Chicago school of economics

• 1. Introduction

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  The Chicago school of economics has awarded more Nobel Memorial Prizes in Economic Sciences than any other university in the world. Fifteen laureates from the University of Chicago Economics Department have walked away with that prize since it was first given in 1969. But what is the Chicago school, exactly? It is not a building, not a department, not even a formal organization. It is a school of thought, shaped by intense argument, heterodox conviction, and a shared belief that prices tell us almost everything we need to know about how the world works. How did a group of economists in the American Midwest come to reshape not just economics, but law, political science, and social theory? And why does the Chicago school still provoke such fierce argument today?

• 2. The Old Guard

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  Frank Knight joined the University of Chicago economics department in 1929, coming from the University of Iowa, and his most influential work had already appeared eight years earlier. Risk, Uncertainty and Profit, published in 1921, gave economists the concept of Knightian uncertainty, the idea that some risks simply cannot be calculated or predicted. Knight believed the free market could be inefficient, a position that set him apart from later Chicago thinkers, and he drew from institutional economics to build his own layered perspective.

  Henry Calvert Simons was first shaped by Knight while Simons was an assistant professor at the University of Iowa from 1925 to 1927. In the summer of 1927, Simons moved to the Department of Economics at the University of Chicago, arriving before Knight himself. He stayed for years and became notable for his work on antitrust and monetarist models. Jacob Viner joined the faculty in 1916 and remained for thirty years, until 1946, and in that span inspired a generation of economists that included Milton Friedman.

  Aaron Director arrived at Chicago's Law School in 1946 and became a founder of the entire field of law and economics. He established The Journal of Law and Economics in 1958, and his influence stretched into the courts: Richard Posner, Antonin Scalia, and Chief Justice William Rehnquist all counted Director among their intellectual influences. These early scholars collectively shaped the environment that would produce the school's most celebrated generation.

• 3. Friedman and Stigler

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  Milton Friedman was born in 1912 and died in 2006, and in between he became one of the most influential economists of the twentieth century. He had studied under Frank Knight, and in 1976 he received the Nobel Prize in Economics for, among other things, A Monetary History of the United States, published in 1963. That book contained his most consequential historical argument: that the Great Depression had been caused by the Federal Reserve's policies through the 1920s and worsened by those same policies in the 1930s.

  Friedman argued that governments should pursue a neutral monetary policy aimed at long-run economic growth through the gradual expansion of the money supply. He advocated the quantity theory of money, which holds that general prices are determined by money, and he warned that active monetary or fiscal policy can produce unintended negative effects. In Capitalism and Freedom, published in 1962, he wrote about the multiple lags between a policy need and its effects, arguing this compounding delay made intervention unreliable. The phrase "money matters" came to be associated with him. He also won the John Bates Clark Medal in 1951, among the first awarded.

  George Stigler was born in 1911, had his thesis supervised by Frank Knight, and won the Nobel Prize in Economics in 1982. He is best known for developing the Economic Theory of Regulation, also called regulatory capture, which holds that interest groups use the regulatory power of government to shape laws in ways that benefit themselves. His 1962 article "Information in the Labor Market" developed the theory of search unemployment. It was Stigler himself who coined the term "Chicago political economy" for a further branch of the school's thought, one that reached the controversial conclusion that politics tends toward efficiency and that policy advice is largely irrelevant.

• 4. Coase and the Cost of Everything

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  Ronald Coase was born in 1910, died in 2013, and won the Nobel Prize in 1991 for work that upended how economists thought about firms and about law. His first major article, "The Nature of the Firm", appeared in 1937 and argued that firms exist because of transaction costs. Rational individuals would otherwise trade through bilateral contracts on open markets, but at some point the costs of those transactions make it more efficient to use corporations.

  His second landmark article, "The Problem of Social Cost", came out in 1960, and it contained an argument that became one of the most discussed propositions in economics. Coase contended that in a world without transaction costs, people would always bargain their way to the same allocation of resources, no matter how a court ruled in a property dispute. To illustrate, he used an 1879 London nuisance case called Sturges v Bridgman, in which a noisy sweetmaker and a quiet doctor were neighbors. The doctor sought an injunction against the noise. Coase argued that whatever the judge decided, the two parties could reach a mutually beneficial bargain producing the same distribution of resources. Transaction costs are the only thing that prevents this from happening.

  The implication was pointed: law and regulation are not as powerful or effective as lawyers and government planners believe. Coase and those who followed him argued that the burden of proof for positive effects should fall on any government intervening in the market.

