynesianism—completely ignored incentives and the way people reacted to them.

What Chicago did—Milton Friedman, George Stigler, and others—was to redress that balance.

They did a whole lot of empirical studies that showed how people did react to incentives, such as

changes in taxes or prices. That was incredibly influential, and it is still is.

In the early nineteen-seventies, Martin Feldstein, of Harvard, showed how changes in

unemployment benefits had a big impact on labor supply. That had an enormous impact on

policy, and it was an application of Chicago economics. Feldstein said he read [Friedman‘s]

―Capitalism and Freedom‖ when he was at graduate school in Oxford, and it had an enormous

influence on his thinking. That was the Chicago influence, and it still stands up. Linking

empirical work to theory, and showing how things like taxes and government programs impact

behavior.

O.K. People were reacting to incentives—the mortgage lenders, the Wall Street bankers, the

homebuyers—I agree. But weren’t market prices sending them the wrong signals, and isn’t that

an indictment of Chicago economics, which, going back to Hayek, at least, has stressed the role

of prices in coordinating behavior?

I tend to think of it more in terms of the market reacting too slowly. Certainly, from the end of

2007 onwards, when it was clear that problems were emerging, many Wall Street professionals

steered away from mortgage securities. For a long time, though, the market was sending the right

signals. People made a lot of money—the traders, and so on. It turned out not to be socially

optimal, but that is a different issue.

[Heckman then criticized behavioral economists, such as Berkeley’s George Akerlor and Yale’s

Robert Shiller, for suggesting that the roots of the crisis lay in irrational behavior:

overconfidence, animal spirits, and so on. For the most part, individuals responded to market

incentives and reacted rationally, he insisted.]

Look, I could subsidize people to murder children, and if I offered enough money I don‘t think I

would find much trouble finding a ready supply of murderers.

Also, I think you could fault the regulators as much as the market. From about 2000 on, there

was a decision made in Washington not to regulate these markets. People like Greenspan were

taking a very crude and extreme form of the efficient-markets hypothesis and saying this justified

not regulating the markets. It was a rhetorical use of the efficient-markets hypothesis to justify

policies.

What about the rational-expectations hypothesis, the other big theory associated with modern

Chicago? How does that stack up now?

I could tell you a story about my friend and colleague Milton Friedman. In the nineteen-

seventies, we were sitting in the Ph.D. oral examination of a Chicago economist who has gone

on to make his mark in the world. His thesis was on rational expectations. After he‘d left,

Friedman turned to me and said, ―Look, I think it is a good idea, but these guys have taken it way

too far.‖

It became a kind of tautology that had enormously powerful policy implications, in theory. But

the fact is, it didn‘t have any empirical content. When Tom Sargent, Lard Hansen, and others

tried to test it using cross equation restrictions, and so on, the data rejected the theories. There

were a certain section of people that really got carried away. It became quite stifling.

What about Robert Lucas? He came up with a lot of these theories. Does he bear responsibility?

Well, Lucas is a very subtle person, and he is mainly concerned with theory. He doesn‘t make a

lot of empirical statements. I don‘t think Bob got carried away, but some of his disciples did. It

often happens. The further down the food chain you go, the more the zealots take over.

What about you? When rational expectations was sweeping economics, what was your reaction

to it? I know you are primarily a micro guy, but what did you think?

What struck me was that we knew Keynesian theory was still alive in the banks and on Wall

Street. Economists in those areas relied on Keynesian models to make short-run forecasts. It

seemed strange to me that they would continue to do this if it had been theoretically proven that

these models didn‘t work.

What about the efficient-markets hypothesis? Did Chicago economists go too far in promoting

that theory, too?

Some did. But there is a lot of diversity here. You can go office to office and get a different

view.

[Heckman brought up the memoir of the late Fischer Black, one of the founders of the Black-

Scholes option-pricing model, in which he says that financial markets tend to wander around,

and don’t stick closely to economics fundamentals.]

[Black] was very close to the markets, and he had a feel for them, and he was very skeptical. And

he was a Chicago economist. But there was an element of dogma in support of the efficient-

market hypothesis. People like Raghu [Rajan] and Ned Gramlich [a former governor of the

Federal Reserve, who died in 2007] were warning something was wrong, and they were ignored.

There was sort of a culture of efficient markets—on Wall Street, in Washington, and in parts of

academia, including Chicago.

What was the reaction here when the crisis struck?

Everybody was blindsided by the magnitude of what happened. But it wasn‘t just here. The

whole profession was blindsided. I don‘t think Joe Stiglitz was forecasting a collapse in the

mortgage market and large-scale banking collapses.

So, today, what survives of the Chicago School? What is left?

I think the tradition of incorporating theory into your economic thinking and confronting it with

data—that is still very much alive. It might be in the study of wage inequality, or labor supply

responses to taxes, or whatever. And the idea that people respond rationally to incentives is also

still central. Nothing has invalidated that—on the contrary.

So, I think the underlying ideas of the Chicago School are still very powerful. The basis of the

rocket is still intact. It is what I see as the booster stage—the rational-expectation hypothesis and

the vulgar versions of the efficient-markets hypothesis that have run into trouble. They have

taken a beating—no doubt about that. I think that what happened is that people got too far away

from the data, and confronting ideas with data. That part of the Chicago tradition was neglected,

and it was a strong part of the tradition.

When Bob Lucas was writing that the Great Depression was people taking extended vacations—

refusing to take available jobs at low wages—there was another Chicago economist, Albert Rees,

who was writing in the Chicago Journal saying, No, wait a minute. There is a lot of evidence

that this is not true.

Milton Friedman—he was a macro theorist, but he was less driven by theory and by the desire to

construct a single overarching theory than by attempting to answer empirical questions. Again, if

you read his empirical books they are full of empirical data. That side of his legacy was

neglected, I think.

When Friedman died, a couple of years ago, we had a symposium for the alumni devoted to the

Friedman legacy. I was talking about the permanent income hypothesis; Lucas was talking about

rational expectations. We have some bright alums. One woman got up and said, ―Look at the

evidence on 401k plans and how people misuse them, or don‘t use them. Are you really saying

that people look ahead and plan ahead rationally?‖ And Lucas said, ―Yes, that‘s what the theory

of rational expectations says, and that‘s part of Friedman‘s legacy.‖ I said, ―No, it isn‘t. He was

much more empirically minded than that.‖ People took one part of his legacy and forgot the rest.

They moved too far away from the data.

Read more: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-james-

heckman.html#ixzz0d3cAnuWE

6 comments | Add your comments

Prof. Heckman, perhaps because of the need for concise answers in the interview format, is a bit

misleading in some respects. 3) From reading this, you'd get the impression that Milton

Friedman was unique in developing the combination of models followed by empirical testing.

But what about Paul Samuelson and Kenneth Arrow (who was at Chicago briefly)? 4) Prof.

Heckman's comments about the legacy of Friedman slides right past an equally important aspect

of Friedman's legacy. Friedman was, as his friend Paul Samuelson once remarked, a libertarian

nut. Friedman felt that things like funding biomedical research and prosecuting heroin trafficking

were inappropriate. Friedman's libertarian writings were a strong contributor to the unfortunate

free market dogmatism of the past generation. 1) Since when did Keynes, or anyone else for that

matter, not believe in incentives? 2) The murdering children comment is revealing of how

limited a "Chicago" perspective can be. Prof. Heckman is undoubtedly correct but is worth

thinking about what really led to systematic murder of children in this century. The Khmer

Rouge and Nazis didn't kill for financial incentives, they killed for ideology. In other writings,

Prof. Heckman has written well of the limitations of markets, so its a bit surprising to read this.

Posted 1/16/2010, 7:28:58pm by RAlbin Report abuse

Perhaps because of the need for concise answers in the interview format, some of Heckman's

comments are a bit misleading. 1) From these comments, you would get the impression that the

Chicago school pioneered the combination of models and empirical testing. But what about Paul

Samuelson and Kenneth Arrow (though Arrow was at Chicago briefly)? 2) I doubt very much

that Keynes or anyone else didn't believe in the importance of incentives. 3) Heckman dicusses

the legacy of Friedman, but Heckman's own remarks ignore a very important aspect of

Friedman's legacy and one that is at odds with the picture he paints of Friedman. Friedman was,

as his friend Paul Samuelson remarked, a libertarian nut. Friedman's strong libertarian ideology

was enormously influential and forms an important part of the background to the dogmatic free-

marketism of people like Fama and Cochrane. A man who believed that government had no

business being involved in funding research and policing things like heroin is not exactly the

pure scientist that Heckman recalls.

Posted 1/16/2010, 10:48:49am by RAlbin Report abuse

Mr. Cassidy, I congratulate you on doing these interviews and asking some good and tough

questions. However, I think the right question was not asked. Rather than ask, did these various

events change your views on some concept such as rational expectations or efficient markets,

you should consider next time asking the following question. What evidence would cause you to

change your views on rational expectations such that you no longer subscribe to that view? This

is the critical question to ask because you will learn one of two things. One, there is no such

evidence that would change their view in which case you are dealing not with a scientist but a

true believer, despite all the empirical work and mathematics. Or they will tell you what that

evidence would change their mind and you can judge whether the theory is a reasonable one. My

guess is if you asked this question, you would find out that there is no data or set of events that

these people can not explain away, rendering the theory somewhat less than useful. This concept

of asking such a question was originally proposed by John Platt in 1964 and is always the right

question to ask. Of course, you can ask this of policy makers as well; what conditions would

cause you to change your policy prescription. It is a great question to ask, but you will be found

annoying when you ask it. Again, thanks for an excellent set of interviews.

Posted 1/15/2010, 11:06:55am by mfichman Report abuse

The theory of greed doesn't require a treatise

Posted 1/15/2010, 11:01:35am by rashidb Report abuse

I know a lot less about economics than Heckman or Lucas, but I was under the impression that

Milton Friedman never actually adopted the theory of rational expectations. Hadn't Friedman

used "adaptive expectations" in creating his permanent-income hypothesis instead? Bobopapal,

isn't the declaration that the correct portion of reserves for all banks is 100% another example of

the "fatal conceit" Hayek warned about?

Posted 1/15/2010, 12:22:09am by TGGP

Report abuse

Mr. Cassidy, I tremendously enjoyed your book "How Markets Fail", in fact I just completed it

this evening. I am familiar with Hayek and thought it a bit odd for you to have him lumped into

the Chicago School. I always think of him in the Austrian camp, and in many ways opposed to

the monetarism and excessive mathematical approach applied by the Chicago school. Austrians

in general are always railing against fractional reserve banking because of the dangers of

leverage, and the against role of the central bank in general. It seems to me that they have a

point. I can't think of another governmental institution that wields such centrally planned and

arbitrary power as the Federal Reserve. Isn't the ultimate irony of the free market that fact that

the price of money for our banking system is centrally planned and often, as with Greenspan,

dominated by the whims of one person? How can a complex and intricate economy full

Hayekian telecommunication be at the mercy of the dictates of one man with the power to set the

price of money? This seems like madness to me.

Read more: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-james-

heckman.html#ixzz0d3cExpw1

Interview with Gary Becker

Posted by John Cassidy

This is the fourth in a series of interviews with Chicago School economists. Read “After the

Blowup,” John Cassidy’s story on Chicago economists and the financial crisis. (Subscribers

only.)

I met Becker in his office at the economics department. I began by telling him I had been

speaking with his friend and co-blogger Richard Posner, and I asked whether he agreed with

Posner that the events of the past two years had called Chicago School economics into question.

