After The Blow Up Chicago School

1he New YorkerJanuary JJ, 20
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Some isitors to the Lerett M. Dirksen United States Courthouse, in dow
others leniency. I went looking or apostasy. Ater passing security and riding
shown into the chambers o Judge Richard A. Posner, the amously proliic ju
who or decades has been a leading igure in the conseratie Chicago Schoo
leather soa that aorded him a gull's-eye iew o Lake Michigan, Posner held
in 200, and the ailure o many economists to oresee it. In a sot oice, he
proession as a whole but to Chicago most o all"
A lawyer by training, Posner is also one o the country's most inluential e
"Lconomic Analysis o Law`, he applied the maxims o ree-market econom
economic eiciency ought to be a primary goal o judges. Posner, who was t
Chicago Law School, helped create the law-and-economics moement, which
judges o similar mind. In 1981, Ronald Reagan nominated him to the Seen
has written more than two dozen books, including one deending the 2000 S
Bush the Presidency.
Larlier this year, Posner published "A lailure o Capitalism" in which he
helped bring on the current slump. \e are learning rom it that we need a m
our model o a capitalist economy rom running o the rails," Posner writes,
industry went too ar by exaggerating the resilience -- the sel-healing powers
accuses proessional economists, including some o his Chicago colleagues, o
came out as a Keynesian, in a long piece in %be ^er Revbtic, he hailed 1he G
Money," which John Maynard Keynes published in 1936, as a "masterpiece,"
guide we hae to the crisis."
As acts o betrayal go, this was roughly akin to Johnny Damon`s shaing o
joining the \ankees. Ler since Milton lriedman, George Stigler, and others
orties and ities, one o its goals has been to displace Keynesianism, and it h
the Second \orld \ar, economics was dominated by Keynesian ideas about
iscal policy to preent slumps. Since 194, howeer, more than a dozen sch
awarded the Nobel Memorial Prize in Lconomic Sciences, in the areas o re
rates and welare, Chicago thinking greatly inluenced policymaking in the U
Keynes appeared to hae been consigned to history.
But in the year ater the crash Keynes`s name appeared to be eerywhere,
policymakers again embraced his ideas. Until the banking crisis erupted, Posn
1heory.` \hen he picked it up, he was greatly impressed by the economic in
though is kind o loose-it doesn't dot all the i`s and cross the 't's," Keynesia
what is going on in the economy," Posner said to me. Much o modern econo
mathematical, and, on the other hand, ery .. credulous about the sel-regul
dangerous.`
In "A lailure o Capitalism," Posner singles out seeral. economists, includ
eminent successors, and John Cochrane, another prominent Chicago econom
subprime crisis. During our con-ersation, Posner questioned the entire meth
pioneered. Its basic notions were the eicient-market hypothesis, which says
assets accurately relect all the aailable inormation about economic undame
which posits that indiiduals and irms are hyper-intelligent decision-makers w
their heads. In rational-expectations theory, the economy is rep-resented in e
including some relied on by the led and other central banks, don't een eatu
Posner's iew, older, less dogmatic theories better ex-plained how the problem
o the economy.
"O course, you hae to know a lot about banking, and that was not the case,
because macroeconomists and inance theorists hae always been inter-ested
understood a lot about it`
Although Posner was unailingly polite, I detected an edge o anger in his
its embrace o such patently unrealistic theories. I asked what he thought eco
\ell, one possibility is that they hae learned nothing,` he replied slowly. "B
correcties work ery slowly in dealing with academic markets. Proessors ha
the pipeline who need to get their Ph.D.s. 1hey hae techniques that they kno
to drie them out o their accustomed way o doing business."
Ater leaing Posner`s oice, I droe south to the Uniersity o Chicago's
century has been a thriing hub o conseratie thought and disputation, hou
acolytes in political philosophy, Albert \ohlstetter and his ellow Cold \arri
Lpstein, and others in law. 1he archetypal Chicago intellectual -- embodied b
political philosophy who appears in Saul Bellow's 2000 noel o the same nam
urgent engagement in current aairs. Last all, as the inancial crisis intensiie
research to concentrate on the moment. "Lerybody here was blindsided by t
leckman, whose work on labor economics and statistics won him a share o
just here. 1he entire proession was blindsided." Conerences were organized
were ull o igorous debate. One panel session at which hal a dozen promin
o Markets" drew more than a thousand people to a Sheraton downtown. "L
inance specialist at the uniersity's Booth School o Business, said. "Lerybo
prescriptions."
In the course o a ew days, I talked to economists rom arious branches
encountered put me in mind o what happened to cosmology ater the astron
the unierse was expanding, and was much larger than scientists had belieed
physicists stuck to the existing theories, which posited a stable unierse. Othe
old models to lubble`s data. Still others attempted to come up with a new ac
eort that ultimately produced the theory o the big bang.
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lama, whom I interiewed in his oice at the Booth School, was irmly in
with cropped hair and wearing a short sleeed lowery shirt, he looked more l
one o the ounders o modern inance. Beginning in the nineteen-sixties and
R. McCormick Distinguished Serice Proessor o linance, propounded the e
the deregulation o the banking system championed by Alan Greenspan and o
the recent crisis, which many, mysel included, hae described as an example
think it did quite well in this episode," he said, traces o his natie Boston aud
prior. to a recession and in a state o recession. 1his was a particularly seere
when people recognized that it was a recession and then continued to decline
markets are eicient".
1he emphasis that lama placed on the stock market surprised me. Surely,
which eentually had burst. "I don't know what a credit bubble means," lam
what a bubble means. 1hese words hae become popular. I don't think they h
became so tired o seeing the word "bubble" in %be covovi.t that he didn't re
entirely sloppy,` he went on. "People hae jumped on the bandwagon o blam
easily in which the inancial markets were a casualty o the recession, not a ca
1he crux o lama`s argument was that the economic slowdown predated t
job and income growth slowed, he said, some homeowners couldn't make the
borrowers who had taken out the riskiest mortgages. \ith delinquencies and
institutions that had inested heaily in subprime-mortgage bonds suered b
lending to others. "As a consequence, we had a so-called credit crisis,` lama
economic crisis."
lama`s story was logically consistent, but it appeared to contain a big gap.
recession, what did \hen I raised this question, lama laughed. 1hat's whe
"\e don't know what causes recessions. Now, I'm not a macroeconornist, an
again. "\e'e neer known. Debates go on to this day about what caused the
A theory o the economic downturn that relies on inexplicable gyrations in
but larna seemed content with it. le insisted that the real culprit in the mor
instructed lannie Mae and lreddie Mac to buy subprime mortgages and mor
that was not a ailure o the market," lama said. According to igures quoted
purchases accounted or less than a third o the subprime market at the heigh
inestors bought most o the subprime securities issued, and the two big goe
larms said simply, "low much does it take"
In addition to accusing the goernment o causing the subprime problem,
all's inancial crisis. Rather than bailing out A.I.G., Citigroup, and other irm
lederal Resere should hae allowed them to go bankrupt. "Let them all ail,`
ail. \e let \ashington Mutual ail. 1hese were big inancial institutions. Som
was not a lot o rhyme or reason to it." le conceded that the entire inancial
hut he expressed conidence that inestors and healthy banks would hae ste
irms, and that, within a week or two, the system would hae been operating
anyway, he said. "1he credit market stopped or vore than a week or two."
lama was no less genial on the subject o Posner. "le's not an economis
economics. \e are talking macroeconomics and inance." Len when I brou
eicient-markets thinking in a recent essay in the %ive. Magaive, lama`s equa
said. "I you are getting attacked by Ktugman, you must be doing something
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In the oice next to lama's, I encountered another true belieer, John Co
Cochrane, who happens to be lama's son-in-law, helped to organize a petitio
hundred-billion-dollar 1roubled Asset Relie Program, more than orty Chica
recent eents that would lead you to say markets are ineicient" he said to m
\e had the eents last September in which the President gets on the teleisio
collapse. On what planet do markets not crash ater that" Larlier this year, C
Obarna Administration's stimulus package lacked a theoretical basis. \hen I
reial, he insisted that Keynesian economics had been plagued or decades w
had done nothing to remoe. "\e threw it out or a reason," he said. "It didn
nineteen-seenties, that was a major ailure o Keynesian economics."
Ater talking to lama and Cochrane, I understood what Posner meant wh
their guns." ,Robert Lucas reused to see me, saying in an e-mail, "I don't wan
willingness to acknowledge errors and seek new ways orward. "1here are a lo
wrong, and Chicago got wrong,` Gary Becker, who won the Nobel in 1992, s
aternoon. "\ou take deriaties and not ully understanding how the aggrega
don't think we understood that, either -- at Chicago or anywhere else. Maybe
inancial sector went a little too ar, and we should hae required higher capit
Chicago. Larry Summers -- the larard economist, who is now President O
1reasury supported deregulation."
Becker is amous or extending economic analysis to areas such as educati
ar as to suggest that haing children is drien partly by inancial consideratio
three graduate courses, notes were piled up on his desk, next to a twenty-inch
that. \all Street inancial engineers deised a series o new instruments that n
understood. In the housing market, buyers had unrealistic expectations about
markets aren`t ully eicient," Becker said, with a wae o his hand. "But the
than any alternatie -- that aspect I don`t think is going to be changed." le a
other deeloping countries making any radical changes in their moements to
Unlike some o his colleagues, Becker beliees that the ederal goernment
crisis, both in extending trillions o dollars to rozen credit markets through t
banks. "I don't accept the iew that in this crisis we should just hae let eery
economy would hae picked itsel up, but it would hae been a much more s
Becker writes a popular economics blog with Posner, where the two o th
\hen I brought it up, Becker said that Posner wasn't the only apostate, the re
that ninety percent o economists had been Keynesians all along but had been
Posner and others had raised air critiques o Chicago economics: "Some o t
didn't turn out to be that useul in helping us to understand what to do to com
1hat sounded likes criticism o Lucas, whose oice was just down the ha
economy is sel-regulating. I in one period a shock -- a big rise in the price o
unemployment to rise, in the next period the economy automatically adjusts b
explanation or long stretches o mass unemployment, such as the Great Dep
paying jobs and preer to remain out o work In such a world, most orms o
\hen I asked Becker about Lucas, he said that his colleague had made "a ma
the economics Nobel in 1995,, but suggested that Lucas`s ollowers might ha
inancial sector, seeing money as being unimportant," he said. I think that st
leckman, one o ie current aculty members to win the economics Nobel,
methods, and he told me that lriedman, who died in 2006, had also been ske
recalled, he and lriedman took part in the oral examination o a Ph.D. candid
techniques, which were then sweeping the ield. In the course o the examina
"Look, I think it`s a good idea, but these guys hae taken it way too ar."
By Chicago standards, leckman is a centrist, his research on preschool ed
Democrats and Republicans, and during the 2008 Presidential election, the O
proposals. But, like most o his colleagues, he places a great deal o emphasis
about many goernment programs. "I think the underlying ideas o the Chica
base o the rocket is still intact. It is what I see as the booster stage -- the rati
o the eicient-markets hypothesis -- that has run into trouble. I think what
the data, and conronting theories with data. 1hat part o the Chicago traditio
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I the economic equialent o a big-bang theory is to emerge, it will almos
inested in the old doctrines than lama and Lucas. Ambitious tenure-track p
schools, are busy trying to incorporate into their theorizing preiously neglect
inancial-market bubbles, and credit crunches. 1his research presents a ormi
expectations models proed so alluring to economists was their tractability: w
could be "soled out" to generate explicit solutions or important economic
inlation. Adding institutional detail complicates things greatly, so does allow
oerconidence. "People say economics needs to incorporate the insights o'
thanks! I'e heard that rom Bob Shiller"- a well-known \ale economist, wh
Lxuberance"- "or thirty years. Do it! Let's see a measure o the psychologi
In the nineteen-sixties and seenties, Chicago economics was largely cut
Berkeley, rarely hired Chicago graduates, and Chicago returned the aor. 1od
many o Chicago's ideas hae been incorporated into mainstream thinking, an
1he most amous Chicago economist today is Steen Leitt, an M.I.1. Ph.D,
known or innoatie empirical studies o crime, abortion, and teacher peror
behaioral economics, which seeks to combine the insights o psychology and
iteen years ago, his oice is now around the corner rom lama`s. In the old
basically under attack the world oer. 1here was a type o bunker mentality. B
lama and 1haler maybe riendly -- the two occasionally play gol togeth
its atermath could hardly be more dierent. lama clings to the idea o eicie
past ten years the U.S. economy has experienced two ruinous speculatie bub
ameliorating them. I think we know what a bubble is," he said. "It's not that
be rich. But we can certainty hae a bubble warning system." Such a system w
such as price-to-earnings ratios or stocks and price-to-rent ratios or housing
went on, the goernment should rein in speculatie actiity, by, or example,
estate markets, "God did not say, '1hou shalt be able to borrow one hundred
1o 1haler, the key causes o the inancial crisis were high leerage and h
were taking out subprime-mortgage loans didn't know what they were doing,
understand what their traders were up to. "Go down the list-A.I.G., Citigro
companies were destroyed or deastated by a small part o the business that w
1he people in charge were greedy or stupid, or possibly both."
At Chicago and elsewhere, behaioral economists hae elucidated many
choice theories. So ar, howeer, they haen't conerted these insights into a
useul new economics will need to integrate an awareness o human with exte
mathematical expertise. In an oice a loor aboe lama's, I met with Raghura
scholar who is one o the ew economists who warned about the dangers o a
the led in 2005, he said that deregulation, trading in complex inancial produ
had greatly increased the risk o a blowup. Senior led oicials and other prom
Lawrence Summers said that Rajan's critical tone supported "a wide ariety o
Rajan, with his colleagues Douglas Diamond and Anil Kashyap, has or y
banking sector. 1he work o this group didn't attract much public attention, b
policymaking and other economists in analyzing the credit crisis and ormulat
supported. "Research dries thinking, and there is all sorts o research being d
lot o press -- people who say, Let`s not do anything, let`s liquidate`....1here
are others who understand that the banking system is a lot more important th
you can close down some banks without a problem, but there are some banks
option."
Rajan, who worked rom 2003 to 2006 as the chie economist at the Inter
inancial blowups in deeloping countries, where irresponsible macroeconom
capitalism -- banks extending reckless loans to inluential people -- oten disto
deelopment is that you deal with some o these problems," Rajan said. "\ou
don't hae banks going haywire.` In some ways, Rajan went on, the subprim
Asia and Latin America. "\ou can't pin it all on Greenspan," as many hae do
look more broadly at why it happened!'
In a new book he is working on, entitled. "lault Lines," Rajan argues tha
stagnant wages and rising inequality. \ith the purchasing power o many mid
liing, there was an urgent demand or credit. 1he inancial industry, with enc
by supplying home-equity loans, subprime mortgages, and auto loans. ,Notwi
ultimately a traditional Chicago argument: in response to changing economic
inancial products that people wanted., 1he side eects o unrestrained cred
possibility that most economists had ailed to consider. "1he ault o the econ
expectations, which is a conenient and useul deice," Rajan said. "It was to
to do that or a long time because the plumbing didn`t backup. Now that the
aren't really made in a pure, pristine market. 1hings can break down."
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1wele months ago, it appeared that history had turned against laissez a
aithul, there was reluctant acceptance that, i politicians were unwilling to le
needed to preent urther taxpayer bail-outs. lama and Becker both endowe
playing with more o their irm's own money. Cochrane called or a breakup o
Goldman Sachs, with their trading actiities being separated rom the banking
Kashyap, meanwhile, adocated reorms in the compensation packages o \
1oday, though, the political and inancial enironment is somewhat dier
enormous scale, the banking system has been stabilized and the economy is e
rescue program has taken some o the heat out o the economic debate. In C
returned to their own research projects. "I this recession had got a lot worse,
said to me. "Much more goernment inolement in the economy and a lot m
understanding what went wrong." Assuming that the economic recoery con
reolution in the role o goernment and in thinking that dominated the econ
Becker maybe right, but the impact o the inancial crisis shouldn't be un
economics. "Rational expectations and strong iews o eicient markets ha
"Keynes is back, and behaioral inance is on the march." Outside o lama a
in Chicago, who beliees that speculatie bubbles aren't a serious problem, o
ull employment. And een most o the diehards now support eorts to regu
Posner, in a new book he is working on entitled "1he Crisis o Capitalist D
embrace some o Keynes's original ideas, and questions the U.S. goernment'
resorting to inlation. Beore I let Posner's oice, he gae me a brie history
collapse o Communism, the basic insights o the Chicago School about dere
worldwide, he recalled, and the bitter enmity between Chicago and its rial ec
many o the ounders o the Chicago School died, and were replaced by more
Now, largely as a result o misguided eorts to extend de-regulation to the in
economic blowup since the nineteen-thirties. Posner, who appeared to be enj
"So probably the term 'Chicago School' should be retired."
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CHICAGO INTERVIEWS
NURY 21, 2010
INTERVIEW WITH RICHARD THALER
Posted by John Cassidy
%his is the eighth in a series of interviews with Chicago School
economists. Read 'After the Blowup,` John Cassidys story on
Chicago economists and the financial crisis. (Subscribers only.)

