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Chicago School of economics post-crisis

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Kai Ryssdal: The recession that we are just now beginning to work our way out of has been miserable for a huge chunk of the economy. For economists, though, it’s literally been a once-in-a-lifetime chance to see how some of the dominant theories in the dismal science hold up in reality.

There are, in essence, two of those theories. One based on the ideas of John Maynard Keynes. The other popularized by Nobel prize winner Milton Friedman and named after the university where he taught: the University of Chicago. The Great Recession of ’08-’09 has exposed some weaknesses in Friedman’s ideas. And in the most recent issue of The New Yorker magazine staff writer John Cassidy explores the decline and fall of the Chicago School of economics. When we talked I asked him if he would start with a little primer.

JOHN CASSIDY: The basic idea of Chicago School economics is the free market left to its own devices works well, so it doesn’t need much government intervention, and indeed, government interventions if they are put into effect will tend to go wrong.

Ryssdal: And in the magazine this week you profile a guy named Richard Posner. He’s a federal judge in New York, and he is, as you say, a convert now. He says it doesn’t work anymore, basically.

CASSIDY: Richard Posner is one of the most famous members of the Chicago school. He was largely responsible for growing the law and economics movement, which has helped populate a lot of American courtrooms with conservative judges and with judges who take free market economics very seriously. Last year, in the wake of the financial crisis, Judge Posner had a conversion, and went from being a sort of standard Chicago school economist to being a Keynesian.

Ryssdal: When you say Keynes, it’s John Maynard Keynes. Explain briefly what it was that he said.

CASSIDY: In the free market view of things, economies are naturally self-correcting. If a recession starts, it will quickly bounce back, and unemployment won’t go up very high, won’t stay very high. Keynes said no, that’s not true. Because of a variety of reasons, economies can get stuck in a recession, and you can have high unemployment for years on end and things can feed on themselves. So in order to avoid that outcome, he said government needs to step in and spend money.

Ryssdal: Well, make the connection for me, though, between the efficient markets theory and regulation and the attitude toward the markets in Washington.

CASSIDY: Well, the efficient markets hypothesis, although it’s sort of obscure economic theory in one sense, also had a very practical impact in that it underpinned a lot of the deregulation in the 1990s and 1980s. The basic idea behind that deregulation was that financial markets, if you left them to their own devices, wouldn’t depart from economic fundamentals. Prices in the market would reflect what companies are really worth, or in the housing market, what houses are really worth. There wouldn’t be any speculative bubbles for example. That’s what Alan Greenspan said, that’s what Bob Rubin, and Larry Summers said when they were Treasury secretaries, and it justified a whole range of deregulatory measures taken to allow banks and investment banks to get together and invest in all sorts of securities, such as credit default swaps, subprime mortgage securities, all these things we’ve heard a lot about in the last few years. Turns out, however, markets aren’t always efficient. Twice in the last 10 years we’ve had enormous speculative bubbles.

Ryssdal: You spent a lot of time out in Chicago, it’s clear in that article, and you talk to a bunch of people. Relate for us what they said when you went out to these Chicago school people and said, hey, what sense do you make of the last two years in this market, if you believe that the market knows everything?

CASSIDY: The reactions really were across the board. Some of the people I spoke to said look, this is just a one off, it doesn’t invalidate the general idea that markets work well and that financial markets work well. Other people, such as Gary Becker, who is one of the Nobel laureates of Chicago, said no, it’s more serious than that, markets aren’t always efficient. And we have to rethink that side of things. If we go back to the two notions of Chicago economics, one that the market always works well, and one that the government always works badly. The first one has sort of gone out the window, but they do tend to fall back on the second idea that that doesn’t mean that governments will do any better.

Ryssdal: You point out in your piece that really a lot of the heat of the moment of the financial crisis is what drove people to reexamine their ideas of models of economics. And now a lot of that heat, frankly, has kind of dissipated.

CASSIDY: Right, well, actually one of the things which Gary Becker said to me was that about a year ago he thought there would be a complete revolution in economics, but twelve months later the economy looks more healthy than it did a year ago and the sort of urgency of the debate has gone out of it a bit, and he thinks there will be some moderate changes to economics but there won’t be a whole new paradigm.

Ryssdal: Safe to say though it will be more nuanced, it won’t be all black and white.

CASSIDY: You would hope so. One would hope that things would be more nuanced. But you never really know in economics. There could be some new genius out there somewhere who comes up with a theory, which everyone buys into. I tend to think that that’s unlikely, but you never know.

Ryssdal: John Cassidy. He’s a staff writer for The New Yorker magazine. His new book is called “How Markets Fail.” Mr. Cassidy, thanks so much for your time.

CASSIDY: Thank you.

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