Gary Becker: No. I think the last twelve months have shown that free markets sometimes don‘t

do a very good job. There‘s no question, financial markets in the United States and elsewhere

didn‘t do a good job over this period of time, but if I take the first proposition of Chicago

economics—that free markets generally do a good job—I think that still holds.

If I were running an economy, and I was looking for the best way to run it, I would do what India

and China did—move much more to a free-market economy. The second proposition of Chicago

economics—that governments don‘t do a good job. I really don‘t understand how, if Posner said

that had been undermined, he can infer that. I don‘t think the government did a good job in the

run-up to the crisis. Posner has himself criticized Alan Greenspan‘s low-interest-rate policy. The

S.E.C. should have done a lot of things it didn‘t do. It‘s hard to sustain the belief that

governments do well.

What I have always learned to be the Chicago view, and taught to be the Chicago view, is that

free markets do a good job. They are not perfect, but governments do a worse job. Again, in

some cases we need government. It is not an anarchistic position. But in general governments do

a worse job. I haven‘t seen any reason to change that other than, yes, we‘ve seen another

example where free markets didn‘t do a good job: they did a bad job. But to me there is no

evidence the government did a good job either, leading up to or during the process.

Posner says that the government’s interventions have staved off another Great Depression.

Well, that‘s a separate argument. Market economists—take my teacher and close friend Milton

Friedman: [he was] a big advocate that the government should have done more during the

Depression. The Fed should have done more. It was too passive and the money supply dropped,

and so on. So it‘s been long recognized that there are situations when you need very strong,

temporary government interventions. [Policymakers] did come in here, and they did help. It was

a very mixed bag of different policies. I don‘t blame them too much for that. It was a novel

situation and they were experimenting a lot. I definitely think they helped, though, overall in

averting a much more serious recession. A lot of people, including Posner, thought that things

were going to turn out a lot worse. We had a bunch of arguments about that on our blog.

Two of the big theories associated with Chicago are the efficient-markets hypothesis and the

rational-expectations hypothesis, both of which, some say, have been called into question. How

do you react to that?

Well, these are not areas that I have particularly specialized in, but let me give you my reaction.

The people who argue that markets were always efficient and there was no problem, that was an

extreme position—something a lot of people at Chicago had recognized before. The weaker

notion that markets, particularly financial markets, usually work pretty well, and it‘s very hard to

beat them by investing against them, that I think is still very powerful.

What I think we experienced, and where I think we went wrong, is that we‘d developed a lot of

new financial instruments, derivatives, and the like. Neither some of the people that developed

them nor the practitioners really understood how these derivatives worked in different situations.

Like mortgage-backed securities—I don‘t think you are going to see them being very popular in

the future. So, there were innovations. They had good aspects, but they had aspects that didn‘t

work out very well, and so the markets weren‘t very efficient in these cases.

Yeah, markets aren‘t fully efficient. Expectations go wrong. We‘ve seen many other episodes in

the past where expectations have gone wrong, where it looks like there were bubbles that

happened. Certainly, in the housing market it did look like there was a bubble going on, and

people were anticipating prices still going up. Nevertheless, the notion that people are forward

looking and try to get things right, and often they do get things right—I still think that comes

through O.K. You just have to be more qualified and more careful in how you state it.

That would be my interpretation. Yes, weakened in terms of simple mechanical application, but

the general thrust that markets are more efficient than any alternative—that aspect I don‘t think

is going to be changed. I don‘t think you are going to see the world moving away from markets,

including financial markets…. I don‘t see China or Brazil, or a lot of other developing countries,

making any radical changes in their movements towards the market, and I think for good reason.

If you take the last twenty or thirty years—take the good and the bad, including this big

recession—growth rates are pretty good…. That‘s not only due to markets, but, certainly, market

orientation and trade were the major factors responsible for that.

But what about speculative bubbles? I recall interviewing Milton Friedman, in 1998, I think, and

he said he thought the stock market was in a bubble. The idea that Chicago economists don’t

believe in bubbles—was that more Greenspan?

Absolutely. I think bubbles have been recognized. Certainly, Friedman and others, including

myself, said there are phenomena that are hard to explain without thinking it‘s a bubble. The

people working in macro theory have had difficulty deriving these bubbles from any reasonably

rational set of actors that are somewhat forward looking, although there are models that can do it

now. That‘s an analytical challenge. But the fact that there have been episodes throughout history

that were clearly bubbles, that foreign-exchange rates overshoot and undershoot their real

values—yes, I don‘t think there‘s any question about that. I don‘t think that most Chicago School

economists thought that these things didn‘t happen. I think most Chicago economists recognized

that, and, certainly, Milton Friedman did.

Lots has changed at Chicago in recent years. What if anything is distinctive about Chicago

economics these days?

It‘s not as distinctive as it was when I graduated with my Ph.D. from Chicago. In those days,

there was a great belief in the price system, in people‘s incentives, and in linking theoretical

research to empirical research. That wasn‘t common at most of our competitors. Both in micro

and in macro, there were major differences. Chicago was hostile to Keynesian economics when I

was in graduate school. Now there‘s been a lot of convergence, particularly in the micro side of

things. Chicago is less unique than it used to be.

But I do think there is still a considerable distinctiveness about what might be called Chicago

economics. One is skepticism about governments—that governments can organize activities

well…. I think that is still a much stronger view in Chicago than in most other places.

Two, more from the micro economists who analyze markets and how people respond to

incentives, I think Chicago economists still consider that more important than most other places

and don‘t believe you can begin to understand how economies work, either empirically or

theoretically, without giving that a major role. That‘s not as sharp a difference as it was, but I

still think it is significant enough to say there is a difference between Chicago and other places.

Are these differences reflected in teaching?

It‘s certainly reflected in our course. [Becker and his colleague, Kevin Murphy, teach a graduate

course in price theory.] Students tell us they haven‘t had a micro course like this before. It would

be reflected in a number of courses taught in both the business school and the economics

department, and also in the law school courses, including some of Posner‘s.

So the rest of the world has moved closer to Chicago?

No question. Quantitative work linked to theory and incentives—that‘s much more commonly

found at our competitors. When I went out on the job market, there were some places that

wouldn‘t hire a Chicago economist, like Berkeley, for example. For decades they didn‘t hire a

graduate of Chicago. Harvard wasn‘t too thrilled with the idea either.

Do Chicago economists now get hired more widely?

Well, much more so than they did. Harvard has a number of Chicago people, liked Ed Glaeser

and others. M.I.T. has several Chicago people. Princeton has several. Even Berkeley has one or

two. I‘m not sure. Stanford certainly does.

What about the notion of rationality and economics, which you yourself are closely associated

with. How much of that is still valid?

I think most of it is still valid. It depends on what you mean by rationality. But if you take the

view that consumers, on the whole, react to incentives in the way you would predict they would

respond—you get very misled in the world if you don‘t put a lot of emphasis on that.

Now there‘s behavioral economics, which has two strands. One is extending the motives of

people, which I worked a lot on from my dissertation on. Chicago was a pioneer in that. It‘s gone

further, but Chicago was a pioneer.

The other aspect is that consumers make a lot of mistakes. I think there is no question that

consumers make mistakes, and I think some of the behavioral-economics literature has made

useful contributions in pointing out some of the types of mistakes…. That has been very useful

but it certainly doesn‘t overthrow the notion … one, that consumers most of the time make pretty

good choices for themselves; and two—now I come back to the government—they generally

make better choices than a government body would make for them. That thing we started our

discussion with, I think has to be brought into play in evaluating the implications of, say,

behavioral economics or books like ―Nudge.‖

A lot of behavioral economics has been devoted to finance. What about investors—are they

rational?

Well, in the following sense. Not all investors are—surely not. But I think it‘s not very easy to

do better than the market. If you look at the behavioral economists who run hedge funds, I don‘t

think, on the whole, they have done much better than others.

It‘s not easy. Yes, there are a lot of mistakes made, but to take these mistakes and make money

from them…. Some trends have been found—the small stock bias, and so on. It shows there are

trends that can persist. But on the whole, if you look at financial markets they do a pretty good

job—not a perfect job. And I think pointing that out has been a useful contribution. There was

some theology built into the efficient-markets literature—some of it in Chicago. It became more

theological than based on empirical evidence. So I think the attacks on it didn‘t eliminate the real

heart of it—these markets work pretty well—but there have been things that are puzzling to

explain in a simple efficient-markets hypothesis.

What about the revival of Keynesianism, which, again, Posner is associated with? That goes

directly against the Chicago School. What is your response to that?

Well, firstly, as a factual matter, there certainly has been a strong resurrection. That led me to

believe that ninety per cent or so of economists were closet Keynesians all along, but they were

afraid to admit it.

How much it has been resurrected? I have a bit of an open mind on that…. A lot of the more

explicit Keynesian remedies, like stimulus spending and the like, will need an evaluation of what

they did in stemming the tide…. I‘m not yet convinced that fiscal policy was very effective in

containing this recession. Take the fiscal stimulus package—eight hundred billion dollars.

They‘ve hardly spent any of it yet. The traditional argument against fiscal stimulus spending,

even from those that believed in it, was that by the time Congress got around to deciding how to

spend it the recession was pretty much over, so you were spending it at the wrong time. Some of

that is going to be happening now…. I think history will say, once we understand it, that it

wasn‘t very effective. The flexibility in financial response—it was understate in a lot of the

previous literature, Keynesian and unKeynesian. That turned out to be important, I think. That‘s

why I think the Fed, despite some mistakes, did a pretty good job.

What about the area of macro-economic theory. I know it’s not your field…

It‘s not Posner‘s field either. (Laughs)

The models that Bob Lucas is associated with—rational expectations, dynamic general

equilibrium models, and so on. Some people now say that they omitted so much—the entire

financial sector was excluded—that they left the economics profession unprepared for this type

of eventuality.

Well, I think [Lucas] made a major contribution. I think there is no doubt about it. On the other

hand, I think some of the dynamic general equilibrium models that were being promoted in

macro didn‘t turn out to be that helpful in helping us to understand what to do to combat a major

recessionary event. If you look at the policies that were being advocated, both here and

elsewhere, they were based on more traditional, I would say Friedmanite, type arguments. So I

think there is some validity to that conclusion.

Obviously, other people took that approach even further than Lucas.

Yes, they did. And now we know that you‘ve got to add more things into it. And I think we are

going to improve macros, but I think some of the models were too simplistic. They captured

important parts of the economy, but they weren‘t really preparing us for how to handle a crisis, I

think that is pretty clear, particularly financial crises.

Surely, the models weren’t merely designed not to handle crises. These models and their builders

ruled crises out by assumption, did they not?

Well, some [did]. I don‘t think Bob would be one, because I think Bob always thought that

money was important. Maybe some of his disciples, or others in the field, did, but I think you‘ve

got to make a distinction. I don‘t think everybody was on the same page on that. Some people

did rule out the whole financial sector, seeing money as being unimportant. I think that stuff just

turned out to be wrong.

The whole argument of money as a “veil”?

Right.

How do you think that the financial crisis will change economics? The nineteen-thirties

revolutionized economics. Do you see that sort of change?

No, not of that magnitude. If this recession had got a lot worse, we would have seen two major

changes: much more government intervention in the economy and a lot more concentration in

economics in trying to understand what went wrong. Assuming I‘m right and, fundamentally, the

recession is over—a severe recession but maybe not much greater than the 1981 recession, or

those in the nineteen-seventies—I think you are not going to see a huge increase in the role of

government in the economy. I‘m more and more confident of that. And economists will be

struggling to understand how this crisis happened and what you can do to head another one off in

the future, but it will be nothing like the revolution in the role of government and in thinking that

dominated the economics profession for decades after the Great Depression. The Great

Depression was a great depression by any measure you want to take—unemployment, decline in

output, and so on. This recession pales in comparison. As a result, I think we are not going to

have anything like the reaction we had at that point.

