Chicago School/Conservative Views of Economics

Guest post by Don Wharton

Milton Friedman

Economic theories are to a great extent ethical claims. They say that shared outcomes will be better if we engage in certain policies of governance, taxation and finance. The outcomes for people living under those laws will be vastly different depending upon which theories and which laws we adopt. Economics is asserted to be a science and in theory we should be able to compare these theoretical claims with the factual data.

Milton Friedman was one of the central figures creating the conservative Chicago School of economics. A prime feature of this variety of economics is a belief in largely unrestricted free markets. This can be very effective in increasing or decreasing commodities, manufactured goods and services in response to changes in relative demand by our society. If there is a shortage of corn the price will rise. There will then be more land, labor, fertilizer and machinery used to produce corn, satisfying the demand.

Friedman wanted an extremely minimal government and disliked things such as permits and licenses as a matter of almost quasi-religious belief. He was opposed to licensing medical doctors. Of course, this would have opened up medical services market to a vast variety of medical fraud and quackery. To be fair, there are laws against fraud and in principle Friedman would argue that these laws would limit misbehavior.  On the other hand, we have seen how well this worked for the banking industry this past decade.

Alan Greenspan was a supporter of Friedman's views. He saw no problem with the mushrooming of sub prime, low documentation loans for real estate or the slicing and dicing of bundled mortgages to finance the recent housing bubble. This fraud was endorsed by rating agencies that seemed willing to give AAA ratings to repackaged mortgage instruments sold to credulous buyers. The ratings agencies were in effect bribed by the financial institutions that were requesting the ratings. Once again laws against fraud in theory apply. A few people have been prosecuted under such laws, but only a very tiny percentage of the army of people who built the housing bubble that destroyed many trillions in the American people's assets. The fear of prosecution was almost totally absent during the building of the housing bubble. The very minimal current levels of prosecution suggests there would be no fear of  bad legal consequences when future markets become similarly disconnected from reality.

A major contributor to the recent credit bubble was the abolition of Glass-Steagall Act which was installed at the height of the Great Depression in 1933, but partially repealed in 1999.  These provision limited the abilities of banks to directly participate in risky investments for their own profit. This reflected the assumption made by Friedman and others that free markets worked and the best government was one that governed least. The result was a disaster with overall median family net worth falling 38.8 percent from 2007 to 2010 (June 2012 report from Federal Reserve).

Friedman was a monetarist asserting that inflation was always a result of an increase in money supply. He argued that the Fed should be abolished and the money supply should be increased at a fixed rate based on the increase in the national economy. He also argued that government should never use government spending to increase demand in recessionary times. The April 2012 GDP rate was slightly over 8% more than the peak rate prior to the crash recorded in April 2008. The M2 money supply increased 28.7% over the same time. Over $1 trillion in federal budget deficits has occurred every year of the Obama administration.

 Based on these facts there has been an avalanche of predictions by conservative economists and politicians that inflation and the fear of inflation will vastly increase the cost of funding our national debt, destroy the value of the dollar, and put us on a pathway to becoming the next Greece. The yield on the ten year US note has collapsed from a recent peak of 4% on 4/5/2010 to 1.51% on 8/2/2012. The dollar index, DXY, at the beginning of August 2012 is higher than at the beginning of August of 2011, 2010, 2009 and 2008.  Their predictions have obviously been flat wrong.

The Neo-Keynesian concensus is that during the recessionary period following a liquidity crisis the government should provide demand which makes use of the people and productive capacity that would otherwise not be put to good use. There was a very large inventment in skills, organization and tools in the construction industry during the housing boom. After years of disuse a large fraction of these investments now have no value. People are unemplyed for years and are living with a sense of desperation with no options to support their families. At the same time we have thousands of schools which are desperately in need of renovation. We have bridges that are in danger of collapse and we have a transportation system which is in near dysfuntional gridlock in many areas of our country.

Much of our society is now focused on paying down debt resulting in an increased demand for safely stored money and lower than normal desire to invest or consume. The result is extremely low interest rates at every future maturity date of Federal debt. Thus, the cost to our national government for most borrowing is less than current or expected rates of inflation. This means that any public sector investment that yields any positive efficiency in our economy creates a net positive benefit for society.

 The Friedman economic view is that these investments will always create distortions and inefficiencies that damage the economy. The obvious net value of children learning better in renovated schools or people getting where they wish to go more rapidly and safely with an updated trasnportation system is strong evidence against conservative economic claims. Public health, fire safety and police protection are other obvious areas where positive value can be generated at low or negative net cost.

A sweaping claim made by conservative economists is that fiscal deficits are financial warfare against our children. The reality is that forcing so many children to live in poverty or the stress of near poverty is an unneeded war against them in the here and now. The impact of forced austerity on employment has been illustrated by the nearly 25% unemployment rates in Greece and Spain. Statistical analysis of changes in budgets and subsequent changes in GDP in Euopean countries suggests that less than half of any reductions in government spending will be seen as smaller deficits. If we slash Federal budgets by a trillion dollars the deficit will be reduced by less than half that amount because the GDP will be reduced and the tax revenue will be much less. That means that in order to balance the US budget there would need to be multiple waves of massive budget slashing.

 The result would certainly be many millions added to the unemployment roles and a huge increase in deprivation for American children. Given the impact on both state budgets and parent's ability to save for education our next generation would be significantly deprived of the education that would be needed for our nation to deal with the problems of the future. Conservatives claim that a balanced budget would create economic growth, but there is no nation that has confirmed the current conservative theory that government austerity creates growth.

As noted before Friedman asserted that the money supply should be increased by law only in response to an increase in the economy. Implicit in his assumption is that the velocity of money will remain constant. This assumption is false. As we know, during and after a liquidity crisis the desire for safe stores of money is sharply increased and the desire to consume and invest is reduced. The net effect is that a given money supply will be associated with a far lower level of economic activity. If the Fed is abolished as Friedman suggested there is no mechanism to increase the money supply in respond to this abnormal situation. If Friedman's rule were in effect our current M2 money supply would have to be reduced 17.5% to be in line with the increase in GDP since 2008. Of course, with a much lower money supply we would not have our current GDP.

Major concepts of conservative economics have not been confirmed by recent evidence. They are about as valid as the phlogiston theory of combustion and the flat Earth theory of geography. It is profoundly sad that one of our major political parties is addicted to demonstrably false economic theories. If these theories are more fully implemented they will yield massive suffering to the citizens of our nation.