Thaler, one oI the Iounders oI behavioral economics, was out oI
town when I visited Chicago. I subsequently caught up with him
on the phone, and I began by asking him what remained oI the
eIIicient-markets hypothesis, which he has long questioned.

Thaler: Well, I always stress that there are two components to
the theory. One, the market price is always right. Two, there is
no Iree lunch: you can`t beat the market without taking on more
risk. The no-Iree-lunch component is still sturdy, and it was in
no way shaken by recent events: in Iact, it may have been
strengthened. Some people thought that they could make a lot oI
money without taking more risk, and actually they couldn`t. So
either you can`t beat the market, or beating the market is very
diIIiculteverybody agrees with that. My own view is that you
can |beat the market| but it is diIIicult.
The question oI whether asset prices get things right is where
there is a lot oI dispute. Gene |Fama| doesn`t like to talk about
that much, but it`s crucial Irom a policy point oI view. We had
two enormous bubbles in the last decade, with massive
consequences Ior the allocation oI resources.
hen I spoke to Fama, he said he didnt know what a bubble
ishe doesnt even like the term.
I think we know what a bubble is. It`s not that we can predict
bubblesiI we could we would be rich. But we can certainly
have a bubble warning system. You can look at things like
price-to-earnings ratios, and price-to-rent ratios. These were
telling stories, and the story they seemed to be telling was true.
So what are the policy implications? hat should the
government do to prevent bubbles from inflating, in the housing
market, for example?
Several things. I think Fannie Mae and Freddie Mac should raise
lending requirements in certain areas that look Irothy. God did
not say that you should be able to borrow one hundred percent
oI the price oI a house.
hat was the ultimate cause of the financial crisis? Poor
regulation? Greed? Bad market signals? Human frailty?
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POSTED N CHCO NTERVEWS

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NURY 15, 2010
INTERVIEW WITH RAGHURAM RAJAN
%his is the seventh in a series of interviews with Chicago School

I met Rajan in his oIIice at the Booth School oI 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 oI 2005, issued a prescient warning about the dangers
oI a Iinancial blowup involving the credit markets. It was
striking, I remarked, that despite Chicago`s image as a bastion
oI market eIIiciency, it was also home to much more
questioning research in the Iinancial system.

Raghuram Rajan: Forget the public utterances: the research done
at this place was, essentially, right on the ballissues oI
liquidity, the Iact that liquidity might dry up, and who`s there to
provide liquidity in those situations. One oI my colleagues,
Doug Diamond, is, in many ways, the Iather oI 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? UnIortunately, this stuII is all too real
these days.
The point is, research drives thinking, and there are all kinds oI
research being done here. People at the extremes get a lot oI
press, people who say: 'Let`s not do anything, let`s liquidate
the Andrew Mellon kind oI 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 diIIerent Irom,
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 Iormerly at the International Monetary
Fund| Ior 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 oI
this sizenot by any stretch oI 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 oI America it is a completely
diIIerent kettle oI Iish. We have to Iigure 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
doit`s just a matter oI nationalizing them or shutting them
downthere are a whole lot oI 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 oI the Iinancial
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 oI what we
haven`t done is that we haven`t made the banks Iace up to more
pain. That would have made it politically easier to do what
needed to be done.
hen you say, 'make the banks face up to more pain,` what do
you mean? %ougher regulation? Big equity stakes for the
governmentalong the British lines?
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NURY 15, 2010
INTERVIEW WITH KEVIN MURPHY
%his is the sixth in a series of interviews with Chicago School

Kevin Murphy is one oI the best-known Chicago economists
Irom the post-Lucas, post-Fama generation. In 1997, he was the
recipient oI the John Bates Clark Medal, which is presented to
the best American economist under Iorty. Although he is
primarily a microeconomist, Murphy has published articles on a
wide range oI subjects, including income inequality, the value oI
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 oI our conversation.

%o 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
Iinancial markets always work eIIiciently, he has taken a
beatingno 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 isnt its media image?
I`ve always thought oI Chicago economics as an approach to the
subjecta way oI doing economics. It`s based on the belieI that
the tools oI economic analysis are really useIul Ior 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 testa guy would give the
same answer in a seminar to a question about the economy that
he would give iI 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.]
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NURY 14, 2010
INTERVIEW WITH JAMES HECKMAN
%his is the fifth in a series of interviews with Chicago School

I interviewed Heckman by telephone in late October. I began by
reIerring to a piece in the University of Chicago Maga:ine in
which he appeared to absolve Chicago economics oI any blame
in causing the Iinancial crisis. How did he react, then, to the
recent criticisms oI Chicago School economics Irom Joseph
Stiglitz, Paul Krugman, and others?

James Heckman: Well, I want to distinguish between two
diIIerent ideas. The Chicago School incorporates many diIIerent
ideas. I think the part oI the Chicago School that has been
justiIied 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 incentivesclearly
they did. It turned out that the incentives they were reacting to
weren`t socially beneIicial, but they deIinitely reacted to them.
The other part oI the Chicago School, which Stiglitz and
Krugman have criticized, is the eIIicient-market hypothesis.
That is something completely diIIerent.
I think it is important to put it into historical perspective. In the
late nineteen-Iorties and nineteen-IiIties, when Keynesianism
was really dominant, that sort oI Keynesianismso-called
hydraulic Keynesianismcompletely ignored incentives and the
way people reacted to them. What Chicago didMilton
Friedman, George Stigler, and otherswas to redress that
balance. They did a whole lot oI empirical studies that showed
how people did react to incentives, such as changes in taxes or
prices. That was incredibly inIluential, and it is still is.
In the early nineteen-seventies, Martin Feldstein, oI Harvard,
showed how changes in unemployment beneIits had a big
impact on labor supply. That had an enormous impact on policy,
and it was an application oI Chicago economics. Feldstein said
he read |Friedman`s| 'Capitalism and Freedom when he was at
graduate school in OxIord, and it had an enormous inIluence on
his thinking. That was the Chicago inIluence, and it still stands
up. Linking empirical work to theory, and showing how things
like taxes and government programs impact behavior.
.K. People were reacting to incentivesthe mortgage lenders,
the all Street bankers, the homebuyersI agree. But werent
market prices sending them the wrong signals, and isnt that an
indictment of Chicago economics, which, going back to Hayek,
at least, has stressed the role of prices in coordinating
behavior?
CONTINUE READING >>

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NURY 14, 2010
INTERVIEW WITH GARY BECKER
%his is the fourth in a series of interviews with Chicago School

I met Becker in his oIIice at the economics department. I began
by telling him I had been speaking with his Iriend and co-
blogger Richard Posner, and I asked whether he agreed with
Posner that the events oI the past two years had called Chicago
School economics into question.

Gary Becker: No. I think the last twelve months have shown
that Iree markets sometimes don`t do a very good job. There`s
no question, Iinancial markets in the United States and
elsewhere didn`t do a good job over this period oI time, but iI I
take the Iirst proposition oI Chicago economicsthat Iree
markets generally do a good jobI think that still holds.
II I were running an economy, and I was looking Ior the best
way to run it, I would do what India and China didmove
much more to a Iree-market economy. The second proposition
oI Chicago economicsthat governments don`t do a good job. I
really don`t understand how, iI Posner said that had been
undermined, he can inIer that. I don`t think the government did
a good job in the run-up to the crisis. Posner has himselI
criticized Alan Greenspan`s low-interest-rate policy. The S.E.C.
should have done a lot oI things it didn`t do. It`s hard to sustain
the belieI that governments do well.
What I have always learned to be the Chicago view, and taught
to be the Chicago view, is that Iree markets do a good job. They
are not perIect, 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 Iree 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 governments interventions have staved off
another Great Depression.
CONTINUE READING >>

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NURY 13, 2010
INTERVIEW WITH JOHN COCHRANE
%his is the third in a series of interviews with Chicago School

I interviewed John Cochrane in his oIIice at the Booth School oI
Business, and I began by asking him about the economics oI
today`s Chicago, and how it diIIered Irom the strident Iree-
market school oI a bygone erathe Chicago oI Milton
Friedman and George Stigler.

John Cochrane: This is not an ideology Iactory. This is a place
where we think about ideas and evidence. Gene Fama is in the
next-door oIIice. Dick Thaler is across the hall. Rob Vishny is
just down the corridor. The Chicago oI 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 stuII no matter
where it comes Irom.
And you have some banking experts who can, perhaps, claim to
be among the few economists that warned us about this crisis.
Raghu Rafan, and so on?
(Laughs) Well, every conIerence 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? ne that favors free
markets?
CONTINUE READING >>

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NURY 13, 2010
INTERVIEW WITH EUGENE FAMA
%his is the second in a series of interviews with Chicago School

I met Eugene Fama in his oIIice at the Booth School oI
Business. I began by pointing out that the eIIicient markets
hypothesis, which he promulgated in the nineteen-sixties and
nineteen-seventies, had come in Ior a lot oI criticism since the
Iinancial crisis began in 1987, and I asked Fama how he thought
the theory, which says prices oI Iinancial assets accurately
reIlect all oI the available inIormation about economic
Iundamentals, had Iared.