You already see it. There‘s been a backing away from some of the things that were being talked

about. Pay controls—we are getting some, but less severe ones than people were talking about at

the height of the recession.

Do you think that Wall Street needs re-regulating?

Well, I do. I think some additional regulation is needed, and I‘ve called for some. But I don‘t

think you can rely on regulators, because they fail along with the market. If we install rules for

capital requirement that would work more or less automatically—I think there is a good case for

that, particularly for larger institutions which we know we are going to bail out if they get into

trouble.

Some people at Chicago don’t accept the too-big-to-fail doctrine. They say, “Let them go.”

There are two questions. What we should be doing and what we actually will be doing. I don‘t

think we are going to let them go. We didn‘t let them go. We never let them go. Continental

Illinois bank we bailed out at a time when it wasn‘t such a crisis situation. We bailed out

Chrysler. So if you accept that we are going to bail them out you‘ve got to do something to

reduce the probability that we are going to have to bail them out.

Number two, should we bail them out? I think in this crisis we had to do it. I don‘t accept the

view that in this crisis we should just have let everything fall where it may. Yeah—the economy

would have picked itself up, but I think it would have been a much more severe recession.

So, you are in favor higher capital requirements on banks. Anything else?

Increase capital requirements. I would have a differential requirement for bigger institutions, so

they can‘t get as big a multiple on their assets. Maybe derivatives markets—those are things I

don‘t feel very expert on, but I follow the literature a little bit, and I think some changes are

needed.

There are a number of things we should be thinking about. But one thing I should stress: I don‘t

think the regulators did very well during this period, and we don‘t want policies that depend on a

group of people living in Washington deciding on whether we should be doing something now or

not. They didn‘t do it well this time. There is no reason to believe they are going to be any

smarter the next time, because it‘s not going to be exactly the same situation that arises next

time.

Do you favor a return to some sort of Glass-Steagall framework? Should we try to separate

deposit taking from speculation?

I don‘t believe so. I think there are some advantages to combining them. But you may want to

force derivatives to go through an organized market. Capital requirements. Swaps—you may

want to have some controls on. I hesitate to say more. There are a lot of people out there who

know a lot more than I do. But those are the directions I would go in.

A historical question. Chicago was always known for advocating deregulation of various

industries—trucks, airlines, and so on. At the time, did people here talk much about deregulating

the financial markets as well?

Absolutely. We got rid of Regulation Q—interest rate controls. Milton Friedman and most of us

were big advocates of that. Glass-Steagall, there was a lot of opposition to. Derivatives—they

came in during the nineteen-seventies, and they weren‘t fully understood…. But on the whole, in

the nineteen-seventies, there is no doubt that there was support for deregulation of many aspects

of the financial markets.

In retrospect, was that position right? Isn’t finance different from other industries?

It depends. We‘ve always had regulations on bank reserves and so on. So, clearly, yes, there are

differences. You don‘t want to think in terms of free banking. I don‘t think people at Chicago

ever thought… I‘ll speak for myself. I never thought, even outside the financial sector, that there

should be no regulation. There are externalities. There‘s pollution. There are a lot of things you

can do. In the education area, the government financing students, and all that. Those things go

back a long time. So it was never zero regulation. It was just an observation that in many sectors

regulation seemed to be throttling industry—like the airline industry, the trucking industry, all

the stock-market regulations: prices were kept up. Nobody wants to go back to the time when

you had a cartel and price-setting.

So people at Chicago did accept the need for dealing with externalities? What about Ronald

Coase? [Coase, an English transplant who won the Nobel Prize in 1991, is famous for arguing

that, under some circumstances, bargaining in the market will take care of externalities.]

Chicago didn‘t deny that there were externalities in the world. Chicago people were not

anarchists. They always believed there was a significant role for government, and not simply in

the obvious areas, like law and the military, and so on. In the educational area, take the vouchers

system. It is government financed. There may be competition among providers, but it is

government financed. Some help at the college level for people from poor backgrounds—there

were many policy areas where Chicago economics tried to analyze what was wrong, and how

you should go about fixing it, finding a better way to do it.

Was there anything, looking back, that Chicago got wrong?

(Laughs) There are a lot of things that people got wrong, that I got wrong, and Chicago got

wrong. You take derivatives and not fully understanding how the aggregate risk of derivatives

operated. Systemic risk. I don‘t think we understood that fully, either at Chicago or anywhere

else…. Maybe some of the calls for deregulation of the financial sector went a little too far, and

we should have required higher capital standards, but that was not just Chicago. Larry Summers,

when he was at the Treasury, was opposed to that. It wasn‘t only a Chicago view. You can go on.

Global warming. Maybe initially at Chicago there was skepticism towards that. But the evidence

got stronger and people accepted it was an important issue.

But it hasn‘t changed my fundamental view, and I think [the view of] a lot of people around here,

that, on the whole, governments don‘t manage things very well, and you have to be consistent

about that. So I supported, say, the invasion of Iraq. In retrospect, I think that was a mistake, not

only because things didn‘t go that well, but because I didn‘t really take into account enough that

governments don‘t manage things very well. You really have to have strong reasons for going in.

Read more: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-gary-

becker.html#ixzz0d3cMQvGo

2 comments | Add your comments

I agree in general that governments don't make decisions as well as the aggregate of consumers.

But some governments can make less bad decisions than other governments. Contrast Canada

(where PM Stephen Harper is an economist) with the US and its community organizer. Canadian

banks were not as highly leveraged or exposed as US banks, and while Canada did notify the

public that it would stand behind Canadian banks, in the event, the government didn't spend a

dime propping up banks. The turn down in the auto and home building industries affected

Canada as well. Harper's responses included the usual infrastructure (roads and bridges) projects

as did America's, which would employ many out of work construction workers, but it also

included a tax credit for home renovations (with a cap) which was a vast improvement. For one

thing, individual homeowners can decide much more quickly to go ahead; many infrastructure

projects, including those which are purportedly "shovel ready", are still stalled at the planning

stage. Homeowners hired those out of work plumbers, electricians, and carpenters, and put them

to work right away. Most of the money spent on home renos used domestic products (wood,

drywall, paint, fixtures, etc.) so the domestic multiplier effect was much higher than say, "Cash

for Clunkers", where much of the money was spent buying imported cars. Best of all, this

program didn't cost the Canadian government a dime in 2009; the costs will be claimed as a tax

credit in 2010. So Canada got the benefit of much faster domestic stimulus with a deferred cost

which will come due when the Canuck economy seems to be set to enjoy a more rapid and more

robust recovery than the US, and is thus more able to afford it. So clearly, there's bad

government policy, and worse government policy. What do you think the US got?

Posted 1/16/2010, 12:22:27pm by KevinB Report abuse

It's a little silly for Becker to use the actions of the Bush Administration in the run up to the

current recession as evidence that governments don't do well in managing the economy. What he

surely must mean is that governments run by ideologues whose primary purpose is to undermine

the ability of government to manage economic factors in even a minimal way typically don't do

well in managing the economy. Certainly governments who take their responsibilities vis-a-vis

the economy seriously, as did the Clinton Administration and many current governments in

Europe, have been proven to do at least a decent job. Perhaps this explains why economic growth

has always been more rapid under Democratic administrations in the U.S. than under Republican

administrations.

Read more: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-gary-

becker.html#ixzz0d3cPJQQC

Interview with John Cochrane

Posted by John Cassidy

This is the third in a series of interviews with Chicago School economists. Read “After the

Blowup,” John Cassidy’s story on Chicago economists and the financial crisis. (Subscribers

only.)

I interviewed John Cochrane in his office at the Booth School of Business, and I began by asking

him about the economics of today‘s Chicago, and how it differed from the strident free-market

school of a bygone era—the Chicago of Milton Friedman and George Stigler.

John Cochrane: This is not an ideology factory. This is a place where we think about ideas and

evidence. Gene Fama is in the next-door office. Dick Thaler is across the hall. Rob Vishny is just

down the corridor. The Chicago of today is a place where all ideas are represented, thought out,

argued. It‘s not an ideological place. The real Chicago is about thinking hard and arguing with

evidence... We like good quality stuff no matter where it comes from.

And you have some banking experts who can, perhaps, claim to be among the few economists

that warned us about this crisis. Raghu Rajan, and so on?

(Laughs) Well, every conference I go to lately, everybody says, ―The crash proved my last paper

right.‖ But Raghu and Doug (Diamond) have a better claim to that than most people.

But there is still a Chicago view of the world, even if it is not as dominant as it once was, is there

not? One that favors free markets?

Well, many of us at least view free markets as a good place to start, because of the centuries of

experience and thought that it reflects. All science is, to some extent, conservative. You find one

butterfly that looks weird, you don‘t say, ―Oh, Darwin was wrong after all.‖ We have a similar

centuries-long experience that markets work tolerably well, and governments running things

works pretty disastrously. We have got to think hard before we throw all of that out.

Even our behavioralists are not jumping into ―the government needs to run everything.‖ They are

pretty good about (saying) well, if we‘re irrational, the guys who are going to regulate us are just

as irrational, and they are subject to political biases too. You don‘t jump from ―We are irrational‖

to ―the federal government is the father who can come and make everything right again.‖

Did the government have to step in and save the banks, or should it have let them collapse? Isn’t

the free-market view that if Citigroup had been allowed to collapse, Citigroup 2 would quickly

have arisen from the ashes?

Yes, this is a good debate we can have. I tend to be fairly sympathetic to that view. Though, in

some sense, the government had painted itself into a corner. We did not wake up on September

24 (of 2008) with a completely free market that collapsed. We had a mortgage market that was

very much run by the federal government, a very regulated banking system, and everybody

expecting that the government was going to bail out the big players.

To say, ―wake up on September 24, 2008 and get some spine‖ is a very different

recommendation to saying we need to build a system in which there is less government

intervention. If everybody expects you to bail them out than not doing so is much harder.

So, given the circumstances of the time, do you think the federal government did the right things?

No. I don‘t want to criticize personalities. If I‘m the captain of the Titanic and I‘m woken up and

somebody says there‘s an iceberg two hundred yards ahead, would I have done any better? I

don‘t know. But I‘ve been on the record saying that the TARP policy and the TARP idea—that

the key to stabilizing the system was buying up mortgage-backed securities on the secondary

market—was a bad idea. Those speeches provoked the panic, probably more than the fact of

Lehman going under. When you get the President going on national television and saying, ―The

financial markets are near collapse,‖...if you weren‘t about to take all of your short-term debt out

of Citigroup, you are going to do so now.

Do you think that what we witnessed was a government failure rather than a market failure?

I think it was a combination, a failure of both. The government set up some regulations. The

banks were very quick to get around them. Lots of people did not think enough about

counterparty risk, because they thought the government will take care of it. But this was hardly a

libertarian paradise gone wrong.

What about today? Do we need more regulation, or should Wall Street be deregulated further,

like trucking or telecoms?

Not completely, but a lot more than it is now. And the path we are headed on is allowing the

great big banks to do whatever they want with a government guarantee, basically. And then

future regulators are going to be so much smarter than the last ones that they‘ll keep the banks

from getting in trouble, even though we all know we are guaranteeing their losses. This strikes

me as a recipe for disaster.

The right and the left agree on that, no?

