Some Notes on the Chicago School of Economics and Economic Liberty

By Ross Emmett

Over the past month, one of the things I’ve been doing is writing a piece for the forthcoming Encyclopedia of Libertarianism (edited by Matt Zwolinski) on the relation of Chicago Economics and Libertarianism. Here are some of the things I’ve had a chance to sort out while writing the essay.

First, while both the Chicago School and libertarianism revere Adam Smith, they appropriated him in different ways. Libertarians’ affection for Smith runs through the use the so-called “Manchester School” of the mid-1800s made of him. Combining Smith’s arguments about exchange with David Ricardo and Jean-Baptiste Say’s arguments, the public intellectuals associated with the Manchester School (Richard Cobden and John Bright, among others), provided the intellectual support for the call to repeal the Corn Laws (tariffs on wheat that enriched aristocratic landlords). The same individuals supported the abolition of slavery in the British Empire, the disestablishment of the Church of England, the freedom of the press, and pacifism. Great Britain’s unilateral repeal of tariffs and other international trade restraints ushered in a half-century of global economic expansion that ended with the onset of the First World War.

One hundred years later, there arose in middle America – the city of Chicago, to be precise – a new school of economic thought that provided similar arguments to support both national and global economic expansion. While no more directly attributable to the Chicago School than the earlier period was to Adam Smith, the arguments for free trade and decreased government regulation over the period from 1980 to 2010 led global trade, rooted in multi-lateral free trade and institutional change in several major economies, to almost quintuple. World GDP tripled (about the same as it did during the period before World War I). And the global poverty gap was reduced by more than 50%, to a point where less than 15% of the world’s population lived in extreme poverty (the data source for all calculations is Andrei Shleifer named that period after the person most associated with the Chicago School of Economics – “The Age of Milton Friedman.” Friedman is the central figure of the second phase of the Chicago School; and he played a role in several of the major libertarian movement’s organizations. He and fellow Chicago economist George Stigler wrote the first policy report (on housing regulations in New York City) for the Foundation of Economic Education, and he attended the first Mont Pelerin Society meeting and served later as the Society’s President (1970-72). The Cato Institute’s highest award is named for him: the Milton Friedman Prize for Advancing Liberty.

Secondly, despite Friedman’s obvious respect for economic liberty, there has always been some level of concern among libertarians about the strength of Chicago’s normative commitment to individual freedom. For some, this centers on the School’s refusal to provide unqualified support for a gold standard, preferring instead to seek to limit monetary control by authorities through legislative and constitutional means. Friedman’s “monetarism” is a case in point: use a monetary rule that is unchanging to provide stability (the Taylor rule is just a modified version of the same idea). For others, Chicago support for redistributive schemes, despite the fact that the support comes in the form of universal or non-discriminatory programs like Friedman’s negative income tax, is a non-starter for their support.

The libertarian support for free enterprise and free trade, and its rejection of government control, is not built on economic arguments about the problems with regulation and control. And their opposition to redistributive programs cuts against both progressivist interests in market interventions such as minimum wage laws and non-market aid such as social security, national healthcare services, or some form of universal income. Fundamentally, the libertarian position is built upon a normative commitment to individual freedom. The right of self-ownership is commonly taken as a natural right, implying as well that individuals can appropriate property rights in things outside themselves that ensure not only their protection but also their survival. The libertarian conception of rights is threefold: person, property, and consent.

Clearly, some Chicago School economists, Milton Friedman and others, shared the normative commitment to individual freedom. But Chicago economics is first built upon a commitment to methodological individualism, with any normative commitments coming at a later state in the argument. Methodological individualism has been a common assumption of economists since before Adam Smith. In many ways, the methodological commitment defines orthodoxy in economics, and is shared by all its traditions, from classical to neoclassical, Keynesian, Chicago, Austrian and game theorists, alike. What differs among the schools of economics are what they build on top of methodological individualism.

Chicago economics has provided three additional methodological commitments on top of methodological individualism. These additional commitments distinguish it from almost all others schools of economic thought. None of the commitments are normative, and hence some libertarian economists may share them with Chicago, and others (for example, Austrians) may not. The first of those methodological principles was captured in Friedman’s 1953 essay “Methodology of Positive Economics.” Friedman’s essay suggested that models are like tools. The tools that a carpenter always carries in her toolbox are simple ones whose worth has been proven in multiple contexts. Evaluating tools, then, comes only in the experience of using them, not in the claims made about them prior to any use. When I interviewed Chicago economists about their experience at the University of Chicago in graduate school, I repeated heard that, in the workshops, the focus was on the ability to apply a model to the data. “What does the data say?” – that is, if your model doesn’t explain the data, toss it aside and pick up a different model. Simple models like supply-and-demand, or the quantity theory, or human capital proved themselves in the workshops to be relevant to many economic problems, regardless of their degree of “realism.”