Eugene Fama: I think it did quite well in this episode. Stock
prices typically decline prior to and in a state oI recession. This
was a particularly severe recession. Prices started to decline in
advance oI 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 iI markets were
eIIicient.
Many people would argue that, in this case, the inefficiency was
primarily in the credit markets, not the stock marketthat 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 Irom 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.
CONTINUE READING >>

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NURY 13, 2010
INTERVIEW WITH RICHARD POSNER
%his is the first in a series of interviews with Chicago School

I spoke to Posner in his chambers at the Federal courthouse in
downtown Chicago, where he sits on the United States Court oI
Appeals Ior the Seventh Circuit. I began by telling him that I
was researching an article about how the Iinancial crisis had
aIIected 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 proIession as a whole,
but to Chicago most oI 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 oI the
orthodox Chicago Schoolthe 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 oI re-examination.
hat 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 Famasome oI 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
beIore this, macro was seen as quite a weak Iield, and the
eIIicient markets theory had taken a lot oI hits: the behavioral
Iinance schoolAndrei ShleiIer, Bob Shiller. Already, the
orthodox Chicago position had been under criticism. But last
September`s Iinancial collapse came as a big shock to the
proIession.
hat is Chicago macroeconomics? And what went wrong with
it?
CONTINUE READING >>

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NURY 13, 2010
THE CHICAGO INTERVIEWS
Apologies Ior the delay in posting the interviews I promised.
BeIore putting them up Ior public inspection, I thought it was
only right to ask the interviewees Ior approval. ThankIully,
everybody I spoke with agreed to be quoted at greater length.
One thing I will say Ior Chicago economistsand it has been
true Ior a long time: they are, Ior the most part, genuine
intellectuals, not mere opportunists or party hacks, and they
enjoy the cut and thrust oI intellectual debate. As Gary Becker
put it in a note to me, 'I do believe in the marketplace oI ideas.
So do I, and it is in that spirit that I am posting these interviews.
Since some oI them are pretty long, I will post them in three
batches, with the subjects appearing roughly in the order they
appeared in my piece in the magazine. I will start out with
Richard Posner, Eugene Fama, and John Cochrane. Tomorrow, I
will try to post three more, and Iinish up on Friday. For the
record, all oI the interviews were done in October, about a year
aIter the Iinancial crisis. The banking system had stabilized, and
an economic recovery had begun, but then, as now, the Iuture
shape oI the regulatory system was very unclear.

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NURY 8, 2010
THE CHICAGO SCHOOL AND THE FINANCIAL CRISIS
Happy New Year everybody. I`ve got a new article in this
week`s magazine about how Iree-market Chicago economists
have been reacting to the Iinancial blowup. II you have a
subscription to %he New Yorker, you can read it online. II you
haven`t got a subscription, I`m aIraid you will have to take one
out online, go the newsstandvery twentieth century, I know
or ask a Iriend to Iax you a copy.
Several people have asked why the piece isn`t available online.
The answer should be obvious. In order to pay me and my
colleagues, %he New Yorker needs to raise some revenues, and
giving everything away Ior Iree isn`t a sustainable business
strategy. I`d much preIer that everybody could read the piece
without going to the trouble oI BUYING it, but, hey, this is our
livelihood, Iellas!
For people interested in the subject, and there seems to be a lot
oI you, the good news is that I`m planning on posting here much
Iuller versions oI the interviews I did in Chicago, with the likes
oI Gene Fama, Gary Becker, and Richard Posner, who recently
converted to Keynesianism. It`s the nature oI long-Iorm
magazine journalism that a lot oI interesting stuII gets leIt out oI
the Iinished article, but, thanks to the Web, there`s no reason it
shouldn`t appear in some Iorm. Plus, I think it`s a good time to
let the Chicago economists speak Ior themselves. Over the last
couple oI years, they have taken a battering at the hands oI
myselI, Paul Krugman, Joe Stiglitz, and others. Having just
Iinished writing a book entitled 'How Markets Fail, I went to
the Windy City eager to learn Iirst hand how the critiques oI
Chicago economics were being received. Some oI what I was
told, I don`t agree with, but at this time oI intellectual tumult I
think it makes Iascinating reading.
I`ll try and post one or more oI the interviews later today and the
rest at the start oI next week. And in the meantime, a
subscription to %he New Yorker, which includes 47 paper issues
a year and Iull access to the Web site and archive, costs just
$39.95Iar too little, in my opinion, but that`s a subject Ior
another day.

Read more
http://www.newyorker.com/online/blogs/johncassidy/chicago-
interviews#ixzz1eSuXaU4M

January 13, 2010
INTERVIEW WITH RICHARD POSNER
%his is the first in a series of interviews with Chicago School

I spoke to Posner in his chambers at the Federal courthouse in
downtown Chicago, where he sits on the United States Court oI
Appeals Ior the Seventh Circuit. I began by telling him that I
was researching an article about how the Iinancial crisis had
aIIected 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 proIession as a whole,
but to Chicago most oI 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 oI the
orthodox Chicago Schoolthe 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 oI re-examination.
hat 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 Famasome oI 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
beIore this, macro was seen as quite a weak Iield, and the
eIIicient markets theory had taken a lot oI hits: the behavioral
Iinance schoolAndrei ShleiIer, Bob Shiller. Already, the
orthodox Chicago position had been under criticism. But last
September`s Iinancial collapse came as a big shock to the
proIession.
hat 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 oI inept monetary policy and
could have been avoided iI only the Fed had not tightened the
money supply. That remains very controversial, but also it
didn`t prepare anybody Ior 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 Iederal
Iunds 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 economicsone that is very Iormal, making very
austere assumptions about human rationality: people have a lot
oI inIormation, a lot oI Ioresight. They look ahead. It is very
diIIicult Ior the government to aIIect behavior, because the
market will oIIset what it does. The more inIormal economics oI
Keynes has made a big comeback because people realize that
even though it is kind oI loose and it doesn`t cross all the 'ts
and dot all the 'is, it seems to have more oI a grasp oI what is
going on in the economy.
In the fall, you wrote a big piece in %he New Republic in which
you declared yourself to be a Keynesian. hat was the reaction
to that article?
I haven`t got much oI a reaction Irom my colleagues. Bob Barro
(a conservative economist at Harvard) sent me an email in
which he reIerred me to an early article oI his. It was a good
article.
I think there is a question oI whether modern economics,
including Chicago economics, is too Iormal and too abstract.
Another question is whether modern economists have lost
interest in or Ieel Ior institutional detail that might be very
important. I don`t know how many oI these economists really
knew anything about how modern banking operates, how the
new Iinancial investments operatecollateralized debt
obligations, credit deIault 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 oI economics in that way.
What we tend to think oI as the Chicago approach is great
skepticism about government and Iaith in the selI-regulating
characteristics oI markets: that`s the essential outlook oI
Chicago. In addition, there is the increasing mathematization oI
economics. That is not necessarily Chicago-led. Chicago once
resisted thatpeople like Ronald Coase and George Stigler.
Even Gary Beckerhe`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 selI-regulating properties oI markets. That
combination is dangerous. Because it means you don`t have
much knowledge oI institutional detail, particular practices and
Iinancial instruments and so on. On the other hand, you have an
exaggerated Iaith 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 oI progress. It`s about
challenging the assumptions about markets because oI human
irrationality. I don`t much like it myselI, because I think they are
very vague about what they mean by rationality. They use terms
like 'Iairness, which are really contentless. But some oI their
skepticism is warranted. And behavioral Iinance, I Iind very
convincing. It`s obvious iI you look at how people trade in
markets: they are not calculating machines that Ilawlessly
discount Iuture corporate proIits.
I put a lot oI emphasis on the Frank Knight (a Iamous Chicago
economist who taught at Chicago Irom the nineteen-twenties to
the nineteen-sixties) and Keynes view oI uncertainty. That
makes economists very uncomIortable, because it is very hard to
model. Once you introduce uncertainty, it means that a lot oI
consumer behavior is not going to be easily modeled as cost-
beneIit 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 proIessor at
University oI Tennessee is a leading post-Keynesian.) I`ve read
some oI those people. But I don`t really get much out oI it that
isn`t in Keynes. I`m kind oI stalled in the General Theory and
his essay in the Q.J.E. (In 1937, a year aIter the publication oI
The General Theory oI Employment, Interest, and Money,
Keynes wrote an expository article in the Quarterly Journal oI
Economics.)
So, in sense, you see yourself reviving an older Chicago
traditionKnightian economicswhich 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 oI the political
spectrum. I never heard Coase mention Keynes, but I am sure he
would have regarded him as a dubious leIt-wing character Coase
is very, very conservative. But they are very similar in their
inIormality. Coase was always saying that he didn`t believe in
utility maximization. He didn`t believe in equilibrium. Both oI
them, they are not concerned with the kind oI 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 Iormal economist. His book 'Risk,
Uncertainty, and ProIit, I read it Ior the Iirst 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 proIessional economist. I don`t have any
economics training. But I`m interested in it. I`m not bashIul
about writing about it.
Youve 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 oI me was crazy. He
had me Iighting a last-ditch stand Ior Chicagothe exact
opposite oI what I wrote.
It does bother me about economistsnot 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 proIession. Krugman is
obviously a good economist. He`s got this book, 'The Return oI
Depression Economics. It`s very good...But his column Ior The
New York %imes is really irresponsible, nasty. Sometimes on his
blog he makes accusations. In one oI his columns, he suggested
that conservatives were traitorous. He used the word 'treason.
I`m bothered by that. II you have a very politicized academic
proIession, you lose your conIidence in their objectivity
ell, some Chicago economists also express very strong views.
John Cochrane (a professor at Chicagos Booth School of
Business) for example, says that government stimulus programs
dont have any impact at all on unemployment and G.D.P.
That`s another reason to be distrustIul oI the proIession. 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 beIore this, I had become less doctrinaire about markets.
For example, one oI the topics Gary Becker and I debated on
our blog was New York City`s ban on transIats. I supported that.
The country has an obesity problem. I didn`t think that just
listing the amount oI transIats on a menu would deal with it
people don`t know this stuII. I thought a ban, even though it
violated Ireedom oI contract, made sense.
hat has been Beckers reaction to your views?
You mean about the economy, about Keynes. I think he
disagrees. We had a debate beIore the university women`s board
some months ago. He`s very down on the stimulus. Some oI the
things we agree about. I thought the cash-Ior-clunkers program
was quite pointless.
Now that we appear to be coming out of the recession, the right
is saying things arent too bad after all, and that markets are
resilient. %he left is saying without government intervention we
would be back in the nineteen-thirties. hat do you think?
It depends what you mean by government intervention. II the
government had limited itselI to reducing the Iederal Iunds rate
and had not bailed out the banks, we could easily have gone
down the route oI the nineteen-thirties. On the other hand, iI
there had just been a bank bailout and no stimulus, then, no, we
would not have gone down as Iar as the nineteen-thirties,
because the economy is diIIerent now. In particular, (there`s
been) the shrinkage oI the construction and manuIacturing
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 Iar 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 oI things they have done, I don`t
approve oI. I don`t like the idea oI 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 deIicits, and what health reIorm will do to
what are already massive deIicits. So I don`t think the
government`s handling oI this has been Ilawless, 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.
Becausehow should I putit market correctives work very
slowly in dealing with academic markets. ProIessors have
tenure. They have a lot oI graduate students in the pipeline who
need to get their Ph.Ds. They have techniques that they know
and are comIortable with. It takes a great deal to drive them out
oI their accustomed way oI doing business.
Robert Lucas takes a very hard line on this. He says the theory
oI 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 isnt 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 iI there is
a school oI economics that has great ideas and techniques Ior
dealing with our economic situation.
hat 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 academiain those days Chicago was very
distinctive. It was distinctive Ior its conservatism, Ior its 1968
Iidelity to price theory, Ior its interest in empirical studies, but
not so much in Iormal modeling. We used to say the diIIerence
between Chicago and Berkeley was Chicago was economics
without models, and Berkeley was models without economics.
But over the years, Chicago became more Iormal, and the other
schools became more oriented towards price theory, towards
micro. So, now there really isn`t a great deal oI diIIerence.
Ronald (Coase) is alive, but he`s very, very old. He`s not active.
Stigler is dead. Friedman is dead. There`s Gary (Becker) oI
course. But I`m not sure there`s a distinctive Chicago School
anymore. Except there are probably a higher percentage oI
conservative people here, but not all. Jim Heckmannot
particularly conservative at all. He`s very distinguished. Steve
Levitthe`s very Iamous. 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 peoplepeople 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 oI the nineteen-IiItiesvery Keynesian, very
regulatory, very aggressive anti-trust, little Iaith in the selI-
regulating nature oI markets. Francis Bator, who`s a very
distinguished Harvard economist, he wrote a Iamous essay
entitled 'The Anatomy oI Market Failure. And he gave so
many examples oI market Iailure that you couldn`t believe a
market could exist. You have to have an inIinite number oI
competitors, Iull inIormation, you can`t have any economies oI
scale, and so on. It was too austere. That was what the Chicago
people, with their more inIormal approach, rebelled against. So
we had our moment in the sun, but by the nineteen-eighties the
basic insights oI the Chicago School had been accepted pretty
much worldwide.
Where the divide continues is in macroin 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 oI course one oI the more signiIicant Chicago
(positions) was in Iavor oI deregulation, based on the notion that
markets are basically selI-regulating. That`s Iine. The mistake
was to ignore externalities in banking. Everyone knew there
were pollution externalities. That was Iine. I don`t think we
realized there were banking externalities, and that the riskiness
oI banking could Iacilitate a global Iinancial crisis. That was a
big oversight. It doesn`t make me Ieel any diIIerent about the
deregulation oI telecommunications, or oil pipelines, or what
have you.
%alking of banking externalities, isnt 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. OI course, you have to know a lot about banking,
and that was not the case with economists. Odd in a way,
because macroeconomists and Iinance theorists have always
been interested in banking, but I don`t think they really
understood a lot about it.