• 5. Third Generation Thinkers

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  Gary Becker was born in 1930 and received his PhD at the University of Chicago in 1955, under H. Gregg Lewis. He returned to Chicago as a professor in 1970 and remained affiliated with the university until his death in 2014. He received the Nobel Prize in Economics in 1992 and the Presidential Medal of Freedom in 2007. Becker became known for applying economic methods to subjects that had rarely been analyzed that way, including crime, sexual relationships, slavery, and drugs, always assuming that people act rationally. His work partly inspired the popular economics book Freakonomics, and in June 2011 the Becker Friedman Institute for Research in Economics was established at the University of Chicago in his and Friedman's honor.

  Robert Lucas, born in 1937, won the Nobel Prize in 1995 for developing and applying the hypothesis of rational expectations, work that transformed macroeconomic analysis. Lucas dedicated his career to unwinding Keynesianism and argued that macroeconomics should be built on the same foundations as microeconomics, not treated as a separate mode of thought.

  Eugene Fama, born in 1939, has spent his entire teaching career at the University of Chicago and is the originator of the efficient-market hypothesis. His 1965 article first defined an efficient market as one where the actual price of a security at any point in time will be a good estimate of its intrinsic value. His 1970 article, "Efficient Capital Markets: A Review of Theory and Empirical Work", brought the notion into the forefront of modern economic theory. He is the fourth most highly cited economist of all time and won the Nobel Prize in 2013.

  Robert Fogel, born in 1926 and died in 2013, won a share of the Nobel Prize in 1993 for introducing cliometrics, a method that applies economic theory and quantitative analysis to historical questions. In his book on railroads and American economic growth, Fogel set out to rebut the widespread idea that railroads drove economic expansion in the nineteenth century. His later book, Time on the Cross, argued that enslaved people in the Southern states had a higher standard of living than the industrial proletariat of the Northern states before the Civil War, a conclusion that generated lasting controversy.

• 6. Hayek and Allied Thinkers

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  Friedrich Hayek was born in 1899 and was still teaching at the London School of Economics when he began making frequent contact with scholars at the University of Chicago in the 1940s. His book The Road to Serfdom was published in the United States in September 1944 by the University of Chicago Press, with help from Aaron Director, and played a significant role in shifting how Milton Friedman and others understood the relationship between economic planning and political freedom. Hayek moved to Chicago in 1950 and was a faculty member of the Committee of Social Thought there until 1962.

  In 1947, Hayek, Frank Knight, Friedman, and George Stigler worked together to form the Mont Pelerin Society, an international forum for libertarian economists. The University of Chicago Press continued publishing Hayek's work in later years, including The Fatal Conceit and The Constitution of Liberty.

  James M. Buchanan, born in 1919, studied under Frank Knight at the University of Chicago and received his PhD in 1948. Though he never held a position at the university afterward, he won the Nobel Prize in Economics in 1986 for his public choice theory, and his later work remained closely tied to Chicago thinking. He became the foremost proponent of the Virginia school of political economy, which had also been shaped by the earlier generation of Chicago economists. Thomas Sowell, born in 1930, received his PhD at Chicago in 1968 under George Stigler, and is considered a representative of the Chicago school.

• 7. Dissent and Controversy

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  Paul Douglas, an economist who also served as a Democratic senator from Illinois for eighteen years, was one of the most direct internal critics. He described finding that economic and political conservatives had acquired almost complete dominance over the department. In his telling, his colleagues would neither use statistical data to develop economic theory nor accept critical analysis of the economic system, and Knight was, as Douglas put it, "openly hostile". Douglas concluded the environment had become too unfriendly to stay.

  The 2008 financial crisis brought the efficient-market hypothesis under renewed scrutiny. Defenders of Eugene Fama's theory argued that the hypothesis was actually consistent with a large decline in asset prices, because the event was unpredictable, which is precisely what the hypothesis would predict. They also pointed to the equity premium puzzle, which implies that market crashes do not happen often enough to justify the high ratio of return on risky assets.

  Nobel laureate Paul Krugman of Princeton University called some Chicago school economists' recent comments "the product of a Dark Age of macroeconomics in which hard-won knowledge has been forgotten", and Brad DeLong of the University of California, Berkeley described what he called an "intellectual collapse". John Cochrane, a Chicago finance economist, countered that these criticisms were ad hominem and showed a politicized ignorance of what economics and finance are actually about. A film called Chicago Boys, which took a highly critical view of the economic reforms associated with the school, was released in Chile in November 2015.