Gimme some of that old-time Chicago insularity (or not)

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When I interviewed Milton Friedman for my book back in 2004, I asked him at one point what he thought of behavioral economics.

“Oh, it’s great,” he said. I was surprised. Milton Friedman had been following the research being done by Dick Thaler and Colin Camerer and David Laibson and a zillion others working along the borders between economics and psychology and neuroscience?

No, it turned out. He hadn’t. What he understood as behavioral economics was the work done decades before by his former Chicago student Gary Becker, who used the techniques of neoclassical economics to examine areas of human behavior previously not on the economists’ radar screens (as Steven Levitt would be the first to tell you, Becker was the original freakonomist).

Friedman was 91 years old at the time, so the fact that he wasn’t up on the latest literature was understandable. I imagine he would have liked the fact that behaviorist research had confirmed something that he and statistics legend Jimmie Savage wrote a famous paper about in 1948: People don’t trade off risk and reward in a smooth, consistent way but instead make very different decisions about different sorts of gambles (that is, they buy both lottery tickets and insurance policies).

Still, there was something about the insularity of Friedman’s response that made me think of it again today when I read Arnold Kling’s post “pointing out the vapidity of” one of Chicago finance legend Gene Fama’s first forays into blogging:

Basically, Fama says that national savings equals national investment. So, if the government deficit goes up and private saving is unchanged, then investment must go down. Therefore, the argument runs, a government deficit crowds out private investment and does not raise output.

That story holds for an economy that is always at full employment. However, if the economy were always at full employment, then hardly anyone would have heard of a fellow named John Maynard Keynes, and we would not be talking about the issue of an economic stimulus. …

The Keynesian story is not without its problems. As David Henderson has pointed out in a couple of recent posts here, and as I pointed out at greater length in my lectures on macroeconomics, the simple Keynesian model is “priceless” in that it acts as if the usual economic adjustment mechanism, most notably the response to prices, does not work.

If Fama wants to make these sorts of criticisms, or add his own criticisms, that would be fine. But to just pretend that full-employment economics is the only economics and ignore Keynes completely contributes nothing to our understanding.

Now Fama is actually one of the heroes of my book, because he didn’t shy from digging up data that disproved his original efficient market hypothesis. But I think Kling’s criticism is right. The form of Fama’s piece is: Here’s this theory of how the world works (and I’m going to completely ignore the fact that there are other well-established theories and a whole lot of data that contradict it).

This insular approach has long been characteristic of Chicago economics and finance, and actually helps explain their spectacular rise in influence from the 1950s through 1980s. For most of that time the Chicagoans were well aware that there were other theories out thereā€”in fact, the other theories (Keynesianism, mainly) were totally dominant in Washington and most of academia. So it made sense for them to stick to their own elegant story of how the economy worked and not muddle it with a lot of back and forth with the other side.

But since the Chicago revolution (counterrevolution, really) began to succeed in the 1970s, this attitude has become problematic. The center of academic economic gravity shifted to Cambridge, Mass., by the late 1970s, as MIT, Harvard, and the newly relocated National Bureau of Economic Research cobbled together a new mainstream that incorporated some Chicago insights but left more room for doubt and debate and evidence. And now that many of the economic arguments made at Chicago over the years seem to be falling definitively out of fashion (or at least going on a deep-discount sale) in the broader marketplace of ideas, it leaves the dyed-in-the-wool Chicagoans (to be distinguished from economists and finance professors who happen to teach at Chicago, a more intellectually diverse group) with a choice.

They can either pretend that nothing has changed, as Fama does in his blog post and as younger Chicago economist Casey Mulligan seems to like to do, or they can take other arguments seriously and address them. I’ve noticed Bob Lucas and Gary Becker taking baby steps toward the latter approach lately. Good for them.