Read more
http://www.newyorker.com/online/blogs/johncassidy/2010/01/interv
iew-with-richard-posner.html#ixzz1eSvNigbN

anuary 13, 2010
INTERVIEW WITH EUGENE FAMA
%his is the second in a series of interviews with Chicago School

I met Eugene Fama in his oIIice at the Booth School oI
Business. I began by pointing out that the eIIicient markets
hypothesis, which he promulgated in the nineteen-sixties and
nineteen-seventies, had come in Ior a lot oI criticism since the
Iinancial crisis began in 1987, and I asked Fama how he thought
the theory, which says prices oI Iinancial assets accurately
reIlect all oI the available inIormation about economic
Iundamentals, had Iared.

Eugene Fama: I think it did quite well in this episode. Stock
prices typically decline prior to and in a state oI recession. This
was a particularly severe recession. Prices started to decline in
advance oI 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 iI markets were
eIIicient.
Many people would argue that, in this case, the inefficiency was
primarily in the credit markets, not the stock marketthat 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 Irom 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 oI money betting on that, iI you could
identiIy it. It`s easy to say prices went down, it must have been a
bubble, aIter the Iact. I think most bubbles are twenty-twenty
hindsight. Now aIter the Iact you always Iind people who said
beIore the Iact 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 halI the time.
Are you saying that bubbles cant exist?
They have to be predictable phenomena. I don`t think any oI this
was particularly predictable.
Is it not true that in the credit markets people were getting
loans, especially home loans, which they shouldnt have been
getting?
That was government policy; that was not a Iailure oI 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 Freddies 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?
asnt the subprime mortgage bond business overwhelmingly a
private sector phenomenon involving all Street firms, other
U.S. financial firms, and European banks?
Well, (it`s easy) to say aIter the Iact that things were wrong. But
at the time those buying them didn`t think they were wrong. It
isn`t as iI they were nave investors, or anything. They were all
the big institutionsnot 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 iI 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 oI stuII
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, oI 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 Irom
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 fro:e up?
Yeah. It had to, to be showing up among people who had
mortgages. Nobody who`s doing mortgage researchwe have
lots oI them heredisagrees with that.
So what caused the recession if it wasnt 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 Ieel 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 dont 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 Iall 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...
OI the mortgage market.What`s the reality now? Everybody
talks about a credit crisis. The variance oI stock returns Ior the
market as a whole went up to, like, sixty per cent a yearthe
Vix measure oI volatility was running at about sixty per cent.
What that implies is not a credit market crisis. It would be stupid
Ior 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 eIIicient 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 activitythe part we don`t
understand. So the Iact we don`t understand it means there`s a
lot oI uncertainty about how bad it really is. That creates all
kinds oI volatility in Iinancial prices, and bonds are no longer a
viable Iorm oI Iinancing.
And all that is consistent with market efficiency?
Yes. It is exactly how you would expect the market to work.
%aking 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 wasnt
warranted...
AIter the Iact...There was enormous investment across the
board: it wasn`t just housing. Corporate investment was very
high. All Iorms oI investment were very high. What you are
really saying is that somewhere in the world people were saving
a lotthe Chinese, Ior example. They were providing capital to
the rest oI the world. The U.S. was consuming capital like it was
going out oI sight.
Sure, but the traditional Chicago view has been that the
financial markets do a good fob of allocating that capital. In
this case it, they didntor so it appears.
(Pauses) A lot oI mortgages went bad. A lot oI corporate debt
went bad. A lot oI debt oI 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 beIore that. But that was
unpredictable at the time.
%here 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 oI 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 oI the
market, iI there isn`t something artiIicial 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 oI that.
In the past, I think you have been quoted as saying that you
dont 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 %he
Economist because they use the world bubble three times on
every page. Any time prices went up and downI guess that is
what they call a bubble. People have become entirely sloppy.
People have jumped on the bandwagon oI blaming Iinancial
markets. I can tell a story very easily in which the Iinancial
markets were a casualty oI the recession, not a cause oI it.
%hats 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 Iinance. That is
not his area.
So you wouldnt 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 iI 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 Iinancial development that occurred Irom 1980 onwards.
The expansion oI worldwide wealthin developed countries, in
emerging countriesall oI that was Iacilitated, in my view, to a
large extent, by the development oI international markets and
the way they allow saving to Ilow to investments, in its most
productive uses. Even iI you blame this episode on Iinancial
innovation, or whatever you want to blame, would that wipe out
the previous thirty years oI development?
hat about here in Chicagohas there been a lot of discussion
about all this, the financial crisis, and what it means, and so on?
Lots oI it. Typical research came to a halt. Everybody got
involved.
Everybody`s got a cure. I don`t trust any oI them. (Laughs.)
Even the people I agree with generally. I don`t think anybody
has a cure. The cure is to a diIIerent problem. The cure is to a
new problem that we Iacethe 'too-big-to-Iail problem. We
can`t do without Iinance. But iI 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 Iirms have a lot more
equity capitalnot 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 oI they system. I am
not sure I agree with them. You talk to Doug Diamond or Raghu
Rajan, and they have theories Ior why leverage in Iinancial
institutions has real uses. I just don`t think that those eIIects are
as important as they think they are.
Lets say the government did what you recommend, and forced
banks to hold a lot more equity capital. ould it then also have
to restructure the industry, say splitting up the big banks, as
some other experts have recommended?
No. II you think about it...I`m a student oI Merton Miller, aIter
all. In the Modigliani-Miller view oI the world, it`s only the
assets that count. The way you Iinance them doesn`t matter. II
you decide that this type oI activity should be Iinanced more
with equity than debt, that doesn`t particularly have adverse
eIIects on the level oI activity in that sector. It is just splitting
the risk diIIerently.
Some people might say one of the big lessons of the crisis is that
the Modigliani-Miller theory doesnt 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
iI 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 Iail. How long would it
have taken to have unscrambled everything and Iigured
everything out? My guess is that we are talking a week or two.
But the problems that were generated by the government
stepping inthose are going to be with us Ior the Ioreseeable
Iuture. Now, maybe it would have been horrendous iI the
government didn`t step in, but we`ll never know. I think we
could have Iigured it out in a week or two.

So you would have fust let them...
Let them all Iail. (Laughs) We let Lehman Iail. We let
Washington Mutual Iail. These were big Iinancial institutions.
Some we didn`t let Iail. To me, it looks like there was not much
rhyme or reason to it.
hat about Ben Bernanke and Hank Paulsons argument that if
they hadnt taken action to save the banks the whole financial
system would have come crashing down?
Maybe it would haveIor a week or two. But it pretty much
stopped Ior a week or two anyway. The credit markets stopped
Ior more than a week or two. But I think that was really a
Iunction oI increased uncertainty about the Iuture.
Did you think this at the timethat the government should let
the banks fail?
Yeahlet em, let em. Because the Iailures oI, like,
Washington Mutual and Wachoviaother banks came
swooping in to pick up their deposits and their other good
assets. OI, course, they didn`t want their bad assets, but that`s
the nature oI bankruptcy. The activities that these banks were
engaged in would have continued.
hy do you think the government didnt fust step back and let it
happen? as the government in hock to all 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 oI risk aversion on the part
oI people currently in government. They don`t want to be
blamed Ior bad outcomes, so they are willing to do bad things to
avoid them. I think Bernanke has been the best oI the
perIormers.
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 oI the world got converted to the notion that markets
are pretty good at allocating resources. The more extreme oI the
leIt-leaning economists got blown away by the collapse oI the
Eastern bloc. Socialism had its sixty years, and it Iailed
miserably. In that way, Chicago theory prospered. Milton
Friedman and George Stigler were Iighting that battle pretty
much alone in the old days. Now it is pretty general. An
experience like we`ve had rehabilitates the remnants oI the old
socialist gang. (Laughs) UnIortunately, they seem to be in
control oI 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 oI time when
Chicago economics was basically under attack the world over.
There was a kind oI a bunker mentality. But now we`ve become
more conIident. 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 oI economist. His brand oI
economics, which is an extension oI 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.
Rightthat`s true even oI Dick (Thaler). I think that is just
rational behavior. (Laughs) It took people a long time to realize
that government oIIicials are selI-interested individuals, and that
government involvement in economic activity is especially
pernicious because the government can`t Iail. Revenues have to
cover coststhe government is not subject to that constraint.
So you dont accept the view, which Paul Krugman, Larry
Summers, and others have put forward, that what has happened
represents a rehabilitation of government actionthat the
government prevented a catastrophe?
Krugman wants to be the czar oI 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.
hat is your view on regulating all Street? Do we need more
of it?
I think it is inevitable, iI you accept the view that the
government will bail out the biggest Iirms iI 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
Iind ways to do things that are in the letter oI the regulations but
not in the spirit. You are not going to be able to attract the best
people to be regulators.
%hat sounds like an old-fashioned Chicago argument
skepticism about regulation.
Yes. We have Ragu (Rajan), Doug Diamondthey are as good
banking people as there are in the world. I have been listening to
them Ior 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 oI big institutions.
So what should we do? If the President called you tomorrow
and said, 'Gene, I dont think our way is working. hat should
we do?` How would you respond?
I don`t know iI these are even the big issues oI 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 Iinancial crisis) started, I joined the debate.
Then I stepped back and said, I`m really not comIortable with
my insights into what the best way oI proceeding is. Let me sit
back and listen to people. So I listened to all the experts, local
and otherwise. AIter 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.

Couldnt we fust ban further bailouts, passing a constitutional
amendment if necessary? %hat would be in line with your views,
wouldnt it?
Right, but is that credible? It`s very diIIicult to explain how
A.I.G. issued all the credit deIault swaps it issued iI 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 oneI think it`s pretty sure that we they couldn`t live up to
it.
hat will be financial crisiss legacy for the subfect of
economics? ill there be big changes?
I don`t see any. Which way is it going to go? II I could have
predicted that, that`s the stuII I would have been working on. I
don`t see it. (Laughs) I`d love to know more about what causes
business cycles.
hat 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 morethat a recession
this big couldn`t happen any more. There`ll be a lot oI work
trying to Iigure 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 oI 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. thers say the market may
be good at pricing in a relative senseone stock versus
anotherbut it is very bad at setting absolute prices, the level of
the market as a whole. hat do you say to that?
People say that. I don`t know what the basis oI it is. II they
know, they should be rich men. What better way to make money
than to know exactly about the absolute level oI prices.
So you still think that the market is highly efficient at the overall
level too?
Yes. And iI it isn`t, it`s going to be impossible to tell.
For the layman, people who dont know much about economic
theory, is that the fundamental insight of the efficient market
hypothesisthat you cant beat the market?
Rightthat`s the practical insight. No matter what research gets
done, that one always looks good.
hat about the findings that long periods of high returns are
followed by long periods of low returns?
Now, there is no evidence oI that...The expected return on
stocks is just a pricethe price people require to bear the
market risk. Like any price, it should vary Irom time to time,
and maybe it should vary in predictable ways. I`ve done a lot oI
work purporting to show there`s a little bit oI predictability in
overall market returns, but that branch oI the literature has so
many statistical problems there`s not a lot oI agreement.
The problem is that, almost surely, expected returns vary
through time because oI risk aversionwealth, everything else
varies through time. But measuring that requires that you have a
good variable Ior tracking (risk aversion) or good models Ior
tracking it. We don`t have that. The way that people do it,
including me, is by using kind oI 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 oI a
statistical Iluke. There`s a whole issue oI the Review of
Financial Studies with people arguing very vociIerously on both
sides oI that. When that happens, you know that none oI the
results are very reliable.
Do you and Dick %haler discuss this stuff when you are playing
golf?
Sure. We don`t want to discuss his golI game, that`s Ior 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 Irom rationality. That branch oI it
has been incredibly useIul. It`s the leap Irom there to what it
implies about market pricing where the claims are not so well-
documented in terms oI empirical evidence. That line oI
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.
%hanks very much. Finally, before I go, what about Paul
Krugmans recent piece in the New York %imes Maga:ine, in
which he attacked Chicago economics and the efficient markets
hypothesis. hat did you think of it?
(Laughs) My attitude is this: iI you are getting attacked by
Krugman, you must be doing something right.
KEYWORDS Chicago; Chicago School; Eugene Fama; John Cassidy;
economics; economists; Iinancial crisis; recession

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January 13, 2010
INTERVIEW WITH JOHN COCHRANE
%his is the third in a series of interviews with Chicago School

I interviewed John Cochrane in his oIIice at the Booth School oI
Business, and I began by asking him about the economics oI
today`s Chicago, and how it diIIered Irom the strident Iree-
market school oI a bygone erathe Chicago oI Milton
Friedman and George Stigler.