Yes. (Laughs) If you are going to guarantee them, you can‘t guarantee and not regulate. A

central bank, a lender of last resort, deposit insurances with the supervision that comes with it—

these are reasonable regulations. If you just say regulation versus no regulation that becomes an

undergraduate 2 A.M. bullshit fest. Talking about ―regulation‖ vs. ―deregulation‖ in the abstract is

pointless. We have to talk about specifics if we want to get anywhere. Stuff like, Do you think

credit default swaps should be forced on to exchanges? It‘s all very boring to your readers, but

unless you are specific you don‘t get anywhere... If you are vague, it sounds kind of fun:

ideology, Chicago versus Harvard, and so on. But to get anywhere you have to be specific.

The banking research that was done in Chicago before the crisis, about liquidity and so on: Did

it attract much internal attention here?

Goodness gracious, yes. It was central. I regard what we went through as not something special

or new. We‘ve had regular banking panics since at least about 1720. The Diamond and Dybvig

paper—(―Bank Runs, Deposit Insurance, and Liquidity,‖ the Journal of Political Economy,

1983)—which Doug and Phil should have got the Nobel Prize for already, described the fragility

of assets where you can run. I don‘t think we have systemically dangerous institutions. I think we

have systemically dangerous contracts, and bank deposits are one of them, as Doug described. A

bank can have risky assets but tell you, ―We‘ll always pay you a dollar, first come first served.‖

Doug described how that thing can cause problems, and I think that‘s basically what happened.

Doug‘s here for a reason. We all said, ―Wow, that‘s great!‖ And he‘s devoted a career to

deepening that analysis. He‘s been one of our stars ever since he came here, which must be thirty

years ago now.

The two biggest ideas associated with Chicago economics over the past thirty years are the

efficient markets hypothesis and the rational expectations hypothesis. At this stage, what’s left of

those two?

I think everything. Why not? Seriously, now, these are not ideas so superficial that you can reject

them just by reading the newspaper. Rational expectations and efficient markets theories are both

consistent with big price crashes. If you want to talk about this, we need to talk about specific

evidence and how it does or doesn‘t match up with specific theories.

In the United States, we’ve had two massive speculative bubbles in ten years. How can that be

consistent with the efficient markets hypothesis?

Great, so now you know how to define ―bubbles‖ for me. I‘ve been looking for that for twenty

years.

So you take the Greenspan view that bubbles can’t be identified except in retrospect? In 2005,

you didn’t think there was a housing bubble?

I think most people mean by a ―bubble‖ just, ―Prices were high and I wish I sold yesterday.‖ The

efficient markets (hypothesis) never told you that wasn‘t going to happen. What efficient markets

says is that prices today contain the available information about the future. Why? Because

there‘s competition. If you think it‘s going to go up tomorrow, you can put your money where

your mouth is, and your doing it sends (the price) up today. Efficient markets are not clairvoyant

markets. People say, ―nobody foresaw saw the market crash.‖ Well, that‘s exactly what an

efficient market is—it‘s one in which nobody can tell you where it‘s going to go. Efficient

markets doesn‘t say markets will never crash. It certainly doesn‘t say markets are clairvoyant. It

just says that, at that moment, there are just as many people saying its undervalued as

overvalued. That certainly seems to be the case.

Ok, now you know what ―efficient markets‖ means. What is there about recent events that would

lead you to say that markets are inefficient? The market crashed, to which I would say, we had

the events last September in which the President gets on television and says the financial markets

are near collapse. On what planet do markets not crash after that?

There are things, by the way, that I saw last year that say markets are not efficient, but not the

ones you had in mind. The interesting things about efficiency are going to be more boring to

your readers. There were lots of little arbitrages. For example, you could buy a corporate bond or

you could write a credit default swap and buy a Treasury (bond). Those are economically the

same thing, but one of those was trading about three per cent higher than the other: one was

eighty-two, the other was eighty-five.

So there were arbitrage opportunities?

Well, close to arbitrage opportunities. The problem was that you need funding. You needed to be

able to borrow money to buy the corporate bond, and it was hard to borrow money. Those are,

strictly speaking, violations of efficiency. Two ways of getting the same thing for a different

price—that smells. You‘ve gotta rethink some part of your theory. What we saw were funding

and liquidity frictions. Those were really interesting last winter.

But that‘s not: Why did we see house prices go up and come down? Why did we see stock prices

go up and come down? Those things are not new. We saw stock prices go up and come down in

the nineteen-twenties, the nineteen-fifties, the nineteen-seventies...

You appear to be saying that the efficient markets hypothesis doesn’t have any implications for

the absolute level of prices, just relative prices. How can that be a theory of pricing?

It does have implications for absolute pricing, and the focus of rational/irrational debate is

exactly on this question. But last fall was not a particularly new and puzzling data point. The

phenomenon of prices going up and coming down is something we have been chewing on for

twenty years. So here are the facts:

When house prices are high relative to rents, when stock prices are high relative to earnings—

that seems to signal a period of low returns. When prices are high relative to earnings, it‘s not

going to be a great time to invest over the next seven to ten years. That‘s a fact. It took us ten

years to figure it out, but that‘s what (Robert) Shiller‘s volatility stuff was about; it is what Gene

(Fama)‘s regressions in the nineteen-eighties were about. That was a stunning new fact. Before,

we would have guessed that prices high relative to earnings means we are going to see great

growth in earnings. It turned out to be the opposite. We all agree on the fact. If prices are high

relative to earnings that means this is going to be a bad ten years for stocks. It doesn‘t reliably

predict a crash, just a period of low returns, which sometimes includes a crash, but sometimes

not.

Ok, this is the one and only fact in this debate. So what do we say about that? Well, one side says

that people were irrationally optimistic. The other side says, wait a minute, the times when prices

are high are good economic times, and the times when prices are low are times when the average

investor is worried about his job and his business. Look at last December (2008). Lots of people

saw this was the biggest buying opportunity of all time, but said, ―Sorry, I‘m about to lose my

job, I‘m about to lose my business, I can‘t afford to take more risk right now.‖ So we would say,

―Aha, the risk premium is higher!‖

So that‘s now where this debate is. We‘re chewing out: Is it a risk premium that varies over time,

or is it psychological variation? So your question is right, but it is not as obvious as: ―Stocks

crashed. We must all be irrational.‖

And if the explanation is time-varying risk premiums, it could all be consistent with rationality

and market efficiency?

Yes. Now, how do you solve this debate? This is supposed to be science. You need a model. You

need some quantifiable way of saying, ―What is the right risk premium?‖ or, ―What is the level

of irrationality—optimism or pessimism?‖ And we need that not to be a catchall explanation that

says, ―Oh, tomorrow if prices go up it must mean there is a return to optimism.‖ That‘s the

challenge. That‘s what we all work on. Both sides say, ―We don‘t have that model yet.‖

(Later in the interview, I brought up the efficient market hypothesis again. This time, Cochrane

argued that in some ways what happened to the credit markets was a vindication of the theory,

because it showed investors generally can’t beat the market without taking on more risk. Here is

what he said:)

If you listened to Eugene Fama and believed that markets are efficient, you wouldn‘t have

invested in auction rate securities that claimed to be as good as cash, but which offered fifty extra

basis points. You wouldn‘t have invested in a Triple A rated mortgage-backed securities pool

that said this is as good as Treasuries, but offered fifty extra basis points of yield. The whole

point of efficient markets theory is that you can‘t beat the market without taking on more risk.

People (here) were saying for years, if you invest in hedge funds that make abnormally high

returns there is an earthquake risk, a tail risk, that nobody is telling you about.

What about the rational expectations hypothesis? Richard Posner is a Keynesian now?

I don‘t want to comment on Posner. He‘s a nice guy. But I spend my life trying to understand

this stuff. My last two papers, which took me three years, were on determinacy conditions in

New-Keynesian models. It took me a lot of time and a lot of math. If Posner can keep with that

and with Law and Economics, good for him. (Laughs)

Rational expectations. Again, it is good to be specific. What is rational expectations? It is the

statement that you fool all the people all the time. In the nineteen-sixties, people said the

government can give us a burst of inflation, and that will give us a little boom in output because

people will be fooled. They‘ll think inflation means they are getting paid better for their work

and they‘ll be fooled into working harder. The rational expectations guys said, ―Well that may

happen once or twice, but sooner or later they will catch on.‖ The principle that you can‘t fool all

the people all the time seems a pretty good principle to me. So, again, I say be specific. What do

you see about the world that invalidates the theory of rational expectations?

O.K. The rational expectations hypothesis by itself is a technical device. But when you marry it

to what is, basically, a market-clearing model, which is what Bob Lucas and others did, there is

no room for involuntary unemployment, for example. Recessions are a matter of workers

voluntarily substituting leisure for work. Is that realistic?

O.K. Now, we are going beyond Lucas to Ed Prescott and the real business cycle school. Today,

there is no ―freshwater versus saltwater.‖ There is just macro. What most people are doing is

adding frictions to it. We are playing by the (Finn) Kydland and Prescott rules but adding some

frictions.

But unemployment is now ten percent. That seems to be inconsistent with a market-clearing

model, no?

It‘s not as simple as that. Unemployment is job search. I think the rational expectations guys

made incredibly valuable contributions. First, the way you do macro. You don‘t just write down

consumption, investment, and so forth. You really write down an economy. You talk about

people and what they want. You talk about their productive opportunities. You talk about market

structure. That revolution in macroeconomics remains. New-Keynesians? One hundred per cent,

yes: this is how we do things.

The second valuable contribution: As of the seventies, people took for granted is that the way the

economy should work is that potential output always looks like this. (Cochrane stood up at the

chalk board and drew and straight line rising from left to right.) And anything that looks like

this (Cochrane drew a line that zig-zagged as it rose from left to right) is bad. Unemployment

should always be constant. Well, wait a minute. That‘s not true. The upward trend comes from

productivity, and where is it written on tablets that productivity grows at 3.0259 percent

constantly. In the nineteen-nineties, you discover the Internet, and it makes sense for output to

grow faster, and for everybody under the age of thirty to spend twenty hours a day writing

websites. So the baseline of an economy working well will include some fluctuations, and the

baseline of an economy well will also include some fluctuations in unemployment.

When we discover we made too many houses in Nevada some people are going to have to move

to different jobs, and it is going to take them a while of looking to find the right job for them.

There will be some unemployment. Not as much as we have, surely, but some. Right now, ten

percent of people are unemployed. Many of them could find a job tomorrow at Wal-Mart but it is

not the right job for them—and I agree, it is not the right job for them. That doesn‘t mean the

world would be right if they took those jobs at Wal-Mart. But some component of

unemployment is people searching for better fits after shifts that have to happen. The baseline

shouldn‘t be that unemployment is always constant. So that is a big and enduring contribution—

some amount of fluctuation does come out of a perfectly functioning economy. Now have to talk

about how much, not just look at any unemployment and say markets are busted.

Is ten per cent the right number? Now we are talking opinions. My opinion is I agree with you.

What we are seeing is the after-effects of a financial crisis that is socially not optimal—agreed

one hundred per cent. But what we need is models, data, predictions to really talk about this. Not

my opinion versus your opinion.

Years ago, Bob Lucas said something similar to what you are saying about the Great

Depression—that many of the unemployed could have taken jobs at lower wages.

Yes, but it wasn‘t the right thing for them to do. Let me not even hint that this is the right thing

now. We had a financial crisis last fall which was socially not optimal. This is probably where

the Minnesota crowd would disagree. It seems to me pretty obvious that we had a financial crisis

last fall, a freezing up of short-term credit markets, a flight to quality. As a result of that financial

crisis, we saw a lot of real effects that didn‘t have to happen. Businesses closed and people lost

their jobs. It didn‘t have to happen. Now in a way, this is what we saw in 1907, 1921, 1849—you

can say we‘ve seen these things before. There I would agree with you, rather than with some

mythical figure from Minnesota who says finance is just totally irrelevant. That makes no sense.

