Economics Schools of Thought

We had family filling the house for Thanksgiving, and that meant time for some conversation about economics with son Economic Sphere. I was wondering about the economics degree of the new, apparently clueless, socialist congresswoman from New York, Alexandria Ocasio-Cortez. Her degree is in economics, and it was my understanding that most notable economics departments had changed in the past few of decades toward free market, and away from Keynesianism. But she seems economically unaware (if I am being kind).

I got this explanation—not recorded, so any errors are mine and not my son’s. Anyway, Economic Sphere said that there are two types of economics programs: those focused on macroeconomics, and those focused on microeconomics. The macroeconomics ones use Keynesian models—despite their being wrong nigh unto 100% of the time. If the model says there will be a particular outcome, they act as though that is the outcome, even after it isn’t, even though sensible people can show why it would never be the outcome.

The ones focused on microeconomics go with free market economic principles. For some reason, they’re more aligned with what actually happens. They’re less willing to interfere, to try to wield power over the economy to get a particular outcome, such as by enforcing pricing, but will instead let the market set prices.

I asked another question, about the difference between the Chicago school (way of thinking) and the Austrian school, since both are free market.

What I got was some basic review. So I thought it might be useful to define a few terms today, and the reasons we prefer what we do--i.e., freedom instead of government interference. While Economic Sphere tends to be a walking encyclopedia, and his answers filter through my explanations below, I've also turned to Wikipedia fairly liberally.

Keynesian Economics

Keynesians, according to my old Webster, “hold that full employment and a stable economy depend on the continued governmental stimulation of spending and investment through adjustment of interest rates and tax rates, deficit financing, etc.” In other words, a healthy economy requires government intervention.

According to Wikipedia,

Keynesian economists generally argue that, as aggregate demand is volatile and unstable, a market economy will often experience inefficient macroeconomic outcomes in the form of economic recessions (when demand is low) and inflation (when demand is high). These can be mitigated by economic policy responses, in particular, monetary policy actions by the central bank and fiscal policy actions by the government, which can help stabilize output over the business cycle. Keynesian economists generally advocate a managed market economy – predominantly private sector, but with an active role for government intervention during recessions and depressions.

One of the first lesson I was taught in a basic econ class, by a free-market economist, was that intervention lags. Legislators—or other officials—look at the current situation, decide it isn’t what they’d like it to be, so they set in motion a policy to change it, that takes about six months, by which time the original situation has changed, and most likely the intervention causes new problems.

Supposedly, the Federal Reserve is there to mitigate and smooth out the damage of cyclical market recessions. What we had before that was occasional volatility. What we’ve had since is occasional volatility plus more regular cyclical recessions. Are the problems all caused by the interventions? We don’t know. And you can’t prove a negative; we don’t have a parallel universe to compare to. But we do know it didn’t do what it set out to do.

Macroeconomics

Macroeconomics is described here by Wikipedia:

Macroeconomics (from the Greek prefix makro- meaning "large" + economics) is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies.

Macroeconomists study aggregated indicators such as GDP, unemployment rates, national income, price indices, and the interrelations among the different sectors of the economy to better understand how the whole economy functions. They also develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade, and international finance.

While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income).

So, macroeconomic models—such as those developed by Keynes—are used by governments to develop policies. But, like I said, interference doesn’t work the way their models say they will. Our Spherical Model saying fits here again: 

Whenever government attempts something beyond the proper role of government (protection of life, liberty, and property), it causes unintended consequences—usually exactly opposite to the stated goals of the interference.

Microeconomics

By comparison, here’s the smaller story of microeconomics, also according to Wikipedia:

Microeconomics (from Greek prefix mikro- meaning "small" + economics) is a branch of economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.

One goal of microeconomics is to analyze the market mechanisms that establish relative prices among goods and services and allocate limited resources among alternative uses. Microeconomics shows conditions under which free markets lead to desirable allocations. It also analyzes market failure, where markets fail to produce efficient results.

Microeconomics stands in contrast to macroeconomics, which involves "the sum total of economic activity, dealing with the issues of growth, inflation, and unemployment and with national policies relating to these issues". Microeconomics also deals with the effects of economic policies (such as changing taxation levels) on the aforementioned aspects of the economy.

In short, microeconomics is what a business would do to figure out how to price a product, and whether to produce the product, based on the price. How well businesses do in predicting price, and allocating limited resources, determines the health of the overall economy. Government interference makes that decision-making process more challenging, adding in tax burdens and other punishments or incentives that distort the actual value of a product.

Free-Market Economics

I looked up both free enterprise and free market in the dictionary.

Free enterprise is “the economic doctrine or practice of permitting private industry to operate under freely competitive conditions with a minimum of governmental control.”

Free market is “any market where buying and selling can be carried on without restrictions as to price, etc.”