John Cochrane: This is not an ideology Iactory. This is a place
where we think about ideas and evidence. Gene Fama is in the
next-door oIIice. Dick Thaler is across the hall. Rob Vishny is
just down the corridor. The Chicago oI 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 stuII no matter
where it comes Irom.
And you have some banking experts who can, perhaps, claim to
be among the few economists that warned us about this crisis.
Raghu Rafan, and so on?
(Laughs) Well, every conIerence 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? ne that favors free
markets?
Well, many oI us at least view Iree markets as a good place to
start, because oI the centuries oI experience and thought that it
reIlects. All science is, to some extent, conservative. You Iind
one butterIly that looks weird, you don`t say, 'Oh, Darwin was
wrong aIter 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
beIore we throw all oI that out.
Even our behavioralists are not jumping into 'the government
needs to run everything. They are pretty good about (saying)
well, iI 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 Irom 'We are irrational to 'the Iederal
government is the Iather 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? Isnt 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 Iairly
sympathetic to that view. Though, in some sense, the
government had painted itselI into a corner. We did not wake up
on September 24 (oI 2008) with a completely Iree market that
collapsed. We had a mortgage market that was very much run
by the Iederal 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 diIIerent recommendation to saying we need to build a
system in which there is less government intervention. II
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. II I`m the captain oI
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 ideathat the key to stabilizing the
system was buying up mortgage-backed securities on the
secondary marketwas a bad idea. Those speeches provoked
the panic, probably more than the Iact oI Lehman going under.
When you get the President going on national television and
saying, 'The Iinancial markets are near collapse,...iI you
weren`t about to take all oI your short-term debt out oI
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 Iailure oI both. The government
set up some regulations. The banks were very quick to get
around them. Lots oI people did not think enough about
counterparty risk, because they thought the government will
take care oI it. But this was hardly a libertarian paradise gone
wrong.
hat about today? Do we need more regulation, or should all
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
Iuture regulators are going to be so much smarter than the last
ones that they`ll keep the banks Irom getting in trouble, even
though we all know we are guaranteeing their losses. This
strikes me as a recipe Ior disaster.
%he right and the left agree on that, no?
Yes. (Laughs) II you are going to guarantee them, you can`t
guarantee and not regulate. A central bank, a lender oI last
resort, deposit insurances with the supervision that comes with
itthese are reasonable regulations. II you just say regulation
versus no regulation that becomes an undergraduate 2 A.M.
bullshit Iest. Talking about 'regulation vs. 'deregulation in
the abstract is pointless. We have to talk about speciIics iI we
want to get anywhere. StuII like, Do you think credit deIault
swaps should be Iorced on to exchanges? It`s all very boring to
your readers, but unless you are speciIic you don`t get
anywhere... II you are vague, it sounds kind oI Iun: ideology,
Chicago versus Harvard, and so on. But to get anywhere you
have to be speciIic.
%he 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 Ior already,
described the Iragility oI 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 oI
them, as Doug described. A bank can have risky assets but tell
you, 'We`ll always pay you a dollar, Iirst come Iirst served.
Doug described how that thing can cause problems, and I think
that`s basically what happened.
Doug`s here Ior a reason. We all said, 'Wow, that`s great! And
he`s devoted a career to deepening that analysis. He`s been one
oI our stars ever since he came here, which must be thirty years
ago now.
%he 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, whats left of
those two?
I think everything. Why not? Seriously, now, these are not ideas
so superIicial that you can reject them just by reading the
newspaper. Rational expectations and eIIicient markets theories
are both consistent with big price crashes. II you want to talk
about this, we need to talk about speciIic evidence and how it
does or doesn`t match up with speciIic theories.
In the United States, weve 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 deIine 'bubbles Ior me. I`ve
been looking Ior that Ior twenty years.
So you take the Greenspan view that bubbles cant be identified
except in retrospect? In 2005, you didnt 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 eIIicient markets (hypothesis)
never told you that wasn`t going to happen. What eIIicient
markets says is that prices today contain the available
inIormation about the Iuture. Why? Because there`s
competition. II 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. EIIicient markets are not clairvoyant
markets. People say, 'nobody Ioresaw saw the market crash.
Well, that`s exactly what an eIIicient market isit`s one in
which nobody can tell you where it`s going to go. EIIicient
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 'eIIicient markets means. What is
there about recent events that would lead you to say that markets
are ineIIicient? The market crashed, to which I would say, we
had the events last September in which the President gets on
television and says the Iinancial markets are near collapse. On
what planet do markets not crash aIter that?
There are things, by the way, that I saw last year that say
markets are not eIIicient, but not the ones you had in mind. The
interesting things about eIIiciency are going to be more boring
to your readers. There were lots oI little arbitrages. For example,
you could buy a corporate bond or you could write a credit
deIault swap and buy a Treasury (bond). Those are
economically the same thing, but one oI those was trading about
three per cent higher than the other: one was eighty-two, the
other was eighty-Iive.
So there were arbitrage opportunities?
Well, close to arbitrage opportunities. The problem was that you
need Iunding. 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 oI eIIiciency. Two ways oI getting
the same thing Ior a diIIerent pricethat smells. You`ve gotta
rethink some part oI your theory. What we saw were Iunding
and liquidity Irictions. 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-IiIties, the nineteen-
seventies...
You appear to be saying that the efficient markets hypothesis
doesnt have any implications for the absolute level of prices,
fust relative prices. How can that be a theory of pricing?
It does have implications Ior absolute pricing, and the Iocus oI
rational/irrational debate is exactly on this question. But last Iall
was not a particularly new and puzzling data point. The
phenomenon oI prices going up and coming down is something
we have been chewing on Ior twenty years. So here are the
Iacts:
When house prices are high relative to rents, when stock prices
are high relative to earningsthat seems to signal a period oI
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 Iact. It took us ten years to Iigure it out, but
that`s what (Robert) Shiller`s volatility stuII was about; it is
what Gene (Fama)`s regressions in the nineteen-eighties were
about. That was a stunning new Iact. BeIore, 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 Iact. II prices are high relative to earnings
that means this is going to be a bad ten years Ior stocks. It
doesn`t reliably predict a crash, just a period oI low returns,
which sometimes includes a crash, but sometimes not.
Ok, this is the one and only Iact 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 oI people saw this was the biggest buying opportunity oI
all time, but said, 'Sorry, I`m about to lose my job, I`m about to
lose my business, I can`t aIIord 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 quantiIiable way oI
saying, 'What is the right risk premium? or, 'What is the level
oI irrationalityoptimism or pessimism? And we need that not
to be a catchall explanation that says, 'Oh, tomorrow iI 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. %his time, Cochrane argued that in some ways
what happened to the credit markets was a vindication of the
theory, because it showed investors generally cant beat the
market without taking on more risk. Here is what he said.)
II you listened to Eugene Fama and believed that markets are
eIIicient, you wouldn`t have invested in auction rate securities
that claimed to be as good as cash, but which oIIered IiIty 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 oIIered IiIty extra basis points oI yield. The
whole point oI eIIicient markets theory is that you can`t beat the
market without taking on more risk. People (here) were saying
Ior years, iI you invest in hedge Iunds that make abnormally
high returns there is an earthquake risk, a tail risk, that nobody
is telling you about.
hat 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 liIe trying to understand this stuII. My last two papers,
which took me three years, were on determinacy conditions in
New-Keynesian models. It took me a lot oI time and a lot oI
math. II Posner can keep with that and with Law and
Economics, good Ior him. (Laughs)
Rational expectations. Again, it is good to be speciIic. What is
rational expectations? It is the statement that you Iool all the
people all the time. In the nineteen-sixties, people said the
government can give us a burst oI inIlation, and that will give us
a little boom in output because people will be Iooled. They`ll
think inIlation means they are getting paid better Ior their work
and they`ll be Iooled 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 Iool all the people all the time seems a pretty good
principle to me. So, again, I say be speciIic. What do you see
about the world that invalidates the theory oI rational
expectations?
O.K. The rational expectations hypothesis by itselI 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 Ior involuntary unemployment, Ior example.
Recessions are a matter oI workers voluntarily substituting
leisure Ior 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 'Ireshwater versus
saltwater. There is just macro. What most people are doing is
adding Irictions to it. We are playing by the (Finn) Kydland and
Prescott rules but adding some Irictions.
But unemployment is now ten percent. %hat 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 Iorth. 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 oI the seventies, people
took Ior 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 :ig-:agged 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 Irom 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 Ior output to grow Iaster, and Ior
everybody under the age oI thirty to spend twenty hours a day
writing websites. So the baseline oI an economy working well
will include some Iluctuations, and the baseline oI an economy
well will also include some Iluctuations in unemployment.
When we discover we made too many houses in Nevada some
people are going to have to move to diIIerent jobs, and it is
going to take them a while oI looking to Iind the right job Ior
them. There will be some unemployment. Not as much as we
have, surely, but some. Right now, ten percent oI people are
unemployed. Many oI them could Iind a job tomorrow at Wal-
Mart but it is not the right job Ior themand I agree, it is not
the right job Ior them. That doesn`t mean the world would be
right iI they took those jobs at Wal-Mart. But some component
oI unemployment is people searching Ior better Iits aIter shiIts
that have to happen. The baseline shouldn`t be that
unemployment is always constant. So that is a big and enduring
contributionsome amount oI Iluctuation does come out oI a
perIectly Iunctioning 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 aIter-
eIIects oI a Iinancial crisis that is socially not optimalagreed
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 Depressionthat many of the
unemployed could have taken fobs at lower wages.
Yes, but it wasn`t the right thing Ior them to do. Let me not even
hint that this is the right thing now. We had a Iinancial crisis last
Iall which was socially not optimal. This is probably where the
Minnesota crowd would disagree. It seems to me pretty obvious
that we had a Iinancial crisis last Iall, a Ireezing up oI short-term
credit markets, a Ilight to quality. As a result oI that Iinancial
crisis, we saw a lot oI real eIIects 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,
1849you can say we`ve seen these things beIore. There I
would agree with you, rather than with some mythical Iigure
Irom Minnesota who says Iinance is just totally irrelevant. That
makes no sense.
Is that the lesson herethat we need to integrate finance into
macroeconomics?
Well, yeah...I`ve been preaching that Ior twenty years. I do halI
Iinance and halI 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 Iinance (research), I see risk
and risk premiums as being what matters most. Macro until a
couple oI years ago wasn`t really thinking about risk and risk
premiums. It was just, oh, the Fed and the level oI interest rates.
So I`ve thought these things should marry each other Ior 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
Iashionable ingredients is easy, it`s the answers that are hard,
actually cooking the soup. People also say economics needs to
incorporate the insights oI psychology. Great. Thanks. I`ve
heard that Irom (Robert) Shiller Ior thirty years. Do it! And do it
not just in a way that can explain anything. Let`s see a measure
oI the psychological state oI the market that could come out
wrong. That`s hard to do. Calling Ior where research should go
is Iun, but I think it`s Iar 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 bama administrations stimulus
package and of the Keynesian revival. hy?
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 Ior Iorty
years until it was thrown out. I mean, we threw it out Ior a
reason. It didn`t work in the data. When inIlation came in the
nineteen-seventies that was a major Iailure oI Keynesian
economics. It was logically incoherent.
What happened is the government wanted to spend a lot oI
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 dont believe stimulus packages work. You are arguing
whatevery dollar the government dissaves somebody else
saves with an eye to the future tax burden? %he so-called
'Ricardian equivalence` argument. Is that it?
I would go Iurther. Ricardian equivalence is a theorem, a
theorem whose 'iIs are Ialse. But it is a nice background
theorem. In the world oI that theorem, deIicit Iinance spending
has no eIIect whatsoeverreally, no eIIect diIIerent Irom taxing
people now and spendingbecause, as you mentioned, people
oIIset it by saving more. Now, we know that theorem is Ialse.
One oI the iIs is 'iI the government raises taxes by lump sum
payments. In Iact, the government raises money by taxes that
distort incentives, so, iI anything, you are going to get a
negative multipliera bad thing. However, government
spending also changes the composition oI output. You build
roads. There are lots oI models where you can have a positive
eIIect, so I don`t want to say exactly zero. But iI you want to get
a multiplier you have to say exactly which 'iI is Ialse, exactly
what Iriction you think the government can exploit to improve
things by borrowing and spending and how.
hat 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 oI
output. 'Well, let`s Iight World War II again is not socially
good.
So is that your argument against the stimulus? r you fust dont
think it will work?
The claim was that this would, on net, reduce unemployment,
create jobs, improve the economy in some quantiIiable 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, Ior
deIicit spending right now.
hy? hat is the mechanism that prevents it from working?
It is even deeper than saying people will respond by saving.
First oI all, there`s this presumption that spending is good and
saving is badexcept 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
IorkliIt. 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 Ior the economy, I don`t get that. The
Chinese are investing IiIty per cent oI 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 Irom 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, iI 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 Iinancing having no eIIect
whatsoever. This is a deeper point. II 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 eIIect. But we have
one less car. That money has to come Irom somewhere. That`s
what people miss out when they think about the stimulus.
hat 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
Iact that trade is balanced. II they were not buying the bonds,
they were going to do something with that money, and blah,
blah, blah. You can shuIIle resources around, but you can`t
create anything out oI 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 Ireeze oI short-term debt. II
somebody Ialls down with a heart attack, you know he has a
clogged artery. A shot oI 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 iI (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. %here are unemployed resources out
there. Youre 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, Iired Irom a big bank. How is going to build a road in
Montana going to help him? Keynes thought oI a world in the
nineteen-thirties where labor was more amorphous labor. II 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 bankbuilding more roads is not going to help
them.
It`s a long logical leap Irom the Iact oI unemployed resources to
the proposition that the Iederal 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 Iairly classic bank run, panic, whatever.
There were good things the government did. The Fed intervened
very creatively, in sort oI a classic lender oI the last resort way.
We also did a lot oI stuIIlots oI bailoutsthat didn`t need to
be done. I think the TARP was silly. The equity injections were
silly. Lender oI the last resortget Irozen markets going again,
and get out oI the wayis probably plenty.
And don`t cause more panic. There was lots oI conIusion 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.
here should we go from here? If you were hired as head of the
hite House Council of Economic Advisers, what would you tell
the President?
I`d get Iired in about Iive minutes. I`d start with a broad
deregulatory approach to health care reIorm. There, I just got
Iired. Financial deregulation, yes, but going in the opposite
direction to where they are going. Financial regulation based on
getting out oI this too-big-to-Iail cycle. Setting it up so that
those things that have to be protected are, but in as limited a way
as possible. Simple, transparent reIorm.
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 accountsthat
was the systemic thing. So what I thought would happen aIter
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 Iast so that Washington doesn`t come in and
regulate us. UnIortunately, 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 Iorever.
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 all Street? r some
version thereof?
Yeah...Glass Steagall itselI had a lot oI problems, but some oI
the basic ideas are good.
But the same principleseparating the casino from the utility?
Separating the casino Irom the dangerous contractsyes. We all
understand that you can`t run an institution that oIIers 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 oI these things doesn`t have
to be ideological. Let`s just think through what works and look
hard at the evidence.
KEYWORDS Chicago; Chicago School; John Cassidy; John Cochrane;