Is that the lesson here—that we need to integrate finance into macroeconomics?

Well, yeah...I‘ve been preaching that for twenty years. I do half finance and half macro. I see this

as a great research opportunity. People who are trained in macro, they think about the interest

rate. They don‘t think about variation in credit spreads or risk premiums. In my finance

(research), I see risk and risk premiums as being what matters most. Macro until a couple of

years ago wasn‘t really thinking about risk and risk premiums. It was just, oh, the Fed and the

level of interest rates. So I‘ve thought these things should marry each other for a long time. But

that‘s an easy thought to have. Doing it is the hard part.

Has anybody got anywhere on it?

Oh yeah, but it‘s hard. Asking big questions, talking about fashionable ingredients is easy, it‘s

the answers that are hard, actually cooking the soup. People also say economics needs to

incorporate the insights of psychology. Great. Thanks. I‘ve heard that from (Robert) Shiller for

thirty years. Do it! And do it not just in a way that can explain anything. Let‘s see a measure of

the psychological state of the market that could come out wrong. That‘s hard to do. Calling for

where research should go is fun, but I think it‘s far too easy.

Back to John Maynard Keynes. Judge Posner is not the only who has rediscovered him and his

policy prescriptions. You have been very critical of the Obama administration’s stimulus

package and of the Keynesian revival. Why?

Look, evaluating economic models is a lot harder than just staring out the window and saying,

―This is going on. Keynes was right.‖ Nothing in the incoming data has removed the

inconsistencies that plagued Keynesian economics for forty years until it was thrown out. I mean,

we threw it out for a reason. It didn‘t work in the data. When inflation came in the nineteen-

seventies that was a major failure of Keynesian economics. It was logically incoherent.

What happened is the government wanted to spend a lot of money. They said ―Keynesian

stimulus‖ and people got excited. What event, what data says we‘ve got to go back to

Keynesianism? Again, I‘m going to throw it back on you. What about it other than that Paul

Krugman thinks we need another stimulus tells us that this is an idea to be rehabilitated?

You don’t believe stimulus packages work. You are arguing what—every dollar the government

dissaves somebody else saves with an eye to the future tax burden? The so-called “Ricardian

equivalence” argument: Is that it?

I would go further. Ricardian equivalence is a theorem, a theorem whose ―ifs‖ are false. But it is

a nice background theorem. In the world of that theorem, deficit finance spending has no effect

whatsoever—really, no effect different from taxing people now and spending—because, as you

mentioned, people offset it by saving more. Now, we know that theorem is false. One of the ifs is

―if the government raises taxes by lump sum payments.‖ In fact, the government raises money by

taxes that distort incentives, so, if anything, you are going to get a negative multiplier—a bad

thing. However, government spending also changes the composition of output. You build roads.

There are lots of models where you can have a positive effect, so I don‘t want to say exactly

zero. But if you want to get a multiplier you have to say exactly which ―if‖ is false, exactly what

friction you think the government can exploit to improve things by borrowing and spending and

how.

What do you think the fiscal policy multiplier is?

I think it is the wrong question. In many models with positive multipliers it is socially bad to do

it. Just because you get more output doesn‘t mean it is a good thing. People have pointed to

World War II and (said), oh, there‘s a case where we had lots of output. ―Well, let‘s fight World

War II again‖ is not socially good.

So is that your argument against the stimulus? Or you just don’t think it will work?

The claim was that this would, on net, reduce unemployment, create jobs, improve the economy

in some quantifiable way. I just don‘t think it is going to happen. My guess is (that the impact is)

a lot closer to zero, and probably slightly negative, for deficit spending right now.

Why? What is the mechanism that prevents it from working?

It is even deeper than saying people will respond by saving. First of all, there‘s this presumption

that spending is good and saving is bad—except that we also want saving to be good and

consuming bad. Let me try to put it (like this): You save money. It goes into a bank, which lends

it out to somebody to buy a forklift. Why is that bad, but you buying a car with the same money

is good? So, presumption number one, that consuming rather than saving is good for the

economy, I don‘t get that. The Chinese are investing fifty per cent of their income, and they seem

to be booming.

Second, just on basic accounting: I‘m going to be the government, I‘m going to borrow from

you, and I‘m going to spend it. So over here, that‘s more output. But you were going to do

something with that dollar, which is now invested in government debt. Now, what else were you

going to do with it? Well, you were going to buy a mortgage backed security; you might have

bought a car. You were going to do something with that money. So, on basic dollar accounting,

if I take that money that‘s a dollar more demand, but you have a dollar less demand.

Barro‘s theorem is about tax vs. debt financing having no effect whatsoever. This is a deeper

point. If you were going go buy a car, and I, the government, go and build a road, we have one

less car and one more road, so there is an effect. But we have one less car. That money has to

come from somewhere. That‘s what people miss out when they think about the stimulus.

What about if foreign investors are buying the government bonds, as they are in the U.S. case?

Surely, they are not crowding out domestic demand?

Well, that makes it harder to explain. We have to go through the fact that trade is balanced. If

they were not buying the bonds, they were going to do something with that money, and blah,

blah, blah. You can shuffle resources around, but you can‘t create anything out of thin air.

The other reason I‘ve been against the stimulus: it‘s pretty clear what the problem with the

economy was. For once, we know why stock prices went down, we know why we had a

recession. We had a panic. We had a freeze of short-term debt. If somebody falls down with a

heart attack, you know he has a clogged artery. A shot of cappuccino is not what he needs right

now. What he needs is to unclog the artery. And the Fed was doing some remarkably interesting

things about unclogging arteries. Even if (the stimulus) was the solution, it‘s the solution to the

wrong problem.

If I were Keynes, I would say we are in a recession; we are not the potential output level. There

are unemployed resources out there. You’re argument may be correct at full-employment, but

when there are unemployed resources out there we can make something out of nothing.

Possibly, but it‘s not obvious how ―stimulus‖ is going to help this recession. Think about an

unemployed accountant in New Jersey, fired from a big bank. How is going to build a road in

Montana going to help him? Keynes thought of a world in the nineteen-thirties where labor was

more amorphous labor. If you hired people to dig ditches, that would solve the unemployment

line in the car industry. We have very specialized labor, and just hiring people doesn‘t resolve

the problem. Somebody who lost their job in a bank—building more roads is not going to help

them.

It‘s a long logical leap from the fact of unemployed resources to the proposition that the federal

government borrowing another trillion dollars and spending on pork is going to make those

resources employed again.

So what should the government response have been?

Not making so many mistakes. First rule: do no harm. What we experienced was a fairly classic

bank run, panic, whatever. There were good things the government did. The Fed intervened very

creatively, in sort of a classic lender of the last resort way. We also did a lot of stuff—lots of

bailouts—that didn‘t need to be done. I think the TARP was silly. The equity injections were

silly. Lender of the last resort—get frozen markets going again, and get out of the way—is

probably plenty.

And don‘t cause more panic. There was lots of confusion and uncertainty about: What‘s the

government going to do? When is it going to do it? Who is going to get bailed out? Who isn‘t

going to get bailed out? That doesn‘t help.

Where should we go from here? If you were hired as head of the White House Council of

Economic Advisers, what would you tell the President?

I‘d get fired in about five minutes. I‘d start with a broad deregulatory approach to health care

reform. There, I just got fired. Financial deregulation, yes, but going in the opposite direction to

where they are going. Financial regulation based on getting out of this too-big-to-fail cycle.

Setting it up so that those things that have to be protected are, but in as limited a way as possible.

Simple, transparent reform.

And I think the government needs to encourage Wall Street to solve its own problems. Let‘s go

back to Bear Stearns. Here we had a proprietary trading group married to a brokerage. We

discovered you could have runs on brokerage accounts—that was the systemic thing. So what I

thought would happen after that is that Wall Street would say, ―Oh wow, we‘ve got a problem!‖

Marrying proprietary trading to brokerage is like managing gambling to bank deposits. What I

thought Wall Street would say is: ―We‘ve got to separate these things. Customers want to know

that their brokerage isn‘t going to get dragged down by the proprietary trading desk, and we want

to separate them fast so that Washington doesn‘t come in and regulate us.‖ Unfortunately, that‘s

not what happened. What happened is that everybody said, ―Aha, the Fed is going to bail us all

out. We can keep this game going forever.‖

So what I would like to see is a strong (statement): ―You guys have got to set this us so it can go

bankrupt next time around. And we are going to set it up so we don‘t even have the legal

authority to bail you out, so you‘d better get cracking.‖

You mean a new Glass-Steagall act for Wall Street? Or some version thereof?

Yeah...Glass Steagall itself had a lot of problems, but some of the basic ideas are good.

But the same principle—separating the casino from the utility?

Separating the casino from the dangerous contracts—yes. We all understand that you can‘t run

an institution that offers bank accounts and gambling in the same place. We are trying to do that

now in the hope that the regulators will watch the gamblers. That‘s not going to work.

It appears that there is liberal and conservative agreement on this issue.

Yes. Which brings me back to where you started. It‘s not about liberal or conservative, and

analysis of these things doesn‘t have to be ideological. Let‘s just think through what works and

look hard at the evidence.

Read more: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-john-

cochrane.html#ixzz0d3cXphxx

3 comments | Add your comments

The Chicago School IS an ideology factory. The entire interview is denial. Now that events have

proven efficient markets practices lead to calamity, Mr. Cochrane says, "We look at evidence."

The evidence is that you are in denial. The efficiency you promised has turned out to be far from

any efficiency. And it is not the government. It is the private sector without structured and

regulated markets. Anything short of mea culpa is dishonest.

Posted 1/16/2010, 12:03:46am by demandside Report abuse

"You save money. It goes into a bank, which lends it out to somebody to buy a forklift. Why is

that bad, but you buying a car with the same money is good? So, presumption number one, that

consuming rather than saving is good for the economy" There is no guarantee that if you put the

money into the bank the bank will lend it out. Right now, banks are sitting on huge amounts of

excess reserves that they have not lend out, so when the money is put into the bank instead of

used for consumption, the total demand for final goods and services (aggregate demand)

declines. As a result, firms sell less goods and lay workers off, just as Keynesian economics

predicts. This is just one specific example, of a general proposition, that there is no guarantee

that saving will automatically result in expenditures by firms on physical capital. An explanation

of the more general case would require a lot more space than I have here. "I don‘t get that." That

is your problem. You really do not understand what you are talking about.

Posted 1/15/2010, 11:57:15pm by RolandBuck Report abuse

"Great, so now you know how to define ―bubbles‖ for me." Dr. Cochrane: You have a bubble in

an asset market if the price of the asset is not being determined by buyers who buy the asset

because they conclude, based on all available information, that the intrinsic value of the asset

will provide an acceptable combination of return and risk. Rather the price is being determined

by people who buy the asset because they believe that its price will go up so that they can sell it

at a profit to someone who then also buys it because he believes that the price will go up, so that

he can sell it at a profit to someone else, who also believes that the price will go up, etc., etc., etc.

This creates a process that feeds on itself so that the belief that the price will go up becomes a

self-fullfilling prediction. Eventually the price goes so high that people lose confidence that it

will still go higher and then the bubble bursts. It is rigid ideological blinders that make you and

Fama unwilling to see this or to admit that you see it.