So these terms relate mainly to microeconomics. But they are affected by macroeconomic policies, which alter money supply, pricing, taxes, and allocation of resources, distorting information that normally leads to sound pricing and/or production decisions.

I also asked Economic Sphere what is the difference between the Chicago school of economics (i.e., a school of thought, or a set of ideas adhered to by various people—not a physical school) and Austrian, or Mises economics, because they’re both free market. Economic Sphere said the Austrian school of economics is theoretical. It’s about principles and ideas related to the free market. The Chicago school of economics is about policy: how to implement policies as close to the free market as we can get in an imperfect political world.

So, the Austrians tend to be libertarians? I guessed. And he said that was right. Here’s a bit more on those terms.

Austrian School of Economics

I usually hear about the Austrians through the Ludwig von Mises Institute. The originals showed up in Vienna in the late 1800s to early 1900s, although they are all over the world today.

According to Wikipedia,

Among the theoretical contributions of the early years of the Austrian School are the subjective theory of value, marginalism in price theory and the formulation of the economic calculation problem, each of which has become an accepted part of mainstream economics.

Since the mid-20th century, mainstream economists have been critical of the modern day Austrian School and consider its rejection of mathematical modelling, econometrics and macroeconomic analysis to be outside mainstream economics, or "heterodox." Although the Austrian School has been considered heterodox since the late 1930s, it attracted renewed interest in the 1970s after Friedrich Hayek shared the 1974 Nobel Memorial Prize in Economic Sciences and following the 2008 global financial crisis.

I’m assuming that “mainstream economists” from mid-century on refers to Keynesians in this context. Interference was all the rage from about 1910 onward. Keynes and Friedrich Hayek were contemporaries, and Hayek does a good job of refuting the pro-controlled economists with real life. The controllers love their models, and they can’t be bothered with things like real-life evidence and facts.

If Hayek hasn’t been on your reading list, his Road to Serfdom is a must read. Hayek qualifies as an Austrian, but he is also of the Chicago school, because of his influence there. Here’s how Wikipedia describes his contribution:

Friedrich Hayek
image from Wikipedia

Friedrich Hayek (1899–1992) Hayek made contact with many at the University of Chicago in the 1940s, with Hayek's The Road to Serfdom playing a seminal role in transforming how Milton Friedman and others understood how society works. Hayek conducted a number of influential faculty seminars while at the U. of Chicago, and a number of academics worked on research projects sympathetic to some of Hayek's own, such as Aaron Director, who was active in the Chicago School in helping to fund and establish what became the "Law and Society" program in the University of Chicago Law School. Hayek, Frank Knight, Friedman and George Stigler worked together in forming the Mont Pèlerin Society, an international forum for libertarian economists. Hayek and Friedman cooperated in support of the Intercollegiate Society of Individualists, later renamed the Intercollegiate Studies Institute, an American student organisation devoted to libertarian ideas.

Chicago School of Economics

This school of thought got its name because of the work of a number of neoclassical economists on the faculty at the University of Chicago, producing twelve Nobel laureates in economics.

They rejected Keynesianism, and looked at a variety of other ideas for macroeconomics—that is, policy ideas. They’re a little harder to pin down, but in general are trying to apply free market principles to national policy. Bruce Kaufman, in The Elgar Companion to the Chicago School of Economics (2010) says they are characterized by:

A deep commitment to rigorous scholarship and open academic debate, an uncompromising belief in the usefulness and insight of neoclassical price theory, and a normative position that favors and promotes economic liberalism and free markets (p. 133).

The great economist Thomas Sowell studied at the University of Chicago for his PhD—and remained a Marxist throughout. It was later, when real life woke him, that he transformed into a free-market economist.

Milton Friedman
image from Wikipedia

The Chicago name I know best is Milton Friedman, who was at the University of Chicago for some thirty years. According to Wikipedia, again:

Milton Friedman (1912–2006) stands as one of the most influential economists of the late twentieth century. A student of Frank Knight, he was awarded the Nobel Prize in Economics in 1976 for, among other things, A Monetary History of the United States (1963). Friedman argued that the Great Depression had been caused by the Federal Reserve's policies through the 1920s, and worsened in the 1930s. Friedman argued that laissez-faire government policy is more desirable than government intervention in the economy.

One of the critics of the Chicago school, economist and three-term Democrat senator Paul Douglas, complained that, “The opinions of my colleagues would have confined government to the eighteenth-century functions of justice, police, and arms.”

That doesn’t seem like a valid criticism to me; it seems like something to appreciate—limiting government to its proper role. What a concept!

We could summarize today’s economics lesson with this Friedman quote:

One of the great mistakes is to judge policies and programs by their intentions rather than their results.— Milton Friedman Interview with Richard Heffner on The Open Mind (7 December 1975)