The second methodological assumption was the choice of starting point. The early Chicago economists, those who taught Friedman and Stigler, among many others, used equilibrium models and started with equilibrium positions. The operation of supply and demand to bring about equilibrium was assumed, so for the most part models assumed that changes required people to respond because they led people away from equilibrium positions. As many have said, at Chicago, when you looked at people in market places, you assumed that their choices were maximizing choices, and the starting point was therefore an equilibrium position. Austrian economists, on the other hand, had a different conception of equilibrium and choice. F. A. Hayek’s conception of spontaneous order suggested that people had plans built on expectations and knowledge, but those plans (often?) were changed while in the marketplace because of unexpected supplies and prices.  

The third methodological assumption was also in use at Chicago long before it was articulated in theory by Gary Becker and George Stigler. Stigler’s return to Chicago was more circuitous than his classmate Friedman’s. Friedman returned in the late 1940s; Stigler’s return was delayed by a decade, during which he taught at Brown and Columbia. Becker had been a graduate student at Chicago during Stigler’s absence, and moved to Columbia about the time Stigler returned to Chicago. Becker returned about 1970, and assumed responsibility for teaching the first-year graduate course in price theory after Milton Friedman, a position he held until 2010. The methodological assumption that Becker and Stigler added is captured in the Latin expression “de gustibus non est disputandum” – there’s no accounting for (or disputing over) taste. In practice, the assumption reinforced the emphasis on data because it told the economist to look for their explanation in terms of costs people experience, rather than in changes in their tastes. A good economic explanation does not end with a claim that consumers changed their tastes; instead, it should end with a change in some cost or constraint that the consumer faces. The “de gustibus” assumption solidified the “positive” economics of Friedman: the relevant data for testing an argument was price data, providing an examination of the comparative costs of different courses of action by participants in a market.

There is another Chicago methodological assumption, one that makes sense in conjunction with the de gustibus assumption. The assumption lies at the heart of the Coase Theorem. In his essay “The Problem of Social Cost,” Ronald Coase used a thought experiment to set up his consideration of the role of institutions (laws, agreements, customs, etc.) in solving various types of market failures. Chicago economists generally agreed with the economics profession at the time that market failures were occasions for some type of government action, although Chicago economists often doubted how successful such actions might be and were also cognizant of equally important government failures. According to legend, one evening everyone showed up at one of the economists’ houses to discuss Coase’s idea. The idea was this, in the absence of transaction costs – that is, in the context of the perfectly competitive world as Chicago economists usually defined it – it would not matter whether the polluter or the person having to deal with the pollution paid. That is, as long as the parties were allowed to bargain with each other freely and equally, the same market outcome would occur regardless of who ended up being responsible for paying for whatever pollution occurred. The polluter could pay, or the consumer could pay, but in the end, society would end up with the same amount of pollution. The point, which Chicago economists saw well, was that in a zero-transaction world the right to pollute would end up in the hands of the person/firm that valued it most. Once grasped, the Coase Theorem, as it was styled, became the backbone of not only the Chicago economics approach to regulation, but also to the Chicago law and economics movement, which examined judicial decisions about pollution and other market failures. We might note that Coase himself did not use his idea in the same way that his Chicago colleagues did. For Coase, the thought experiment set up an analysis of what happens in a world with transactions costs, in which institutions, and actor decisions within those institutions, mattered.

