Sunday, January 17, 2010

Chicago School interviews

The classic Chicago School macroeconomic theories, pioneered by the likes of Milton Friedman, George Stigler, Robert Lucas, Gary Becker, and Eugene Fama, assume that human beings can act with near complete rationality, are capable of making optimal decisions by processing a load of information, and respond to government policies by forming expectations about the future. Its implications, as popularized by followers among politicians and policy makers, are two-fold

1. The invisible hand of the market, working to co-ordinate the rationally-directed actions of utility (or profit) maximizing and self-interested individuals (or firms), is the most effective administrator of the economy. This conclusion takes different forms - people respond to incentives, markets are efficient, markets discover prices correctly, prices are the most efficient signaling mechanism, markets allocate resources most efficiently, markets can regulate themselves, and markets are capable of repairing themselves. Taken to its extreme, this ideological trend manifests itself in a blind faith in the superiority of markets to not only achieve outcomes, but also address problems in the economy and financial markets.

2. No government policy can co-ordinate actions of individual market actors more efficiently than the mechanisms of the market. This in turn means that governments should stay away from intervening in the markets and (again taken to extremes) should restrict themselves to maintenance of law and order, providing national security and dealing with international relations, and issuance of currency. This manifests in a visceral opposition to the government's role in delivering goods and services and even regulating the markets, and a nagging suspicion of the intentions of all government actions.

John Cassidy's superbly broad sweep of the history of modern economics and finance, How Markets Fail: The Logic of Economic Calamities, is one of the best accounts of the ideological trends that caused the latest example of market failure. He also has an article and a series of interviews with the Chicago School economists to explore their perspectives on the current crisis.

Richard Posner agrees that though the Chicago School's macroeconomic positions have taken a major hit (eg. Friedman's monetary policy theories have been found completely blunt in the face of the zero-bound), there appears to be no serious introspection. He blames the isolation of the Chicago School on the excessive use of mathematics and models, and the consequent glossing over of uncertainty, imperfections in markets, irrationality of market actors, and the specific institutional details of particular markets.

Eugene Fama defends his efficient market hypothesis ("prices of financial assets accurately reflect all of the available information about economic fundamentals") and feels that it came out well during the crisis. He also rejects concepts like bubbles as having no meaning, atleast ex-ante, and being a post-facto rationalization of financial market events. He also rejects the explanation that there was a credit bubble due to a massive mis-allocation of resources by the market, and argues that it was a plain economic crisis where economy entered a recession (for whatever reason) and people defaulted on their mortgages (and thereby triggered off the financial crisis). He feels that all the boom in asset market prices and flow of funds into these sectors were an inevitable prelude to a recession. "The financial markets were a casualty of the recession, not a cause of it".

He feels that the solution to addressing the TBTF problem is to have higher equity capital requirements. He also feels that the government erred in stepping in too quickly and aggressively with its bailouts, and should instead have let institutions fail and then markets would have themselves cleared up the mess in one or two weeks. Fama argues that the moral hazard implicit in the strong possibility of government bailouts distorted incentives and made firms assume unsustainable risks.

John Cochrane is as unapologetic as ever and defends both efficient market (stock "prices today contain the available information about the future") and rational expectations hypotheses, and rejects government stimulus spending as contractionary. He rejects bubbles as a deviation from efficient market hypothesis and claims that attitudes to risk vary over time and this is consistent with an efficient-market equilibrium. He also blames government actions - federal government guaranteed mortgage institutions, Obama administration's scare mongering after Lehman fell, knee-jerk bailouts of big institutions like Citi through the TARP, poor enforcement of existing regulations, etc - for much of the crisis. He makes the point that there are no dangerous or TBTF institutions, but only dangerous contracts, and regulation should focus on separating the normal banking activities from the gambling part and then supervising the gambling activities.

Gary Becker accepts that though the free markets did not do a good job during the present crisis, they "generally do a good job", atleast better than governments. "They are not perfect, but governments do a worse job... markets are more efficient than any alternative." However, he concedes that in certain situations, as now, governments should step in aggressively and he therefore supports many of the bailout actions that helped prevent a slippage in a deeper recession. He feels that Chicago economists continue to be relevant and they are characterized by a greater skepticism of governments and the central role attributed to incentives in determining individual (and firm) behaviors. He also favors greater regulation of the financial markets, including larger capital requirements for the TBTF firms and forcing the shadow banking system into organized and transparent contracts.

James Heckman feels that Chicago still continues its relevance in the form of the critical importance of incentives in shaping individual and firm behavior and designing policies. He however agrees that Chicago economists stretched both the efficient market and rational expectations theories too far and in the process distorted it.

Raghuram Rajan favors government regulating bank pay by making all payment above a certain limit with equity (and not shares, where they buy back a certain amount of shares and then give it to the employee, so as to not dilute equity) and forcing higher capital requirements. He argues that given the large amounts of "organizational and relationship capital embedded in the banks", it may not be advisable to let them, at least the larger ones, fail, and that they may take much longer to regenerate and with unacceptably higher costs. He however does feel that the bailouts were too easy and the government could have been tougher with the firms and extracted a higher price for the guarantees and capital injections. He also concedes that we may not have learnt all the required lessons from the crisis and incorporated the desired regulatory and other response mechanisms in place to prevent a similar recurrence in future.

Kevin Murphy feels that efficient market hypothesis is very much alive in so far as "you can't beat the market or predict it" and time varying risk premiums (or irrational exuberance) makes prices depart from fundamentals and causes bubbles. He also defends his opposition to the stimulus spending proposals of the Obama administration on the grounds 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 "the government wouldn’t spend the stimulus money wisely, and that much of it would be wasted".

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