Read more: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-john-

cochrane.html#ixzz0d3caSHdm

Interview with Eugene Fama

Posted by John Cassidy

This is the second in a series of interviews with Chicago School economists. Read “After the

Blowup,” John Cassidy’s story on Chicago economists and the financial crisis. (Subscribers

only.)

I met Eugene Fama in his office at the Booth School of Business. I began by pointing out that the

efficient markets hypothesis, which he promulgated in the nineteen-sixties and nineteen-

seventies, had come in for a lot of criticism since the financial crisis began in 1987, and I asked

Fama how he thought the theory, which says prices of financial assets accurately reflect all of the

available information about economic fundamentals, had fared.

Eugene Fama: I think it did quite well in this episode. Stock prices typically decline prior to and

in a state of recession. This was a particularly severe recession. Prices started to decline in

advance of when people recognized that it was a recession and then continued to decline. There

was nothing unusual about that. That was exactly what you would expect if markets were

efficient.

Many people would argue that, in this case, the inefficiency was primarily in the credit markets,

not the stock market—that there was a credit bubble that inflated and ultimately burst.

I don‘t even know what that means. People who get credit have to get it from somewhere. Does a

credit bubble mean that people save too much during that period? I don‘t know what a credit

bubble means. I don‘t even know what a bubble means. These words have become popular. I

don‘t think they have any meaning.

I guess most people would define a bubble as an extended period during which asset prices

depart quite significantly from economic fundamentals.

That‘s what I would think it is, but that means that somebody must have made a lot of money

betting on that, if you could identify it. It‘s easy to say prices went down, it must have been a

bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you

always find people who said before the fact that prices are too high. People are always saying

that prices are too high. When they turn out to be right, we anoint them. When they turn out to be

wrong, we ignore them. They are typically right and wrong about half the time.

Are you saying that bubbles can’t exist?

They have to be predictable phenomena. I don‘t think any of this was particularly predictable.

Is it not true that in the credit markets people were getting loans, especially home loans, which

they shouldn’t have been getting?

That was government policy; that was not a failure of the market. The government decided that it

wanted to expand home ownership. Fannie Mae and Freddie Mac were instructed to buy lower

grade mortgages.

But Fannie and Freddie’s purchases of subprime mortgages were pretty small compared to the

market as a whole, perhaps twenty or thirty per cent.

(Laughs) Well, what does it take?

Wasn’t the subprime mortgage bond business overwhelmingly a private sector phenomenon

involving Wall Street firms, other U.S. financial firms, and European banks?

Well, (it‘s easy) to say after the fact that things were wrong. But at the time those buying them

didn‘t think they were wrong. It isn‘t as if they were naïve investors, or anything. They were all

the big institutions—not just in the United States, but around the world. What they got wrong,

and I don‘t know how they could have got it right, was that there was a decline in house prices

around the world, not just in the U.S. You can blame subprime mortgages, but if you want to

explain the decline in real estate prices you have to explain why they declined in places that

didn‘t have subprime mortgages. It was a global phenomenon. Now, it took subprime down with

it, but it took a lot of stuff down with it.

So what is your explanation of what happened?

What happened is we went through a big recession, people couldn‘t make their mortgage

payments, and, of course, the ones with the riskiest mortgages were the most likely not to be able

to do it. As a consequence, we had a so-called credit crisis. It wasn‘t really a credit crisis. It was

an economic crisis.

But surely the start of the credit crisis predated the recession?

I don‘t think so. How could it? People don‘t walk away from their homes unless they can‘t make

the payments. That‘s an indication that we are in a recession.

So you are saying the recession predated August 2007, when the subprime bond market froze

up?

Yeah. It had to, to be showing up among people who had mortgages. Nobody who‘s doing

mortgage research—we have lots of them here—disagrees with that.

So what caused the recession if it wasn’t the financial crisis?

(Laughs) That‘s where economics has always broken down. We don‘t know what causes

recessions. Now, I‘m not a macroeconomist so I don‘t feel bad about that. (Laughs again.)

We‘ve never known. Debates go on to this day about what caused the Great Depression.

Economics is not very good at explaining swings in economic activity.

Let me get this straight, because I don’t want to misrepresent you. Your view is that in 2007

there was an economic recession coming on, for whatever reason, which was then reflected in

the financial system in the form of lower asset prices?

Yeah. What was really unusual was the worldwide fall in real estate prices.

So, you get a recession, for whatever reason, that leads to a worldwide fall in house prices, and

that leads to a financial collapse...

Of the mortgage market…What‘s the reality now? Everybody talks about a credit crisis. The

variance of stock returns for the market as a whole went up to, like, sixty per cent a year—the

Vix measure of volatility was running at about sixty per cent. What that implies is not a credit

market crisis. It would be stupid for anybody to give credit in those circumstances, because the

probability that any borrower is going to be gone within a year is pretty high. In an efficient

market, you would expect that debt would shorten up. Any new debt would be very short-term

until that volatility went down.

But what is driving that volatility?

(Laughs) Again, its economic activity—the part we don‘t understand. So the fact we don‘t

understand it means there‘s a lot of uncertainty about how bad it really is. That creates all kinds

of volatility in financial prices, and bonds are no longer a viable form of financing.

And all that is consistent with market efficiency?

Yes. It is exactly how you would expect the market to work.

Taking a somewhat broader view, the usual defense of financial markets is that they facilitate

investment, facilitate growth, help to allocate resources to their most productive uses, and so on.

In this instance, it appears that the market produced an enormous amount of investment in real

estate, much of which wasn’t warranted...

After the fact...There was enormous investment across the board: it wasn‘t just housing.

Corporate investment was very high. All forms of investment were very high. What you are

really saying is that somewhere in the world people were saving a lot—the Chinese, for example.

They were providing capital to the rest of the world. The U.S. was consuming capital like it was

going out of sight.

Sure, but the traditional Chicago view has been that the financial markets do a good job of

allocating that capital. In this case it, they didn’t—or so it appears.

(Pauses) A lot of mortgages went bad. A lot of corporate debt went bad. A lot of debt of all sorts

went bad. I don‘t see how this is a special case. This is a problem created by a general decline in

asset prices. Whenever you get a recession, it turns out that you invested too much before that.

But that was unpredictable at the time.

There were some people out there saying this was an unsustainable bubble…

Right. For example, (Robert) Shiller was saying that since 1996.

Yes, but he also said in 2004 and 2005 that this was a housing bubble.

O.K., right. Here‘s a question to turn it around. Can you have a bubble in all asset markets at the

same time? Does that make any sense at all? Maybe it does in somebody‘s view of the world, but

I have a real problem with that. Maybe you can convince me there can be bubbles in individual

securities. It‘s a tougher story to tell me there‘s a bubble in a whole sector of the market, if there

isn‘t something artificial going on. When you start telling me there‘s a bubble in all markets, I

don‘t even know what that means. Now we are talking about saving equals investment. You are

basically telling me people are saving too much, and I don‘t know what to make of that.

In the past, I think you have been quoted as saying that you don’t even believe in the possibility

of bubbles.

I never said that. I want people to use the term in a consistent way. For example, I didn‘t renew

my subscription to The Economist because they use the world bubble three times on every page.

Any time prices went up and down—I guess that is what they call a bubble. People have become

entirely sloppy. People have jumped on the bandwagon of blaming financial markets. I can tell a

story very easily in which the financial markets were a casualty of the recession, not a cause of it.

That’s your view, correct?

Yeah.

I spoke to Richard Posner, whose view is diametrically opposed to yours. He says the financial

crisis and recession presents a serious challenge to Chicago economics.

Er, he‘s not an economist. (Laughs) He‘s an expert on law and economics. We are talking

macroeconomics and finance. That is not his area.

So you wouldn’t take what he says seriously?

I take everything he says seriously, but I don‘t agree with him on this one. And I don‘t think the

people here who are more attuned to these areas agree with him either.

His argument is that the financial system brought down the economy, and not vice versa.

Well then, you can say that about every recession. Even if you believe that, which I don‘t, I

wonder how many economists would argue that the world wasn‘t made a much better place by

the financial development that occurred from 1980 onwards. The expansion of worldwide

wealth—in developed countries, in emerging countries—all of that was facilitated, in my view,

to a large extent, by the development of international markets and the way they allow saving to

flow to investments, in its most productive uses. Even if you blame this episode on financial

innovation, or whatever you want to blame, would that wipe out the previous thirty years of

development?

What about here in Chicago—has there been a lot of discussion about all this, the financial

crisis, and what it means, and so on?

Lots of it. Typical research came to a halt. Everybody got involved.

Everybody‘s got a cure. I don‘t trust any of them. (Laughs.) Even the people I agree with

generally. I don‘t think anybody has a cure. The cure is to a different problem. The cure is to a

new problem that we face—the ―too-big-to-fail‖ problem. We can‘t do without finance. But if it

becomes the accepted norm that the government steps in every time things go bad, we‘ve got a

terrible adverse selection problem.

So what is the solution that problem?

The simple solution is to make sure these firms have a lot more equity capital—not a little more,

but a lot more, so they are not playing with other people‘s money. There are other people here

who think that leverage is an important part of they system. I am not sure I agree with them. You

talk to Doug Diamond or Raghu Rajan, and they have theories for why leverage in financial

institutions has real uses. I just don‘t think that those effects are as important as they think they

are.

Let’s say the government did what you recommend, and forced banks to hold a lot more equity

capital. Would it then also have to restructure the industry, say splitting up the big banks, as

some other experts have recommended?

No. If you think about it...I‘m a student of Merton Miller, after all. In the Modigliani-Miller view

of the world, it‘s only the assets that count. The way you finance them doesn‘t matter. If you

decide that this type of activity should be financed more with equity than debt, that doesn‘t

particularly have adverse effects on the level of activity in that sector. It is just splitting the risk

differently.

Some people might say one of the big lessons of the crisis is that the Modigliani-Miller theory

doesn’t hold. In this case, the way that things were financed did matter. People and firms had too

much debt.

Well, in the Modigliani-Miller world there are zero transaction costs. But big bankruptcies have

big transaction costs, whereas if you‘ve got a less levered capital structure you don‘t go into

bankruptcy. Leverage is a problem...

The experiment we never ran is, suppose the government stepped aside and let these institutions

fail. How long would it have taken to have unscrambled everything and figured everything out?

My guess is that we are talking a week or two. But the problems that were generated by the

government stepping in—those are going to be with us for the foreseeable future. Now, maybe it

would have been horrendous if the government didn‘t step in, but we‘ll never know. I think we

could have figured it out in a week or two.

So you would have just let them...

Let them all fail. (Laughs) We let Lehman fail. We let Washington Mutual fail. These were big

financial institutions. Some we didn‘t let fail. To me, it looks like there was not much rhyme or

reason to it.

What about Ben Bernanke and Hank Paulson’s argument that if they hadn’t taken action to save

the banks the whole financial system would have come crashing down?

Maybe it would have—for a week or two. But it pretty much stopped for a week or two anyway.

The credit markets stopped for more than a week or two. But I think that was really a function of

increased uncertainty about the future.

Did you think this at the time—that the government should let the banks fail?

Yeah—let ‗em, let ‗em. Because the failures of, like, Washington Mutual and Wachovia—other

banks came swooping in to pick up their deposits and their other good assets. Of, course, they

didn‘t want their bad assets, but that‘s the nature of bankruptcy. The activities that these banks

were engaged in would have continued.

Why do you think the government didn’t just step back and let it happen? Was the government in

hock to Wall Street, as many have claimed?

No. I think the government, Bernanke...Bob Lucas, I shouldn‘t quote Bob Lucas, but what he

says is ―not on my watch.‖ That, basically, there is just a high degree of risk aversion on the part

of people currently in government. They don‘t want to be blamed for bad outcomes, so they are

willing to do bad things to avoid them. I think Bernanke has been the best of the performers.

