Thursday, July 17, 2008

Turning Points in Intellectual History

To illustrate the rise of the Chicago School of economics, people often contrast Richard Nixon's 1971 statement, "We're all Keynesians now," with Bill Clinton's 1996 statement, "The era of big government is over." The former is supposed to represent the pinnacle of Keynesianism's influence; the latter is supposed to represent the pinnacle of (or at least the recognized dominance of) the Chicago School's influence. It's a neat little narrative, but is it accurate? On the macroeconomic side, the central clash was between traditional Keynesianism and monetarism. To simplify quite a bit, traditional Keynesian economists believed that policy should be expansionary during recessions, and emphasized the importance of fiscal policy in boosting short-run aggregate demand; monetarists emphasized the importance of monetary policy in the short-run, but believed that monetary policy should set a fixed rate of growth in the money supply. The Fed played around with some monetarist ideas in the early 1980s, but quickly abandoned them. Modern macroeconomics represents a mix of Keynesian and monetarist ideas. Strict monetarism has been discarded: discretionary monetary policy has been curtailed, but not eliminated. In short, we're all faint-hearted Keynesians and faint-hearted monetarists now. Clinton's 1996 statement that "the era of big government is over" didn't signal the end of Keynesian economics. Clinton's 1996 statement did, I think, signal the pinnacle of the Chicago School in microeconomics. To me, the starting point for this Chicago School was Ronald Coase's 1960 article, The Problem of Social Cost, which established the Coase theorem. Before Coase's article, the mainstream school of thought on externalities was dominated by Arthur Pigou's welfare economics. Pigou advocated government interventions to internalize externalities—most notably, taxes on negative externalities, and subsidies for positive externalities. (Hence the term, "Pigovian tax.") Coase, however, showed that under certain assumptions—most importantly, well-defined property rights and zero transaction costs—parties would internalize externalities through private bargaining, without government intervention. The idea that market failures should be remedied without government intervention is central to Chicago School economics. Coase's landmark article, in my mind, was the liftoff point for the Chicago School. This is always the way I've seen it in my head. Is my intellectual history wrong?

6 comments:

Gabriel said...

A few points:

1) I wouldn't say that the so-called monetarist experience was particularly monetarist... Se, for example:

The U.S. Monetary Experience of 1979-1982
http://economistsview.typepad.com/economistsview/2008/07/the-us-monetary.html

2) Coase's work is not necessarily a call for smaller government: instead of calling for big government taxing stuff (Pigou), it called for big government being careful about allocating property rights.

3) Some of the less controversial achievements of the Chicago school:

* Flexible exchange rates;

* Futures markets;

* IO and Regulation (in its day);

* Partial equilibrium/applied welfare analysis... the Chicago "Price Theory" tradition.

Lastly, they kept the belief in the market system, including in its potential for self-stabilization, when people were giving up on it for various reasons.

We should remember the Keynesians' calls for price controls and other similar crimes (mostly inability to deal sensibly with inflation), not only their (arguably) more succesful policy proposals, IMHO.

Anonymous said...

See Sam Bowles ("Microeconomics") and D. McClosky on misinterpretation of Coase.

--MaxSpeak

Economics of Contempt said...

Gabriel: Thanks for the link to the article on the Fed's monetarist experience. I read a similar account of that time period many, many years ago; but over time, as people casually stated that the Fed adopted monetarism and then abandoned it, I eventually forgot that the Fed wasn't particularly monetarist after all. Argument by repetition, I guess. I needed the reminder!

MaxSpeak: I realize that Coase is often badly misinterpreted, especially by the Chicago School, but that's kind of beside the point. Coase's article was the launching point for the Chicago School, whether their interpretation of Coase was correct or not. Sad but true, I'm afraid.

Also, I've actually read (almost all of) Bowles' Microeconomics. I was warned beforehand that it was one of those "crazy heterodox" books, but I found it distinctly uncrazy. I didn't always agree with it, but it was definitely a worthwhile contribution. Assigning portions of it to econ students wouldn't really be as "dangerous" as some professors seem to think.

Patrick R. Sullivan said...

I first opened an economics text in 1966, and, as far as I can remember, Coase had exactly zero impact on that book. Milton Friedman was treated as a kind of charming eccentric; amusing, but not relevant to modern economics.

Without Friedman's persistence in arguing against the neo-Keynesian consensus, and being there with a counter argument to the 1970s troubles, few would know of the Chicago School. And, my dear friend Brad DeLong seems to agree:

The importance of analyzing policy in an explicit, stochastic context and the limits on stabilization policy that result comes from Friedman (1953a). The importance of thinking not just about what policy would be best in response to this particular shock but what policy rule would be best in general--and would be robust to economists' errors in understanding the structure of the economy and policy makers' errors in implementing policy--comes from Friedman (1960). The proposition that the most policy can aim for is stabilization rather than gap-closing was the principal message of Friedman (1968). We recognize the power of monetary policy as a result of the lines of research that developed from Friedman and Schwartz (1963) and Friedman and Meiselman (1963). And a large chunk of the way that New Keynesians think about aggregate supply saw its development in Friedman’s discussions in Friedman (1970) and Friedman (1971a).

Thus a look back at the intellectual battle lines between "Keynesians" and "monetarists" in the 1960s cannot help but be followed by the recognition that perhaps "new Keynesian" economics is misnamed. We may not all be Keynesians now, but the influence of "monetarism" on how we all think about macroeconomics today has been deep, pervasive, and subtle.

The form of "monetarism" that has had a profound and deep influence on macroeconomics today was Milton Friedman's monetarism. It either emerged as a natural evolution from the old oral Chicago monetarist tradition of the Great Depression era (according to Friedman, 1974) or sprang full-grown like Athena from Milton Friedman's brain (according to Patinkin, 1972, and Johnson, 1971). This classic form of monetarism as laid out in Friedman's classic Essays in Positive Economics, Studies in the Quantity Theory of Money, A Program for Monetary Stability (see Friedman, 1953b, 1956, 1960, 1968) contained a number strands of thought that have proven remarkably durable.

Economics of Contempt said...

Patrick,

I'm not surprised that Coase had very little impact by 1966. I wouldn't expect the ideas in The Problem of Social Cost to immediately spring into dominance. It takes time for a new theory to displace an old one (IMHO, due to sheer intellectual inertia). Prior to Coase, the thinking went: "Market failures cause externalities, so we must use government to fix them." But after Coase, the thinking went: "Market failures cause externalities, but with well-defined property rights, the market will probably solve the problem itself." I think that's a powerful transformation from an ideological standpoint. Of course, it's a distortion of what Coase actually said, but it's a concept that nevertheless stands at the heart of the Chicago School approach to microeconomics.

The passage from DeLong is interesting, and it seems to confirm my position that there wasn't an end to the Keynesian era and a beginning to the Chicago School era in macroeconomics. There was just a slow blending of the two schools. That's why I think it's stupid to cite Bill Clinton's statement that "the era of big government is over" as marking the end of the Keynesian era.

Journalists love simple and easily digestible narratives like, "in 1971 we were all Keynesian, but by 1996 we were all Chicagoans." So I'm not holding my breath for an accurate description in the press!

PENNY STOCK INVESTMENTS said...

Theirs always a turning point.