1

RATIONAL IRRATIONALITY
John Cassidy on economics, money, and more.
JANUARY 13, 2010

INTERVIEW WITH RICHARD POSNER

Posted by John Cassidy

This is the first in a series of interviews with Chicago School economists. Read After the Blowup, John Cassidys story on Chicago economists and the financial crisis. (Subscribers only.) I spoke to Posner in his chambers at the Federal courthouse in downtown Chicago, where he sits on the United States Court of Appeals for the Seventh Circuit. I began by telling him that I was researching an article about how the financial crisis had affected Chicago economics, and, indeed, economics as a whole. At this distance from the financial blow up, what was the nature of the intellectual challenge it presented? I think the challenge is to the economics profession as a whole, but to Chicago most of all. Has there been much self-analysis, or critical reassessment of long held positions, here in Chicago? I dont think so. There are people here who are not part of the orthodox Chicago Schoolthe Bob Lucas/Gene Fama crowdpeople like Raghu Rajan, Luigi Zingales, and Dick Thaler. But I dont think there has been much in the way of re-examination. What about your critique of some aspects of Chicago economics, which you detailed in your recent book, A Failure of Capitalism? Have you received much of a reaction to that?

Ive had an exchange with Lucas and Famasome of it on my blog at The Atlantic. Its all very civil: not angry. But I think they are pretty much sticking to their guns. (Laughs.) Even before this, macro was seen as quite a weak field, and the efficient markets theory had taken a lot of hits: the behavioral finance schoolAndrei Shleifer, Bob Shiller. Already, the orthodox Chicago position had been under criticism. But last Septembers financial collapse came as a big shock to the profession. What is Chicago macroeconomics? And what went wrong with it? Going back to Milton Friedman, there was the idea that the Great Depression was a product of inept monetary policy and could have been avoided if only the Fed had not tightened the money supply. That remains very controversial, but also it didnt prepare anybody for what has happened recently. The concern then was that the Fed had raised rates prematurely during the Depression. But now the concern is that the interest rates were too low during the early 2000s, and that is what precipitated all the trouble. For that, the monetarists were unprepared. When the crisis began Bernanke reduced the federal funds rate essentially to zero and nothing happened. That was the point at which Friedmans macro theory, along with Lucass macro theory, did not have a clue as to what had happened. That was pretty bad. Also, and more interesting to me, it called into question a whole approach to economicsone that is very formal, making very austere assumptions about human rationality: people have a lot of information, a lot of foresight. They look ahead. It is very difficult for the government to affect behavior, because the market will offset what it does. The more informal economics of Keynes has made a big comeback because people realize that even though it is kind of loose and it doesnt cross all the ts and dot all the is, it seems to have more of a grasp of what is going on in the economy.

In the fall, you wrote a big piece in The New Republic in which you declared yourself to be a Keynesian. What was the reaction to that article? I havent got much of a reaction from my colleagues. Bob Barro (a conservative economist at Harvard) sent me an email in which he referred me to an early article of his. It was a good article. I think there is a question of whether modern economics, including Chicago economics, is too formal and too abstract. Another question is whether modern economists have lost interest in or feel for institutional detail that might be very important. I dont know how many of these economists really knew anything about how modern banking operates, how the new financial investments operatecollateralized debt obligations, credit default swaps, and so on. So modern economics is too formal, and it has lost interest in institutional reality: is that what you are saying? You dont want to characterize all of economics in that way. What we tend to think of as the Chicago approach is great skepticism about government and faith in the self-regulating characteristics of markets: thats the essential outlook of Chicago. In addition, there is the increasing mathematization of economics. That is not necessarily Chicago-led. Chicago once resisted thatpeople like Ronald Coase and George Stigler. Even Gary Beckerhes more mathematical than they are, but hes not as mathematical as, say, M.I.T. and Berkeley economists. Modern economics is, on the one hand, very mathematical, and, on the other, very skeptical about government and very credulous about the self-regulating properties of markets. That combination is dangerous. Because it means you dont have much knowledge of institutional detail, particular practices and financial instruments and so on. On the other hand, you have an exaggerated faith in the market.

That was a dangerous combination. But that is not all there is in economics. There is also behavioral economics, which has made a lot of progress. Its about challenging the assumptions about markets because of human irrationality. I dont much like it myself, because I think they are very vague about what they mean by rationality. They use terms like fairness, which are really contentless. But some of their skepticism is warranted. And behavioral finance, I find very convincing. Its obvious if you look at how people trade in markets: they are not calculating machines that flawlessly discount future corporate profits. I put a lot of emphasis on the Frank Knight (a famous Chicago economist who taught at Chicago from the nineteen-twenties to the nineteen-sixties) and Keynes view of uncertainty. That makes economists very uncomfortable, because it is very hard to model. Once you introduce uncertainty, it means that a lot of consumer behavior is not going to be easily modeled as cost-benefit analysis. In that sense, then, your version of Keynesianism is what some professional economists would refer to as Post-Keynesianism? Yes. Ive read Davidson. (Paul Davidson, a professor at University of Tennessee is a leading post-Keynesian.) Ive read some of those people. But I dont really get much out of it that isnt in Keynes. Im kind of stalled in the General Theory and his essay in the Q.J.E. (In 1937, a year after the publication of The General Theory of Employment, Interest, and Money, Keynes wrote an expository article in the Quarterly Journal of Economics.) So, in sense, you see yourself reviving an older Chicago tradition Knightian economicswhich in some ways is closer to Keynes? Not only that, but there is a curious link between Keynes and Coase, even though they are at opposite ends of the political spectrum. I never heard Coase mention Keynes, but I am sure he would have regarded him