Back to Chicago economics. Is there still anything distinctive about Chicago, or have the rest of

the world and Chicago largely converged, which is what Richard Posner thinks?

The rest of the world got converted to the notion that markets are pretty good at allocating

resources. The more extreme of the left-leaning economists got blown away by the collapse of

the Eastern bloc. Socialism had its sixty years, and it failed miserably. In that way, Chicago

theory prospered. Milton Friedman and George Stigler were fighting that battle pretty much

alone in the old days. Now it is pretty general. An experience like we‘ve had rehabilitates the

remnants of the old socialist gang. (Laughs) Unfortunately, they seem to be in control of the

government, at this point.

In the old days, a person like (Richard) Thaler would have had trouble getting a job here. But

that was a period of time when Chicago economics was basically under attack the world over.

There was a kind of a bunker mentality. But now we‘ve become more confident. Now, our only

criterion is we want the best people who do whatever they do. As long as they are honest about

it, and they respect other people‘s work, and we respect their work, great.

I know the business school has a lot of diversity, but is that also true of the university economics

department?

Sure. John List is over there. He‘s a behavioral economist. Steve Levitt is a very unusual type of

economist. His brand of economics, which is an extension of Gary‘s is taking over

microeconomics.

I spoke to Becker. His view is that what remains distinctive about Chicago is its degree of

skepticism toward the government.

Right—that‘s true even of Dick (Thaler). I think that is just rational behavior. (Laughs) It took

people a long time to realize that government officials are self-interested individuals, and that

government involvement in economic activity is especially pernicious because the government

can‘t fail. Revenues have to cover costs—the government is not subject to that constraint.

So you don’t accept the view, which Paul Krugman, Larry Summers, and others have put

forward, that what has happened represents a rehabilitation of government action—that the

government prevented a catastrophe?

Krugman wants to be the czar of the world. There are no economists that he likes. (Laughs)

And Larry Summers?

What other position could he take and still have a job? And he likes the job.

What is your view on regulating Wall Street? Do we need more of it?

I think it is inevitable, if you accept the view that the government will bail out the biggest firms

if they get into trouble. But I don‘t think it will work. Private companies are very good at

inventing ways around the regulations. They will find ways to do things that are in the letter of

the regulations but not in the spirit. You are not going to be able to attract the best people to be

regulators.

That sounds like an old-fashioned Chicago argument—skepticism about regulation.

Yes. We have Ragu (Rajan), Doug Diamond—they are as good banking people as there are in

the world. I have been listening to them for six months, and I would not trust them to write the

regulations. In the end, there is so much uncertainty, and so much depends on how people will

react to certain things that nobody knows what good regulation would be at this point. That is

what is scary about government bailouts of big institutions.

So what should we do? If the President called you tomorrow and said, “Gene, I don’t think our

way is working. What should we do?” How would you respond?

I don‘t know if these are even the big issues of the time. I think that what is going on in health

care could end up being more important. I don‘t think we are going down the right road there.

Insurance is not the solution: it‘s the problem. Making the problem more widespread is not going

to solve it.

When all this (the financial crisis) started, I joined the debate. Then I stepped back and said, I‘m

really not comfortable with my insights into what the best way of proceeding is. Let me sit back

and listen to people. So I listened to all the experts, local and otherwise. After a while, I came to

the conclusion that I don‘t know what the best thing to do it, and I don‘t think they do either.

(Laughs) I don‘t think there is a good prescription. So I went back and started doing my own

research.

Couldn’t we just ban further bailouts, passing a constitutional amendment if necessary? That

would be in line with your views, wouldn’t it?

Right, but is that credible? It‘s very difficult to explain how A.I.G. issued all the credit default

swaps it issued if people didn‘t think the government was going to step in and bail them out.

Government pledged, in any case, have little credibility. But that one—I think it‘s pretty sure that

we they couldn‘t live up to it.

What will be financial crisis’s legacy for the subject of economics? Will there be big changes?

I don‘t see any. Which way is it going to go? If I could have predicted that, that‘s the stuff I

would have been working on. I don‘t see it. (Laughs) I‘d love to know more about what causes

business cycles.

What lessons have you learned from what happened?

Well, I think the big sobering thing is that maybe economists, like the population as a whole, got

lulled into thinking that events this large couldn‘t happen any more—that a recession this big

couldn‘t happen any more. There‘ll be a lot of work trying to figure out what happened and why

it happened, but we‘ve been doing that with the Great Depression since it happened, and we

haven‘t really got to the bottom of that. So I don‘t intend to pursue that. I used to do

macroeconomics, but I gave (it) up long ago.

Back to the efficient markets hypothesis. You said earlier that it comes out of this episode pretty

well. Others say the market may be good at pricing in a relative sense—one stock versus

another—but it is very bad at setting absolute prices, the level of the market as a whole. What do

you say to that?

People say that. I don‘t know what the basis of it is. If they know, they should be rich men. What

better way to make money than to know exactly about the absolute level of prices.

So you still think that the market is highly efficient at the overall level too?

Yes. And if it isn‘t, it‘s going to be impossible to tell.

For the layman, people who don’t know much about economic theory, is that the fundamental

insight of the efficient market hypothesis—that you can’t beat the market?

Right—that‘s the practical insight. No matter what research gets done, that one always looks

good.

What about the findings that long periods of high returns are followed by long periods of low

returns?

Now, there is no evidence of that...The expected return on stocks is just a price—the price people

require to bear the market risk. Like any price, it should vary from time to time, and maybe it

should vary in predictable ways. I‘ve done a lot of work purporting to show there‘s a little bit of

predictability in overall market returns, but that branch of the literature has so many statistical

problems there‘s not a lot of agreement.

The problem is that, almost surely, expected returns vary through time because of risk

aversion—wealth, everything else varies through time. But measuring that requires that you have

a good variable for tracking (risk aversion) or good models for tracking it. We don‘t have that.

The way that people do it, including me, is by using kind of ad hoc variables to pick it up. All the

argument centers on whether what‘s picked up by these variables is really what‘s there, or

whether it is just kind of a statistical fluke. There‘s a whole issue of the Review of Financial

Studies with people arguing very vociferously on both sides of that. When that happens, you

know that none of the results are very reliable.

Do you and Dick Thaler discuss this stuff when you are playing golf?

Sure. We don‘t want to discuss his golf game, that‘s for sure.

Has the advance of all this behavioral stuff, behavioral finance, made you rethink anything?

Yes, sure. I‘ve always said they are very good at describing how individual behavior departs

from rationality. That branch of it has been incredibly useful. It‘s the leap from there to what it

implies about market pricing where the claims are not so well-documented in terms of empirical

evidence. That line of research has survived the market test. More people are getting into it.

But you are skeptical about the claims about how irrationality affects market prices?

It‘s a leap. I‘m not saying you couldn‘t do it, but I‘m an empiricist. It‘s got to be shown.

Thanks very much. Finally, before I go, what about Paul Krugman’s recent piece in the New

York Times Magazine, in which he attacked Chicago economics and the efficient markets

hypothesis. What did you think of it?

(Laughs) My attitude is this: if you are getting attacked by Krugman, you must be doing

something right.

Read more: http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-

eugene-fama.html#ixzz0d3couIwo

Interview with Richard Posner

Posted by John Cassidy

This is the first in a series of interviews with Chicago School economists. Read “After the

Blowup,” John Cassidy’s story on Chicago economists and the financial crisis. (Subscribers

only.)

I spoke to Posner in his chambers at the Federal courthouse in downtown Chicago, where he sits

on the United States Court of Appeals for the Seventh Circuit. I began by telling him that I was

researching an article about how the financial crisis had affected Chicago economics, and,

indeed, economics as a whole.

At this distance from the financial blow up, what was the nature of the intellectual challenge it

presented?

I think the challenge is to the economics profession as a whole, but to Chicago most of all.

Has there been much self-analysis, or critical reassessment of long held positions, here in

Chicago?

I don‘t think so. There are people here who are not part of the orthodox Chicago School—the

Bob Lucas/Gene Fama crowd—people like Raghu Rajan, Luigi Zingales, and Dick Thaler. But I

don‘t think there has been much in the way of re-examination.

What about your critique of some aspects of Chicago economics, which you detailed in your

recent book, “A Failure of Capitalism?” Have you received much of a reaction to that?

I‘ve had an exchange with Lucas and Fama—some of it on my blog at The Atlantic. It‘s all very

civil: not angry. But I think they are pretty much sticking to their guns. (Laughs.) Even before

this, macro was seen as quite a weak field, and the efficient markets theory had taken a lot of

hits: the behavioral finance school—Andrei Shleifer, Bob Shiller. Already, the orthodox Chicago

position had been under criticism. But last September‘s financial collapse came as a big shock to

the profession.

What is Chicago macroeconomics? And what went wrong with it?

Going back to Milton Friedman, there was the idea that the Great Depression was a product of

inept monetary policy and could have been avoided if only the Fed had not tightened the money

supply. That remains very controversial, but also it didn‘t prepare anybody for what has

happened recently. The concern then was that the Fed had raised rates prematurely during the

Depression. But now the concern is that the interest rates were too low during the early 2000s,

and that is what precipitated all the trouble. For that, the monetarists were unprepared. When the

crisis began Bernanke reduced the federal funds rate essentially to zero and nothing happened.

That was the point at which Friedman‘s macro theory, along with Lucas‘s macro theory, did not

have a clue as to what had happened. That was pretty bad.

Also, and more interesting to me, it called into question a whole approach to economics—one

that is very formal, making very austere assumptions about human rationality: people have a lot

of information, a lot of foresight. They look ahead. It is very difficult for the government to

affect behavior, because the market will offset what it does. The more informal economics of

Keynes has made a big comeback because people realize that even though it is kind of loose and

it doesn‘t cross all the ―t‖s and dot all the ―i‖s, it seems to have more of a grasp of what is going

on in the economy.

In the fall, you wrote a big piece in The New Republic in which you declared yourself to be a

Keynesian. What was the reaction to that article?

I haven‘t got much of a reaction from my colleagues. Bob Barro (a conservative economist at

Harvard) sent me an email in which he referred me to an early article of his. It was a good article.

I think there is a question of whether modern economics, including Chicago economics, is too

formal and too abstract. Another question is whether modern economists have lost interest in or

feel for institutional detail that might be very important. I don‘t know how many of these

economists really knew anything about how modern banking operates, how the new financial

investments operate—collateralized debt obligations, credit default swaps, and so on.

So modern economics is too formal, and it has lost interest in institutional reality: is that what

you are saying?

You don‘t want to characterize all of economics in that way. What we tend to think of as the

Chicago approach is great skepticism about government and faith in the self-regulating

characteristics of markets: that‘s the essential outlook of Chicago. In addition, there is the

increasing mathematization of economics. That is not necessarily Chicago-led. Chicago once

resisted that—people like Ronald Coase and George Stigler. Even Gary Becker—he‘s more

mathematical than they are, but he‘s not as mathematical as, say, M.I.T. and Berkeley

economists.

Modern economics is, on the one hand, very mathematical, and, on the other, very skeptical

about government and very credulous about the self-regulating properties of markets. That

combination is dangerous. Because it means you don‘t have much knowledge of institutional

detail, particular practices and financial instruments and so on. On the other hand, you have an

exaggerated faith in the market.

That was a dangerous combination.

