Chicago School of Economics Circles the Theoretical Drain

In the current issue of the New Yorker there is an alternatively depressing and fascinating piece by John Cassidy about how the Chicago School of economics – monetarism, rational expectations, efficient market theory, etc. – is circling the theoretical drain. While some economists are abandoning the faith, many are not, and the result is, as Cassidy says, much like what happened in cosmology with Edwin Hubble discovered the expanding universe: Economists have lost their footing and are engaged in everything from rear-guard actions to active peer denunciations, and pretty much everything in between.

The following quote from Chicago economist John Cochrane jumped out at me, however, in its mealy-mouthed implicit apologia for the theoretical status quo:

“What is there about recent events that would lead you to say markets are inefficient?” he said to me. “The market crashed. To which I would say, We had the events last September in which the President gets on television and says the financial markets are near collapse. On what planet do markets not crash after that?”

The only reason the markets crashed in 2008 was because the U.S. President got on TV and said they might? Leaving aside that heads of state say stupid things about markets, both in the U.S. and elsewhere, all the time and nothing happens, that is just dumb. By that point we had had an unprecedented run on the shadow-banking system, assets for many banks looking like zero, Fannie/Freddie as state wards, banks up to Goldman and Merrill wobbling, and it was the President that made a crash happen? Simply staggering – and, in its fact-free and inflexible defense of a particular economic ideology, a crushing indictment.