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January 14, 2010
INTERVIEW WITH GARY BECKER
%his is the fourth in a series of interviews with Chicago School

I met Becker in his oIIice at the economics department. I began
by telling him I had been speaking with his Iriend and co-
blogger Richard Posner, and I asked whether he agreed with
Posner that the events oI the past two years had called Chicago
School economics into question.

Gary Becker: No. I think the last twelve months have shown
that Iree markets sometimes don`t do a very good job. There`s
no question, Iinancial markets in the United States and
elsewhere didn`t do a good job over this period oI time, but iI I
take the Iirst proposition oI Chicago economicsthat Iree
markets generally do a good jobI think that still holds.
II I were running an economy, and I was looking Ior the best
way to run it, I would do what India and China didmove
much more to a Iree-market economy. The second proposition
oI Chicago economicsthat governments don`t do a good job. I
really don`t understand how, iI Posner said that had been
undermined, he can inIer that. I don`t think the government did
a good job in the run-up to the crisis. Posner has himselI
criticized Alan Greenspan`s low-interest-rate policy. The S.E.C.
should have done a lot oI things it didn`t do. It`s hard to sustain
the belieI that governments do well.
What I have always learned to be the Chicago view, and taught
to be the Chicago view, is that Iree markets do a good job. They
are not perIect, 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 Iree 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 governments interventions have staved off
another Great Depression.
Well, that`s a separate argument. Market economiststake my
teacher and close Iriend 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 oI diIIerent
policies. I don`t blame them too much Ior that. It was a novel
situation and they were experimenting a lot. I deIinitely think
they helped, though, overall in averting a much more serious
recession. A lot oI people, including Posner, thought that things
were going to turn out a lot worse. We had a bunch oI
arguments about that on our blog.
%wo 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 eIIicient and there was no problem, that
was an extreme positionsomething a lot oI people at Chicago
had recognized beIore. The weaker notion that markets,
particularly Iinancial markets, usually work pretty well, and it`s
very hard to beat them by investing against them, that I think is
still very powerIul.
What I think we experienced, and where I think we went wrong,
is that we`d developed a lot oI new Iinancial instruments,
derivatives, and the like. Neither some oI the people that
developed them nor the practitioners really understood how
these derivatives worked in diIIerent situations. Like mortgage-
backed securitiesI don`t think you are going to see them being
very popular in the Iuture. 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 eIIicient in these cases.
Yeah, markets aren`t Iully eIIicient. 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 Iorward
looking and try to get things right, and oIten they do get things
rightI still think that comes through O.K. You just have to be
more qualiIied and more careIul in how you state it.
That would be my interpretation. Yes, weakened in terms oI
simple mechanical application, but the general thrust that
markets are more eIIicient than any alternativethat aspect I
don`t think is going to be changed. I don`t think you are going
to see the world moving away Irom markets, including Iinancial
markets.. I don`t see China or Brazil, or a lot oI other
developing countries, making any radical changes in their
movements towards the market, and I think Ior good reason.
II you take the last twenty or thirty yearstake the good and the
bad, including this big recessiongrowth rates are pretty
good.. That`s not only due to markets, but, certainly, market
orientation and trade were the major Iactors responsible Ior 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. %he idea that Chicago economists
dont believe in bubbleswas that more Greenspan?
Absolutely. I think bubbles have been recognized. Certainly,
Friedman and others, including myselI, said there are
phenomena that are hard to explain without thinking it`s a
bubble. The people working in macro theory have had diIIiculty
deriving these bubbles Irom any reasonably rational set oI actors
that are somewhat Iorward looking, although there are models
that can do it now. That`s an analytical challenge. But the Iact
that there have been episodes throughout history that were
clearly bubbles, that Ioreign-exchange rates overshoot and
undershoot their real valuesyes, 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. hat if anything
is distinctive about Chicago economics these days?
It`s not as distinctive as it was when I graduated with my Ph.D.
Irom Chicago. In those days, there was a great belieI in the price
system, in people`s incentives, and in linking theoretical
research to empirical research. That wasn`t common at most oI
our competitors. Both in micro and in macro, there were major
diIIerences. Chicago was hostile to Keynesian economics when
I was in graduate school. Now there`s been a lot oI convergence,
particularly in the micro side oI 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 governmentsthat governments can organize activities
well.. I think that is still a much stronger view in Chicago than
in most other places.
Two, more Irom 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 diIIerence as it was, but I still think it
is signiIicant enough to say there is a diIIerence between
Chicago and other places.
Are these differences reflected in teaching?
It`s certainly reIlected 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 beIore.
It would be reIlected in a number oI courses taught in both the
business school and the economics department, and also in the
law school courses, including some oI Posner`s.
So the rest of the world has moved closer to Chicago?
No question. Quantitative work linked to theory and
incentivesthat`s much more commonly Iound at our
competitors. When I went out on the job market, there were
some places that wouldn`t hire a Chicago economist, like
Berkeley, Ior example. For decades they didn`t hire a graduate
oI 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 oI
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. StanIord certainly does.
hat about the notion of rationality and economics, which you
yourself are closely associated with. How much of that is still
valid?
I think most oI it is still valid. It depends on what you mean by
rationality. But iI you take the view that consumers, on the
whole, react to incentives in the way you would predict they
would respondyou get very misled in the world iI you don`t
put a lot oI emphasis on that.
Now there`s behavioral economics, which has two strands. One
is extending the motives oI people, which I worked a lot on
Irom my dissertation on. Chicago was a pioneer in that. It`s
gone Iurther, but Chicago was a pioneer.
The other aspect is that consumers make a lot oI mistakes. I
think there is no question that consumers make mistakes, and I
think some oI the behavioral-economics literature has made
useIul contributions in pointing out some oI the types oI
mistakes.. That has been very useIul but it certainly doesn`t
overthrow the notion . one, that consumers most oI the time
make pretty good choices Ior themselves; and twonow I come
back to the governmentthey generally make better choices
than a government body would make Ior them. That thing we
started our discussion with, I think has to be brought into play in
evaluating the implications oI, say, behavioral economics or
books like 'Nudge.
A lot of behavioral economics has been devoted to finance.
hat about investorsare they rational?
Well, in the Iollowing sense. Not all investors aresurely not.
But I think it`s not very easy to do better than the market. II you
look at the behavioral economists who run hedge Iunds, I don`t
think, on the whole, they have done much better than others.
It`s not easy. Yes, there are a lot oI mistakes made, but to take
these mistakes and make money Irom them.. Some trends
have been Ioundthe small stock bias, and so on. It shows there
are trends that can persist. But on the whole, iI you look at
Iinancial markets they do a pretty good jobnot a perIect job.
And I think pointing that out has been a useIul contribution.
There was some theology built into the eIIicient-markets
literaturesome oI 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 oI itthese markets work pretty
wellbut there have been things that are puzzling to explain in
a simple eIIicient-markets hypothesis.
hat about the revival of Keynesianism, which, again, Posner is
associated with? %hat goes directly against the Chicago School.
hat is your response to that?
Well, Iirstly, as a Iactual matter, there certainly has been a
strong resurrection. That led me to believe that ninety per cent
or so oI economists were closet Keynesians all along, but they
were aIraid to admit it.
How much it has been resurrected? I have a bit oI an open mind
on that.. A lot oI the more explicit Keynesian remedies, like
stimulus spending and the like, will need an evaluation oI what
they did in stemming the tide.. I`m not yet convinced that
Iiscal policy was very eIIective in containing this recession.
Take the Iiscal stimulus packageeight hundred billion dollars.
They`ve hardly spent any oI it yet. The traditional argument
against Iiscal stimulus spending, even Irom 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 oI that is going to be
happening now.. I think history will say, once we understand
it, that it wasn`t very eIIective. The Ilexibility in Iinancial
responseit was understate in a lot oI 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.
hat about the area of macro-economic theory. I know its not
your field.
It`s not Posner`s Iield either. (Laughs)
%he models that Bob Lucas is associated withrational
expectations, dynamic general equilibrium models, and so on.
Some people now say that they omitted so muchthe entire
financial sector was excludedthat 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 oI the
dynamic general equilibrium models that were being promoted
in macro didn`t turn out to be that helpIul in helping us to
understand what to do to combat a major recessionary event. II
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.
bviously, 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 oI the models were too simplistic. They captured
important parts oI the economy, but they weren`t really
preparing us Ior how to handle a crisis, I think that is pretty
clear, particularly Iinancial crises.
Surely, the models werent merely designed not to handle crises.
%hese 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 oI his disciples, or others in the Iield, 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
Iinancial sector, seeing money as being unimportant. I think that
stuII just turned out to be wrong.
%he whole argument of money as a 'veil`?
Right.
How do you think that the financial crisis will change
economics? %he nineteen-thirties revolutioni:ed economics. Do
you see that sort of change?
No, not oI that magnitude. II 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, Iundamentally, the recession is
overa severe recession but maybe not much greater than the
1981 recession, or those in the nineteen-seventiesI think you
are not going to see a huge increase in the role oI government in
the economy. I`m more and more conIident oI that. And
economists will be struggling to understand how this crisis
happened and what you can do to head another one oII in the
Iuture, but it will be nothing like the revolution in the role oI
government and in thinking that dominated the economics
proIession Ior decades aIter the Great Depression. The Great
Depression was a great depression by any measure you want to
takeunemployment, 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 Irom some oI
the things that were being talked about. Pay controlswe are
getting some, but less severe ones than people were talking
about at the height oI the recession.
Do you think that all Street needs re-regulating?
Well, I do. I think some additional regulation is needed, and I`ve
called Ior some. But I don`t think you can rely on regulators,
because they Iail along with the market. II we install rules Ior
capital requirement that would work more or less
automaticallyI think there is a good case Ior that, particularly
Ior larger institutions which we know we are going to bail out iI
they get into trouble.
Some people at Chicago dont accept the too-big-to-fail
doctrine. %hey 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 iI 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 Iall where it may. Yeahthe economy
would have picked itselI 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 diIIerential
requirement Ior bigger institutions, so they can`t get as big a
multiple on their assets. Maybe derivatives marketsthose are
things I don`t Ieel very expert on, but I Iollow the literature a
little bit, and I think some changes are needed.
There are a number oI 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 oI 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 Iorce 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 oI 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 industriestrucks, airlines,
and so on. At the time, did people here talk much about
deregulating the financial markets as well?
Absolutely. We got rid oI Regulation Qinterest rate controls.
Milton Friedman and most oI us were big advocates oI that.
Glass-Steagall, there was a lot oI opposition to. Derivatives
they came in during the nineteen-seventies, and they weren`t
Iully understood.. But on the whole, in the nineteen-seventies,
there is no doubt that there was support Ior deregulation oI
many aspects oI the Iinancial markets.
In retrospect, was that position right? Isnt finance different
from other industries?
It depends. We`ve always had regulations on bank reserves and
so on. So, clearly, yes, there are diIIerences. You don`t want to
think in terms oI Iree banking. I don`t think people at Chicago
ever thought. I`ll speak Ior myselI. I never thought, even
outside the Iinancial sector, that there should be no regulation.
There are externalities. There`s pollution. There are a lot oI
things you can do. In the education area, the government
Iinancing 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
industrylike 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? hat about Ronald Coase? [Coase, an English
transplant who won the Nobel Pri:e 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 signiIicant role Ior 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
Iinanced. There may be competition among providers, but it is
government Iinanced. Some help at the college level Ior people
Irom poor backgroundsthere were many policy areas where
Chicago economics tried to analyze what was wrong, and how
you should go about Iixing it, Iinding a better way to do it.
as there anything, looking back, that Chicago got wrong?
(Laughs) There are a lot oI things that people got wrong, that I
got wrong, and Chicago got wrong. You take derivatives and
not Iully understanding how the aggregate risk oI derivatives
operated. Systemic risk. I don`t think we understood that Iully,
either at Chicago or anywhere else.. Maybe some oI the calls
Ior deregulation oI the Iinancial sector went a little too Iar, 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 Iundamental view, and I think |the
view oI| a lot oI 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 oI 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 Ior going in.
KEYWORDS Chicago School; Gary Becker; John Cassidy; economics;
economists; Iinancial crisis; recession

