The Fed: The Chicago School's Achilles Heel

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In a recent
post "Triumph
of the Austrian Economists
," David Frum laments the displacement
of the respectable Chicago School as the economists of choice among
the political Right. Frum fails to see that conservative Republicans
are justified in switching their allegiance to the Austrian economists,
because supply-side monetarists have a glaring blind spot when it
comes to the Federal Reserve.

Frum Is Flummoxed

Frum is dismayed
at the resurgent interest in Austrian analysis and policy recommendations:

An important
subtheme of Noah Green’s survey
of Fed critics is the triumph of Austrian over Chicago economics
within the modern political right.

Thirty years
ago, right of center economists did not accept recessions as necessary
and indeed healthful responses to speculative bubbles. They still
winced at the memory of Hoover era officials who welcomed the
Great Depression as a means to "purge the rottenness"
from the market system.

Thirty years
ago, right-of-center economists did not celebrate high interest
rates as a safeguard of the currency. Thirty years ago, they measured
inflation by the dollar’s ability to buy goods and services –
not its value relative to gold or some other commodity.

Even today,
probably most business economists – most Republican economists!
– reject those ideas. I notice that the e21
criticizing the Fed was not signed by two distinguished
right-of-center academic economists, Greg Mankiw and Robert Barro.
I notice that it was not signed by President George W. Bush’s
two leading economic advisers, Glenn Hubbard and Larry Lindsey.

In the first
place, Frum seems to have forgotten that, after several years of
Republican control of both Congress and the White House, we are
in the midst of the worst economic crisis since the Great Depression.
For all I know, the president ignored their advice, but the refusal
of economic advisers to George W. Bush to sign a letter hardly
makes me suspicious of the letter’s soundness.

Before delving
into the main focus of this article – namely, the superiority
of the Austrian over the Chicago School when it comes to the insidious
role of the Fed – I want to correct two historical errors in
Frum’s condescending post:

Frum’s line
about "Hoover era officials" who wanted to "purge
the rottenness out of the system" is a reference to Andrew
Mellon, treasury secretary to Herbert Hoover. In Hoover’s memoirs,
he describes the White House discussions following the stock-market
crash of October 1929. Hoover explains that Mellon did indeed advocate
a policy of liquidationism, in which the federal government would
stand back and allow the market to run its natural course.

This is the
point at which modern Keynesians – a category that includes
David Frum himself
, whether or not he chooses to use the label
– stop quoting from Hoover’s memoirs. "Aha!" they
say, "Hoover sat back and did nothing, and that’s why the 1929
crash turned into the Great Depression. Quick, let’s spend some
more borrowed money!"

for the Keynesians, if they would just read the
very next page
in Hoover’s memoirs, he explains that he
rejected Mellon’s advice. Even though people like Paul Krugman,
Brad DeLong,
and yes, David Frum continue to insist otherwise, Herbert Hoover
was a big-government man
who instituted a New Deal lite.

that is why the financial crash that occurred on his watch
mushroomed into the Great Depression. If Hoover had actually been
the laissez-faire ideologue portrayed by his critics – if Hoover
really had done nothing much, just as his predecessors did when
facing their own financial panics – then modern
Americans wouldn’t know anything about him
. How many Americans
can confidently identify the presidents during the Panic
of 1819
or the Panic
of 1907
? Yet everybody "knows" that Herbert Hoover
caused the Great Depression because he believed in pure capitalism.

Besides perpetuating
the myth of a liquidationist Hoover, Frum also seems to be ignorant
of how the Volcker Fed ended the Carter-era stagflation and ushered
in the "Great Moderation." Specifically, Paul Volcker
restored people’s faith in the US dollar by jacking
up interest rates
and by stabilizing commodity prices (as explained
at the time in the Wall Street Journal
by Arthur Laffer
, whose Chicago School bona fides Frum presumably
can respect).

The Achilles
Heel of the Chicago School

People often
ask me why I call myself an Austrian economist, as opposed to a
more generic "free-market economist." After all, what’s
the big difference between the average Austrian and the average
supply-side monetarist?

Beyond the
methodological differences,
in practice the Chicago School has one major shortcoming: its neglect
of capital theory. Specifically,
many followers of Milton Friedman think that the Fed is "doing
its job" so long as the CPI does not rise too quickly.

Ludwig von
Mises and Friedrich Hayek
pointed out long ago that this "[consumer] price stabilization
rule" would lead to disaster. Indeed, Murray Rothbard stressed
that the stock-market bubble of the late 1920s – fueled by
the Fed’s policies – did not coincide with rampant consumer-price

We saw a similar
pattern in our times, during the housing-bubble years. Many prominent
Chicago School economists thought everything was fine. After all,
the Bush administration had (modestly) cut tax rates, and although
it had increased spending far too much, that would hardly sow the
seeds for a minidepression. It was also true that Fannie Mae, Freddie
Mac, and other government incentives were pushing banks into making
risky loans, but I do not recall any Chicago School economists before
the crash saying that this would devastate the economy.

On the other
hand, there were plenty of academics
and investors
who relied on Austrian business-cycle theory to diagnose the housing
bubble. They quite rightly understood that the Greenspan Fed’s decision
to push interest rates down to incredible lows would distort the
capital structure of the economy (the regulation of which is, after
all, what the market-interest rate is for, in the Austrian
view). Artificially low interest rates could generate a euphoric
boom, but it would inevitably give way to a bust.

Paul Krugman
is right when he says that many of the current critics of Keynesian
policies were caught completely flat-footed by the housing crash.
In contrast, some interventionist economists (such as Nouriel
) went on record with surprisingly accurate predictions
of how fragile the economy was.


Republicans have traditionally associated themselves with the Chicago
School. But if the only choice is between that approach – especially
in its most extreme rational
expectations form
– and the worldview of a Roubini or Krugman,
conservatives will appear incapable of explaining major crashes,
which is a rather serious weakness.

No school of
economic thought is perfect; I personally learned more about international
trade from the work of Arthur Laffer than I have from the Austrians.
But when it comes to explaining the boom-bust cycle – and recognizing
the dangers of Bernanke’s actions – I turn to the Austrians.


14, 2010

Murphy [send him mail],
adjunct scholar of the Mises Institute,
is the author of The
Politically Incorrect Guide to Capitalism
Human Action Study Guide
and The
Man, Economy, and State Study Guide
His latest book is The
Politically Incorrect Guide to the Great Depression and the New

Best of Bob Murphy

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