You may have wondered, reading this, about the start of Chicago economics? Did it really just spring up with Friedman and Stigler writing about housing in the post-war years? The answer is, of course, no. But I’ve left the Chicago origin story to the end because the essay I’m writing is about the Chicago School and libertarianism, not just the history and methodological assumptions of Chicago economics. Historians often say that the Chicago School started when Jacob Viner and Frank Knight returned to Chicago just before 1930. The combination of their teaching of price theory and the history of economic thought, as well as the constellation of other economists that were also there, perhaps in particular the couple of years when Friedman and Stigler, and Henry Simons and their other good friends were there in the mid-1930s, is what really kicked it off. But writing the essay on the Chicago School and Libertarianism has convinced me of my previous position, which sees the circle of people around Knight as important in the later development of the School, but not as a group that was building a coherent vision in the 1930s. Each of the faculty members in the Knight Circle influenced the Chicago School: Lloyd Mints set the stage for Friedman’s monetary theory with his criticism of the real bills doctrine that had been a favorite of monetary theorists back to Adam Smith. Henry Simons taught price theory in the Law School, and created the model of teaching adopted by several of the subsequent members of the School. But his policy proposals called for significant government intervention (trust breaking, for instance) and control, despite being quite radical in their proposed reforms. Jacob Viner was their model of the theorist, using a basic price theoretic model, and examining actual policies to see where regulation and intervention could be reduced. But Viner was not a member of the Knight Circle, and was not a libertarian. Knight himself is usually suggested as the originator of the School, but he was more the philosophical thinker, constructing a social philosophy within which to situate economics, than an applied policy scientist. And Viner, Simons, and Mints departed Chicago in the late 1940s; only Knight remained, but in retirement simply as a presence rather than as a professor and mentor. Furthermore, despite his affection for markets and belief that coercion was the ethic of the state, Knight is an unlikely candidate for designation as a libertarian because he rejected any natural rights argument for property, believed the family was the foundation of society, even though he accepted that individual action was the proper focus of study in economics; and believed that democracy was fundamentally built on discussion. Thus, the Knight Circle provided the context from which the Chicago School emerged, but did not present a coherent School.

My conclusion to the paper I’m finishing over the next few weeks will be that Chicago School economists may be fellow traveler in the cause of freedom with libertarians, but one should always be careful because the methodological assumptions do not lead to the normative foundation. Indeed, they often lead to modest government intervention in the promotion of liberty, and the libertarian should pay attention to the parts of the Chicago School that might guide one away, step by step, from the normative commitment to economic liberty.

Resources mentioned here:

Becker, Gary S. (1976). The Economic Approach to Human Behavior. Chicago: University of Chicago Press.

Becker, Gary S., and Kevin M. Murphy. (2003). Social Economics: Market Behavior in a Social Environment. Cambridge, MA: Belknap Press.

Coase, R. H. (1960). The Problem of Social Cost. Journal of Law and Economics, 3, pp. 1-44.

Emmett, R. B. (2009). Frank Knight and the Chicago School in American Economics. London: Routledge.

Friedman, M., and George J. Stigler. (1946). Roofs or Ceilings?: The Current Housing Problem. Irvington-on-Hudson, NY: Foundation for Economic Education.

Friedman, M. (1953). The Methodology of Positive Economics, in Essays in Positive Economics, pp. 3-43. Chicago: University of Chicago Press.

Friedman, M. (1962). Capitalism and Freedom. Chicago: University of Chicago Press.

Friedman, M. (1998). Two Lucky People: Milton and Rose D. Friedman Memoirs. Chicago: University of Chicago Press.

Hayek, F. A. (1989). The Pretence of Knowledge. Nobel Memorial Lecture, December 11, 1974. American Economic Review, 79.6, pp. 3-7.

Knight, Frank H. (1935). The Ethics of Competition and Other Essays. Harper & Bros.

Knight, Frank H. (1947). Freedom and Reform: Essays in Economics and Social Philosophy. New York: Harper & Bros.

Medema, Steven G. (2011). A Case of Mistaken Identity: George Stigler, “The Problem of Social Cost,” and the Coase Theorem. European Journal of Law and Economics, 31.1, pp. 11-38.

Mints, Lloyd W. (1945). A History of Banking Theory in Great Britain and the United States. Chicago: University of Chicago Press.

Shleifer, Andre. (2009). The Age of Milton Friedman. Journal of Economic Literature, 47.1, pp. 123-35.

Simons, H. C. (1934). A Positive Program for Laissez Faire: Some Proposals for a Liberal Economic Policy. Public Policy Pamphlets, no. 15. Chicago: University of Chicago.

Stigler, George J., and Gary S. Becker. (1977). De Gustibus Non Est Disputandum. American Economic Review, 67.2, pp. 76-90.

Waterman, A. M. C. (2019/2020). The Evolution of ‘Orthodoxy’ in Economics: From Adam Smith to Paul Samuelson. The Independent Review: A Journal of Political Economy, 24.3, pp. 325-45.

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