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January 14, 2010
INTERVIEW WITH JAMES HECKMAN
%his is the fifth in a series of interviews with Chicago School

I interviewed Heckman by telephone in late October. I began by
reIerring to a piece in the University of Chicago Maga:ine in
which he appeared to absolve Chicago economics oI any blame
in causing the Iinancial crisis. How did he react, then, to the
recent criticisms oI Chicago School economics Irom Joseph
Stiglitz, Paul Krugman, and others?

James Heckman: Well, I want to distinguish between two
diIIerent ideas. The Chicago School incorporates many diIIerent
ideas. I think the part oI the Chicago School that has been
justiIied 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 incentivesclearly
they did. It turned out that the incentives they were reacting to
weren`t socially beneIicial, but they deIinitely reacted to them.
The other part oI the Chicago School, which Stiglitz and
Krugman have criticized, is the eIIicient-market hypothesis.
That is something completely diIIerent.
I think it is important to put it into historical perspective. In the
late nineteen-Iorties and nineteen-IiIties, when Keynesianism
was really dominant, that sort oI Keynesianismso-called
hydraulic Keynesianismcompletely ignored incentives and the
way people reacted to them. What Chicago didMilton
Friedman, George Stigler, and otherswas to redress that
balance. They did a whole lot oI empirical studies that showed
how people did react to incentives, such as changes in taxes or
prices. That was incredibly inIluential, and it is still is.
In the early nineteen-seventies, Martin Feldstein, oI Harvard,
showed how changes in unemployment beneIits had a big
impact on labor supply. That had an enormous impact on policy,
and it was an application oI Chicago economics. Feldstein said
he read |Friedman`s| 'Capitalism and Freedom when he was at
graduate school in OxIord, and it had an enormous inIluence on
his thinking. That was the Chicago inIluence, and it still stands
up. Linking empirical work to theory, and showing how things
like taxes and government programs impact behavior.
.K. People were reacting to incentivesthe mortgage lenders,
the all Street bankers, the homebuyersI agree. But werent
market prices sending them the wrong signals, and isnt 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 oI it more in terms oI the market reacting too
slowly. Certainly, Irom the end oI 2007 onwards, when it was
clear that problems were emerging, many Wall Street
proIessionals steered away Irom mortgage securities. For a long
time, though, the market was sending the right signals. People
made a lot oI moneythe traders, and so on. It turned out not to
be socially optimal, but that is a diIIerent issue.
[Heckman then critici:ed behavioral economists, such as
Berkeleys George Akerlor and Yales 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 iI I
oIIered enough money I don`t think I would Iind much trouble
Iinding a ready supply oI murderers.
Also, I think you could Iault 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 Iorm oI the
eIIicient-markets hypothesis and saying this justiIied not
regulating the markets. It was a rhetorical use oI the eIIicient-
markets hypothesis to justiIy policies.
hat 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 Iriend and colleague Milton
Friedman. In the nineteen-seventies, we were sitting in the Ph.D.
oral examination oI a Chicago economist who has gone on to
make his mark in the world. His thesis was on rational
expectations. AIter he`d leIt, Friedman turned to me and said,
'Look, I think it is a good idea, but these guys have taken it way
too Iar.
It became a kind oI tautology that had enormously powerIul
policy implications, in theory. But the Iact 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 oI people
that really got carried away. It became quite stiIling.
hat 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 oI empirical statements. I
don`t think Bob got carried away, but some oI his disciples did.
It oIten happens. The Iurther down the Iood chain you go, the
more the zealots take over.
hat about you? hen 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 Iorecasts. It
seemed strange to me that they would continue to do this iI it
had been theoretically proven that these models didn`t work.
hat about the efficient-markets hypothesis? Did Chicago
economists go too far in promoting that theory, too?
Some did. But there is a lot oI diversity here. You can go oIIice
to oIIice and get a diIIerent 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 dont stick closely to economics fundamentals.]
|Black| was very close to the markets, and he had a Ieel Ior
them, and he was very skeptical. And he was a Chicago
economist. But there was an element oI dogma in support oI the
eIIicient-market hypothesis. People like Raghu |Rajan| and Ned
Gramlich |a Iormer governor oI the Federal Reserve, who died
in 2007| were warning something was wrong, and they were
ignored. There was sort oI a culture oI eIIicient marketson
Wall Street, in Washington, and in parts oI academia, including
Chicago.
hat was the reaction here when the crisis struck?
Everybody was blindsided by the magnitude oI what happened.
But it wasn`t just here. The whole proIession was blindsided. I
don`t think Joe Stiglitz was Iorecasting a collapse in the
mortgage market and large-scale banking collapses.
So, today, what survives of the Chicago School? hat is left?
I think the tradition oI incorporating theory into your economic
thinking and conIronting it with datathat is still very much
alive. It might be in the study oI 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 thaton the contrary.
So, I think the underlying ideas oI the Chicago School are still
very powerIul. The basis oI the rocket is still intact. It is what I
see as the booster stagethe rational-expectation hypothesis
and the vulgar versions oI the eIIicient-markets hypothesis that
have run into trouble. They have taken a beatingno doubt
about that. I think that what happened is that people got too Iar
away Irom the data, and conIronting ideas with data. That part
oI the Chicago tradition was neglected, and it was a strong part
oI the tradition.
When Bob Lucas was writing that the Great Depression was
people taking extended vacationsreIusing to take available
jobs at low wagesthere was another Chicago economist,
Albert Rees, who was writing in the Chicago Journal saying,
No, wait a minute. There is a lot oI evidence that this is not true.
Milton Friedmanhe 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, iI you read his empirical books they are Iull oI
empirical data. That side oI his legacy was neglected, I think.
When Friedman died, a couple oI years ago, we had a
symposium Ior 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 oI rational
expectations says, and that`s part oI Friedman`s legacy. I said,
'No, it isn`t. He was much more empirically minded than that.
People took one part oI his legacy and Iorgot the rest. They
moved too Iar away Irom the data.
KEYWORDS Chicago; Chicago School; James Heckman; John
Cassidy; economics; economists; Iinancial crisis; recession

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January 15, 2010
INTERVIEW WITH KEVIN MURPHY
%his is the sixth in a series of interviews with Chicago School

Kevin Murphy is one oI the best-known Chicago economists
Irom the post-Lucas, post-Fama generation. In 1997, he was the
recipient oI the John Bates Clark Medal, which is presented to
the best American economist under Iorty. Although he is
primarily a microeconomist, Murphy has published articles on a
wide range oI subjects, including income inequality, the value oI
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 oI our conversation.

%o 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
Iinancial markets always work eIIiciently, he has taken a
beatingno 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 isnt its media image?
I`ve always thought oI Chicago economics as an approach to the
subjecta way oI doing economics. It`s based on the belieI that
the tools oI economic analysis are really useIul Ior 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 testa guy would give the
same answer in a seminar to a question about the economy that
he would give iI 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 oI 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 oI phenomena in the real world, you are
always trying to give an example. II you can`t give one it is a
problem.
It is also true in seminars. II you present a paper in Chicago, you
don`t get much oI a chance to present. You have to deIend. The
type oI paper where the presenter says, 'Well, this assumption
clearly isn`t realistic, but I`m just going to ignore that Ior now
and derive some resultsthere isn`t a whole lot oI sympathy
Ior 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.
hat about skepticism toward the government. Isnt 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 Iailure 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
eIIectiveness oI the two.
hat 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 Irom housingthe rental cost oI
housing capitalis going to be really high in the Iuture. How
realistic is that? Boy, it`s really hard to justiIy 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 Irom 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 arent.]
Empirically, I don`t see how you can distinguish between the
two. It`s become almost a matter oI semantics. Do you call it
time varying risk premiums or irrational exuberance?
But the Iact is that much oI the variation in the market is
unpredictable. In Iinance research, it`s a major victory iI you can
explain halI oI one per cent oI the price variation with your
model. The idea that you can`t beat the market, or predict it
that part oI the eIIicient-markets hypothesis is very much alive
and well.
hat 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
refected much of that work early on.
Well, I think that work does have empirical implications, but it
is certainly a larger distance back Irom the theory to the data.
[At this point, Murphy defended Lucass work, saying that it
helped fill in an important gap in Keynesian economics, which
couldnt explain the inflation of the nineteen-seventies. Going
back to the nineteen-sixties, Milton Friedman and Columbias
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 unemploymentin the fargon of
economics, the 'Phillips Curve` was vertical. Lucas added a lot
of rigor to that idea, Murphy said. He also brought up Lucass
work on the causes of economic growth, which date back to the
nineteen-eighties.]
That side oI his contribution is probably even more important,
because it says that the questions oI what we can do to keep
creating growth is really critical. That gets us back to physical
capital, human capital, and technical progressand those are
the things that really matter in the end. How do we do a better
job oI promoting physical investment, human capital
investment, and technological progress? When you think that
way, you have to always consider the long-run implications oI
short-term actions.
%hat takes us neatly back to the current situation. You have
written skeptically about the bama administrations stimulus
package. hy are you so critical?
[Murphy referred me to a January 2009 presentation of his
(pdf). %he presentation analy:es the likely impact of the stimulus
and concludes that it wouldnt do much good. %he 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 wouldnt 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 oI what size the |Iiscal| multipliers are
that`s just part oI the question.
KEYWORDS Chicago; Chicago School; John Cassidy; Kevin Murphy;

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January 15, 2010
INTERVIEW WITH RAGHURAM RAJAN
%his is the seventh in a series of interviews with Chicago School

I met Rajan in his oIIice at the Booth School oI 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 oI 2005, issued a prescient warning about the dangers
oI a Iinancial blowup involving the credit markets. It was
striking, I remarked, that despite Chicago`s image as a bastion
oI market eIIiciency, it was also home to much more
questioning research in the Iinancial system.