But that is not all there is in economics. There is also behavioral economics, which has made a

lot of progress. It‘s about challenging the assumptions about markets because of human

irrationality. I don‘t much like it myself, because I think they are very vague about what they

mean by rationality. They use terms like ―fairness,‖ which are really contentless. But some of

their skepticism is warranted. And behavioral finance, I find very convincing. It‘s obvious if you

look at how people trade in markets: they are not calculating machines that flawlessly discount

future corporate profits.

I put a lot of emphasis on the Frank Knight (a famous Chicago economist who taught at Chicago

from the nineteen-twenties to the nineteen-sixties) and Keynes view of uncertainty. That makes

economists very uncomfortable, because it is very hard to model. Once you introduce

uncertainty, it means that a lot of consumer behavior is not going to be easily modeled as cost-

benefit analysis.

In that sense, then, your version of Keynesianism is what some professional economists would

refer to as “Post-Keynesianism”?

Yes. I‘ve read Davidson. (Paul Davidson, a professor at University of Tennessee is a leading

post-Keynesian.) I‘ve read some of those people. But I don‘t really get much out of it that isn‘t in

Keynes. I‘m kind of stalled in the General Theory and his essay in the Q.J.E. (In 1937, a year

after the publication of The General Theory of Employment, Interest, and Money, Keynes wrote

an expository article in the Quarterly Journal of Economics.)

So, in sense, you see yourself reviving an older Chicago tradition—Knightian economics—which

in some ways is closer to Keynes?

Not only that, but there is a curious link between Keynes and Coase, even though they are at

opposite ends of the political spectrum. I never heard Coase mention Keynes, but I am sure he

would have regarded him as a dubious left-wing character Coase is very, very conservative. But

they are very similar in their informality. Coase was always saying that he didn‘t believe in

utility maximization. He didn‘t believe in equilibrium. Both of them, they are not concerned with

the kind of axiomatic reasoning where you start with human beings assumed to have rational

calculators inside them. They are much more likely to take people as they are.

And Knight was not at all a formal economist. His book ―Risk, Uncertainty, and Profit,‖ I read it

for the first time. It really was excellent. There‘s no math. Coase in his later work: no math.

Keynes in the General Theory: some math, but it‘s not central to his argument.

Do you regard yourself as an economist?

No. (Smiles) I‘m not a professional economist. I don‘t have any economics training. But I‘m

interested in it. I‘m not bashful about writing about it.

You’ve received some criticisms from professional economists—from Brad De Long, of Berkeley,

and from others.

Yes. These people are impossible. I haven‘t read (DeLong‘s) academic work, just his blog. His

criticism of me was crazy. He had me fighting a last-ditch stand for Chicago—the exact opposite

of what I wrote.

It does bother me about economists—not just (Paul) Krugman and De Long; it‘s not just a liberal

versus conservative thing. Some conservative writing bothers me also. They are not at all

reluctant about taking extreme positions in an Op-Ed, or in blogs, and so on. It really demeans

the profession. Krugman is obviously a good economist. He‘s got this book, ―The Return of

Depression Economics.‖ It‘s very good...But his column for The New York Times is really

irresponsible, nasty. Sometimes on his blog he makes accusations. In one of his columns, he

suggested that conservatives were traitorous. He used the word ―treason.‖ I‘m bothered by that.

If you have a very politicized academic profession, you lose your confidence in their objectivity

Well, some Chicago economists also express very strong views. John Cochrane (a professor at

Chicago’s Booth School of Business) for example, says that government stimulus programs don’t

have any impact at all on unemployment and G.D.P.

That‘s another reason to be distrustful of the profession. You have irresponsible positions about

the stimulus on both sides. What are people supposed to believe?

Has your critique of the efficient markets hypothesis made you rethink your view of markets

outside of finance?

Even before this, I had become less doctrinaire about markets. For example, one of the topics

Gary Becker and I debated on our blog was New York City‘s ban on transfats. I supported that.

The country has an obesity problem. I didn‘t think that just listing the amount of transfats on a

menu would deal with it—people don‘t know this stuff. I thought a ban, even though it violated

freedom of contract, made sense.

What has been Becker’s reaction to your views?

You mean about the economy, about Keynes. I think he disagrees. We had a debate before the

university women‘s board some months ago. He‘s very down on the stimulus. Some of the things

we agree about. I thought the cash-for-clunkers program was quite pointless.

Now that we appear to be coming out of the recession, the right is saying things aren’t too bad

after all, and that markets are resilient. The left is saying without government intervention we

would be back in the nineteen-thirties. What do you think?

It depends what you mean by government intervention. If the government had limited itself to

reducing the federal funds rate and had not bailed out the banks, we could easily have gone down

the route of the nineteen-thirties. On the other hand, if there had just been a bank bailout and no

stimulus, then, no, we would not have gone down as far as the nineteen-thirties, because the

economy is different now. In particular, (there‘s been) the shrinkage of the construction and

manufacturing industries. That is where unemployment was highest in the Depression. And we

have the automatic stabilizers—unemployment insurance, and so on. It wouldn‘t have been as

bad, but it could have been considerably worse without the stimulus. You can never be certain

how far down an economy will spiral.

After all the federal government has done, does the amount of public intervention in the economy

not worry you?

I think it is worrisome. A lot of things they have done, I don‘t approve of. I don‘t like the idea of

taking an ownership stake in General Motors: I think that‘s very bad. I don‘t like this messing

with compensation: that‘s unhealthy. And I‘m particularly concerned about the deficits, and what

health reform will do to what are already massive deficits. So I don‘t think the government‘s

handling of this has been flawless, by any means. But I think the stimulus probably was

essential.

As a result of all that has happened, what has the economics profession learned?

Well, one possibility is that they have learned nothing. Because—how should I put—it market

correctives work very slowly in dealing with academic markets. Professors have tenure. They

have a lot of graduate students in the pipeline who need to get their Ph.Ds. They have techniques

that they know and are comfortable with. It takes a great deal to drive them out of their

accustomed way of doing business.

Robert Lucas takes a very hard line on this. He says the theory of depressions is something

economics isn‘t good at. He hasn‘t been doing depression economics, so he‘ll stick with what

he‘s doing and unapologetically.

But isn’t Lucas still offering policy advice on the basis of his theories?

Yes, he is occasionally. But he‘s a real academic. He‘s content with his academic career and his

models and so on. And it isn‘t very clear what replaces his modern vision. It isn‘t as if there is a

school of economics that has great ideas and techniques for dealing with our economic situation.

What about Chicago economics in particular? At this stage, what is left of the Chicago School?

Well, the Chicago School had already lost its distinctiveness. When I started in academia—in

those days Chicago was very distinctive. It was distinctive for its conservatism, for its 1968

fidelity to price theory, for its interest in empirical studies, but not so much in formal modeling.

We used to say the difference between Chicago and Berkeley was Chicago was economics

without models, and Berkeley was models without economics. But over the years, Chicago

became more formal, and the other schools became more oriented towards price theory, towards

micro. So, now there really isn‘t a great deal of difference.

Ronald (Coase) is alive, but he‘s very, very old. He‘s not active. Stigler is dead. Friedman is

dead. There‘s Gary (Becker) of course. But I‘m not sure there‘s a distinctive Chicago School

anymore. Except there are probably a higher percentage of conservative people here, but not all.

Jim Heckman—not particularly conservative at all. He‘s very distinguished. Steve Levitt—he‘s

very famous. I don‘t think he‘s conservative. You‘ve got people like (Richard) Thaler. So

probably the term ―Chicago School‖ should be retired.

There were people—people like Stigler and Coase, Harold Demsetz, Reuben Kessel, and people

at other schools like Armen Alchian. They were people rebelling against the very liberal

economics of the nineteen-fifties—very Keynesian, very regulatory, very aggressive anti-trust,

little faith in the self-regulating nature of markets. Francis Bator, who‘s a very distinguished

Harvard economist, he wrote a famous essay entitled ―The Anatomy of Market Failure.‖ And he

gave so many examples of market failure that you couldn‘t believe a market could exist. You

have to have an infinite number of competitors, full information, you can‘t have any economies

of scale, and so on. It was too austere. That was what the Chicago people, with their more

informal approach, rebelled against. So we had our moment in the sun, but by the nineteen-

eighties the basic insights of the Chicago School had been accepted pretty much worldwide.

Where the divide continues is in macro—in business cycle economics. That‘s where you have

these very liberal people at Berkeley, Harvard, M.I.T., and so on, and very conservative people

like Lucas, Fama, and so on, in Chicago.

You are famous for extending economic analysis, and a free-markets approach, to the law. Has

the financial crisis undermined your faith in markets and the price system outside of the financial

sector?

No. But of course one of the more significant Chicago (positions) was in favor of deregulation,

based on the notion that markets are basically self-regulating. That‘s fine. The mistake was to

ignore externalities in banking. Everyone knew there were pollution externalities. That was fine.

I don‘t think we realized there were banking externalities, and that the riskiness of banking could

facilitate a global financial crisis. That was a big oversight. It doesn‘t make me feel any different

about the deregulation of telecommunications, or oil pipelines, or what have you.

Talking of banking externalities, isn’t that an application of traditional price theory? Going back

as far as Pigou, economists have talked about externalities in many parts of the economy.

There‘s nothing inconsistent with basic economic theory in externalities. Of course, you have to

know a lot about banking, and that was not the case with economists. Odd in a way, because

macroeconomists and finance theorists have always been interested in banking, but I don‘t think

they really understood a lot about it.

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I am pleased that Posner has read what I (Davidson) wrote. Yes P{osner is correct that I have

used Keynes as the basis for my analysis of uncertainty and Post Keynesian theory. When

Keynes wrote, unfortunately, the theory of stochastic probability theory [ ergodic theory] had not

been developed in the English language. Thus Keynes‘s uncertainty is not terchnically defined

and can easily be thought to be the same of Knight‘s concept of uncertainty – but they are quite

different. Knight is using an epistemological definition of uncertainty, Keynes has an ontological

uncertainty concept. This makes a big difference in understanding how financial institutions and

money contracts, especially loan contracts i.e., leverage making contracts, affect financial crisis.

What I have done was to use technical language to show Keynes‘s general theory rejects several

axioms that underlie classical theory. The Classical theory's ergodic axiom underlies Friedman‘s

monetarism, Lucas‘s rational expectations, , andthe laissez-faire economic philosophy Fama‘s

efficient market theory. An axiom is defined as a universal truth that needs not be proven.The

ergodic axiom presumes that the same probability distribution that governed past economic

outcomes governs all future outcomes. Thus, given the ergodic axiom, the future is statistically

predictable– and rational decision makers know (in the actuarial sense at least) what the future is

when they make a decision today. Thus, a rational economic person would never sign a loan

contract unless he/she ―knew‖ they could service this debt within their known future income and

budget constraints. In a classical theory, there can never be a default by optimizing rational

people, there can be no foreclosures, and no insolvencies. Hence the theories based on the

ergodic axiom cannot develop a useful policy to solve these financial systemic problems when

they occur in the world of experience. Keynes rejected the ergodic axiom as a basis for his

general theory. Thus, in his general theory, there need not exist any current objective probability

distribution that decision makers ―know‖ will govern future outcomes. Without going into

details, Knight‘s unique events that cause uncertainty is the equivalent of Taleb‘s black swan –

an occurrence that occurs in an ergodic system but that will have a very low, but still fixed

probability , of occurrence. So with a big enough sample one can predict the existence of a black

swan financial disaster in a Knight system. In a nonergodic system there is no probability (as

Keynes stated in his 1937 article) on which to estimate future outcomes. Thus the necessity to

seal economic transaction with monetary contracts that FIX payments into the future!

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