Raghuram Rajan: Forget the public utterances: the research done
at this place was, essentially, right on the ballissues oI
liquidity, the Iact that liquidity might dry up, and who`s there to
provide liquidity in those situations. One oI my colleagues,
Doug Diamond, is, in many ways, the Iather oI 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? UnIortunately, this stuII is all too real
these days.
The point is, research drives thinking, and there are all kinds oI
research being done here. People at the extremes get a lot oI
press, people who say: 'Let`s not do anything, let`s liquidate
the Andrew Mellon kind oI 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 diIIerent Irom,
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 Iormerly at the International Monetary
Fund| Ior 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 oI
this sizenot by any stretch oI 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 oI America it is a completely
diIIerent kettle oI Iish. We have to Iigure 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
doit`s just a matter oI nationalizing them or shutting them
downthere are a whole lot oI 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 oI the Iinancial
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 oI what we
haven`t done is that we haven`t made the banks Iace up to more
pain. That would have made it politically easier to do what
needed to be done.
hen you say, 'make the banks face up to more pain,` what do
you mean? %ougher regulation? Big equity stakes for the
governmentalong 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 oI 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
accountsgetting 0.25 per centand the banks are making a
huge spread on nearly every asset they hold, because they are
Iinancing them at pretty close to zero rates. Another way oI
doing thisa way that would be nice to tryis to Iorce the
banks to load up on capital.
What is the point oI all this? The point oI 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 proIitable
lending opportunities at this point. But iI there aren`t, why are
all the savers paying Ior this? Because you are not getting them
to lend any more, and you are not getting more investment,
which was the whole point oI having interest rates so low. In
Iact, what you are doing is setting up a whole lot oI other asset
bubbles at this point.
Another way would be to put more direct pain on the banks. For
example, iI they were Ilush with capital and Iound they couldn`t
pay bonuses, so all oI this |money| went into increasing the
capital base, they would have an incentive to make loans to
reduce the eIIective capital that they had. What we have at the
moment is that the citizenry is paying Ior the banks. Get the
banks to pay Ior themselves.
That gets away Irom the whole Chicago issue. But what I`m
arguing is in Chicago you have the extreme, which says, 'Let
the chips Iall they may. What`s the problem with letting a Iew
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 oI
organizational and relationship capital embedded in the banks. II
you let them go, it is very hard to start them up |again|.
hat about the causes of the crisis?
Within the big tent oI Chicago, again, there are |also| so many
diIIerent explanations Ior why this happened. Whether it was an
agency problem in the banking system itselI. Whether it was
markets going haywireDick Thaler would be in that camp
irrational exuberance oI one kind or another. Or whether it was
government interventionthe story about pushing credit to the
less well oII segments oI the population. My sense is, iI you
think seriously about this, all parts oI it are important.
When you have a systemic crisis oI this kind in a developed
country . the whole point about development is that you deal
with some oI these problems. You don`t have populist extension
oI 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 oI 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.
hen it was largely associated with the efficient-markets
hypothesis?
I would guess.. When I came here, Merton Miller and Gene
Fama were the leaders oI the Iinance group. Clearly, both oI
them were strongly persuaded oI the old Chicago viewpoint.
Since then, I would say that Dick Thaler and Rob Vishny have
been two important Iigures arguing that there are some serious
departures Irom Iundamentals. The whole point about a strong
Iorm oI eIIiciency is this: II everybody knows things are going
wrong why don`t they correct it? Vishny`s arguments have been
about why it doesn`t get correctedlimits to arbitrage and stuII
like that. I think that is quite persuasive. Dick Thaler`s |work|
has been about how people make mistakes oI a certain kind.
That by itselI is not enough to explain major departures. II
somebody makes mistakes, why doesn`t somebody else see
those mistakes and try to take advantage oI them?
ho brought in %haler and Jishny? as a deliberate decision
taken to try and broaden out the Chicago approach?
Vishny evolved. He was a dyed-in-the-wool corporate-Iinance
guy when he came in, and then he got interested in market
eIIiciency and things like that. He put his money where his
mouth is. He ran a very successIul |investment| Iund. And now
he`s come back. Vishny evolved and thereIore wasn`t an import
oI 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 iI anybody else has
told you. Dick Thaler used to teach a course on market
ineIIiciency. 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 bestwhere 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. UnIortunately, in too many departments,
disagreements about ideas turns into personal disagreement.
That`s an important diIIerence in Chicagothat we criticize the
idea, and we criticize it very Iiercely 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 Iewer
personalities.. Maybe there are Iewer giants at the business
school, but it may also be that the culture here is one oI 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 peoplejust because oI the size.
We have an economics group, a behavioral group, a Iinance
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 Iormidable 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 oI seminars across the school. And our
lunchroom is Iull oI debate about this, all the timeagain,
because we diIIer 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 oI the banking system. II you let them all
collapse, can they regenerate immediately, or is there a
diIIiculty in rebuilding organizations once they collapse? Some
people say liquidate and Irom the ashes you will see the
phoenixes rising. Other say noashes are ashes and you get
nothing Irom that.
Three: there is also some argument about the extent oI the
Iinancial center-political system nexus. Those on the leIt and the
right basically think they are in bed with each other. Those at
the center think that |policymakers| are in a diIIicult situation.
So you have some sympathy for %im Geithner, Larry Summers,
and others in the bama Administration who are being attacked
for being too soft on all 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 oI 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 Iail? They aren`t going back to what
they said either.. Maybe iI we had let them Iail we would have
had a better outcomewho knows? But I think you have to give
the authorities credit Ior at least putting a Iloor under the panic.
And I think |Hank| Paulson deserves some oI the credit. This
Administration Iollowed some oI 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 oI
sympathy Ior what they did. But I do think in hindsight, and
even at the time, that they could have been a lot tougher. Their
Iear was that iI 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 infections and so on?
Yes. At that time, they could have asked Ior more |in return|,
but I don`t think they were Iocussed on it. The problem now is
the banks act as iI there was never a problem. It`s the ex post
rationale: we paid you back with proIits. Well, nobody was
willing to lend to you then. The eIIective interest rate the
government should have charged would have been inIinity.
When there is no quantity available, the price was inIinity.
(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.
here 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 Ior
other things that haven`t been solved. So we muddle along
because the crisis wasn`t deep enough |to Iorce big changes|.
We used all our bullets. We don`t have any bullets leIt, and we
are in the process oI 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 iI we haven`t dealt with the
Iundamental problems? That`s my worrythat we will emerge
without a serious sense that there are problems we need to Iix.
We will have identiIied 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 oI it drying up. It wasn`t about
market eIIiciency, or anything oI 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.
ere there are precursors at Chicago to your line of work?
Well, there is Ronald Coase. Coase is an important Iigure at
Chicago, and he started this whole thing about worrying about
organization.
e have talked about the efficient-markets theory. hat about
the other big modern theory associated with Chicagothe
rational-expectations hypothesis? hats left of that one?
The Iault oI the macroeconomics proIession was not so much
rational expectations, which is a convenient and useIul device. It
was to ignore the plumbing. Economists could aIIord to do that
Ior a long time because the plumbing didn`t back up. Now that
the plumbing has backed up you Iind 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.
KEYWORDS Chicago; Chicago School; John Cassidy; Raghu Rajan;
Raghuram Rajan; economics; economists; Iinancial crisis; recession

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January 21, 2010
INTERVIEW WITH RICHARD THALER
%his is the eighth in a series of interviews with Chicago School

Thaler, one oI the Iounders oI behavioral economics, was out oI
town when I visited Chicago. I subsequently caught up with him
on the phone, and I began by asking him what remained oI the
eIIicient-markets hypothesis, which he has long questioned.

Thaler: Well, I always stress that there are two components to
the theory. One, the market price is always right. Two, there is
no Iree lunch: you can`t beat the market without taking on more
risk. The no-Iree-lunch component is still sturdy, and it was in
no way shaken by recent events: in Iact, it may have been
strengthened. Some people thought that they could make a lot oI
money without taking more risk, and actually they couldn`t. So
either you can`t beat the market, or beating the market is very
diIIiculteverybody agrees with that. My own view is that you
can |beat the market| but it is diIIicult.
The question oI whether asset prices get things right is where
there is a lot oI dispute. Gene |Fama| doesn`t like to talk about
that much, but it`s crucial Irom a policy point oI view. We had
two enormous bubbles in the last decade, with massive
consequences Ior the allocation oI resources.
hen I spoke to Fama, he said he didnt know what a bubble
ishe doesnt even like the term.
I think we know what a bubble is. It`s not that we can predict
bubblesiI we could we would be rich. But we can certainly
have a bubble warning system. You can look at things like
price-to-earnings ratios, and price-to-rent ratios. These were
telling stories, and the story they seemed to be telling was true.
So what are the policy implications? hat should the
government do to prevent bubbles from inflating, in the housing
market, for example?
Several things. I think Fannie Mae and Freddie Mac should raise
lending requirements in certain areas that look Irothy. God did
not say that you should be able to borrow one hundred percent
oI the price oI a house.
hat was the ultimate cause of the financial crisis? Poor
regulation? Greed? Bad market signals? Human frailty?
Leverage caused the crisisand I would say that is a pretty
uncontroversial statement. Human Irailty comes into play at two
levels. One, the people who were taking out the subprime
mortgage loansmany oI them didn`t understand what they
were doing. Two, the C.E.O.s clearly didn`t understand what
their traders were doing. I call that the 'dumb principal
problem. Go down the listA.I.G., Citigroup, Bear Stearns,
Lehman Brothers. These companies were destroyed or
devastated by a small part oI the Iirm that was hurtling Iorward
and was risking the entire Iirm. The people in charge were either
greedy or stupid, or possibly both.
hat about the rational-expectations hypothesis, another
Chicago theory? hats left of that one?
(Laughs) Is there anybody who really believes in Ricardian
equivalence? That`s a preposterous idea. I wonder iI you can
Iind anyone, other than, possibly, |John| Cochrane and |Robert|
Barro, who has made the calculation as to what impact
government spending will have on their Iuture taxes and
bequests. People don`t act 'as iI they were doing that either.
They are ignoring it.
I spoke to Cochrane. He said the problem with behavioral
economics is it is too flexibleyou can use it to explain
anything. He also pointed out that Robert Shiller has been
calling for economics to incorporate psychological insights for
thirty years, but little progress has been made.
[In answering this question, %haler brought up the Internet
stock bubble, during which shares in Palm, the handheld
computing companies, were worth more than the entire market
capitali:ation of Palms parent company, 3Com.]
|Cochrane| has a model explaining why, during the Internet
bubble, the prices oI Palm and 3Com were rational. Rational
models are one hundred per cent Ilexible. II you allow time-
varying discount rates, there is no discipline whatsoever. II you
look at what happened to tech stocks and then to real estate, and
you say maybe there wasn`t a bubblewhere is the discipline in
that?
I think it`s Iair to say that behavioral economics hasn`t solved
everything. That is true. But to say Shiller and I have been doing
it Ior thirty yearsthere was just me and him. Now we have
some young recruits. We are not outmanned a thousand to one.
But there is work to do.
Do you think the financial crisis will come to be seen as a
watershed for behavioral economicsa moment it became
mainstream, or even dominant?
I think it is seen as a watershed, but we have had a lot oI
watersheds. October 1987 was a watershed. The Internet stock
bubble was a watershed. Now we have had another one. What is
the old linethat science progresses Iuneral by Iuneral?
Nobody changes their mind.
What will happen is that the economists |in their thirties and
Iorties| are pretty open to these ideas. They don`t think it is very
controversial. That`s where economics will be in ten years. They
will be running the subject. People like Posner and Becker and
Fama and Lucas and Iwe will be history.
But you dont think the financial crisis and recession will cause
an intellectual revolution in economics, as happened in the
nineteen-thirties?
No. Nothing will happen Iast. But the next generation oI
economists, it is saIe to say, will be more open to alternative
models oI human behavior and less conIident that markets work
perIectly.
Do you think that Chicago economics of the old school has lost
some of its swagger?
No, I don`t see any measurable loss oI swagger. Posner goes
against the grain. He`s probably the counterexample to the
theory that nobody learns anything. Becker and Lucas and so
onthat group probably thinks he has lost his mind.
%hat brings us to the Keynesian revival, and to the dispute about
the bama Administrations stimulus package. hat are your
views on that?
The General Theoryanybody who goes back and reads that
book can`t help but be impressed. It contains so many insights,
including many that anticipated behavioral Iinance. As Ior the
stimulus, I don`t know where we would be now iI there hadn`t
been a stimulus package.
Back to Chicago matters. You say you dont see much less
swagger, but I hear that there has been a lot of internal
discussion, and debate, about what happened. Is that not true?
Yes. There has been a ton oI discussion in the lunchroom. For
six months, it was the only thing anybody could talk about. The
thing I will say about my colleagues is that they were very
engaged by what was going on. The good thing I will say about
the Chicago School is that it was always about the world, not
about the abstract. That continues. People like Kevin Murphy
just want to understand how the world works.
The tradition oI Chicago price theory is a good one, and it is a
low-tech methodology that tries to apply simple economic
theory to the world. |Steve| Levitt is a perIect illustration oI
that. In some ways, I, too, can Iit into that deIinition oI the
Chicago School.
KEYWORDS Chicago; Chicago School; John Cassidy; Richard Thaler;

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After The Blow Up Chicago School

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1he New YorkerJanuary JJ, 20

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