as a dubious left-wing character Coase is very, very conservative. But they are very similar in their informality. Coase was always saying that he didnt believe in utility maximization. He didnt believe in equilibrium. Both of them, they are not concerned with the kind of axiomatic reasoning where you start with human beings assumed to have rational calculators inside them. They are much more likely to take people as they are. And Knight was not at all a formal economist. His book Risk, Uncertainty, and Profit, I read it for the first time. It really was excellent. Theres no math. Coase in his later work: no math. Keynes in the General Theory: some math, but its not central to his argument. Do you regard yourself as an economist? No. (Smiles) Im not a professional economist. I dont have any economics training. But Im interested in it. Im not bashful about writing about it. Youve received some criticisms from professional economistsfrom Brad De Long, of Berkeley, and from others. Yes. These people are impossible. I havent read (DeLongs) academic work, just his blog. His criticism of me was crazy. He had me fighting a last-ditch stand for Chicagothe exact opposite of what I wrote. It does bother me about economistsnot just (Paul) Krugman and De Long; its not just a liberal versus conservative thing. Some conservative writing bothers me also. They are not at all reluctant about taking extreme positions in an Op-Ed, or in blogs, and so on. It really demeans the profession. Krugman is obviously a good economist. Hes got this book, The Return of Depression Economics. Its very good...But his column for The New York Times is really irresponsible, nasty. Sometimes on his blog he makes accusations. In one of his columns, he suggested that conservatives were traitorous. He used the word

treason. Im bothered by that. If you have a very politicized academic profession, you lose your confidence in their objectivity Well, some Chicago economists also express very strong views. John Cochrane (a professor at Chicagos Booth School of Business) for example, says that government stimulus programs dont have any impact at all on unemployment and G.D.P. Thats another reason to be distrustful of the profession. You have irresponsible positions about the stimulus on both sides. What are people supposed to believe? Has your critique of the efficient markets hypothesis made you rethink your view of markets outside of finance? Even before this, I had become less doctrinaire about markets. For example, one of the topics Gary Becker and I debated on our blog was New York Citys ban on transfats. I supported that. The country has an obesity problem. I didnt think that just listing the amount of transfats on a menu would deal with itpeople dont know this stuff. I thought a ban, even though it violated freedom of contract, made sense. What has been Beckers reaction to your views? You mean about the economy, about Keynes. I think he disagrees. We had a debate before the university womens board some months ago. Hes very down on the stimulus. Some of the things we agree about. I thought the cash-for-clunkers program was quite pointless. Now that we appear to be coming out of the recession, the right is saying things arent too bad after all, and that markets are resilient. The left is saying without government intervention we would be back in the nineteen-thirties. What do you think? It depends what you mean by government intervention. If the government had limited itself to reducing the federal funds rate and had

not bailed out the banks, we could easily have gone down the route of the nineteen-thirties. On the other hand, if there had just been a bank bailout and no stimulus, then, no, we would not have gone down as far as the nineteen-thirties, because the economy is different now. In particular, (theres been) the shrinkage of the construction and manufacturing industries. That is where unemployment was highest in the Depression. And we have the automatic stabilizersunemployment insurance, and so on. It wouldnt have been as bad, but it could have been considerably worse without the stimulus. You can never be certain how far down an economy will spiral. After all the federal government has done, does the amount of public intervention in the economy not worry you? I think it is worrisome. A lot of things they have done, I dont approve of. I dont like the idea of taking an ownership stake in General Motors: I think thats very bad. I dont like this messing with compensation: thats unhealthy. And Im particularly concerned about the deficits, and what health reform will do to what are already massive deficits. So I dont think the governments handling of this has been flawless, by any means. But I think the stimulus probably was essential. As a result of all that has happened, what has the economics profession learned? Well, one possibility is that they have learned nothing. Becausehow should I putit market correctives work very slowly in dealing with academic markets. Professors have tenure. They have a lot of graduate students in the pipeline who need to get their Ph.Ds. They have techniques that they know and are comfortable with. It takes a great deal to drive them out of their accustomed way of doing business. Robert Lucas takes a very hard line on this. He says the theory of depressions is something economics isnt good at. He hasnt been doing depression economics, so hell stick with what hes doing and unapologetically.

But isnt Lucas still offering policy advice on the basis of his theories? Yes, he is occasionally. But hes a real academic. Hes content with his academic career and his models and so on. And it isnt very clear what replaces his modern vision. It isnt as if there is a school of economics that has great ideas and techniques for dealing with our economic situation. What about Chicago economics in particular? At this stage, what is left of the Chicago School? Well, the Chicago School had already lost its distinctiveness. When I started in academiain those days Chicago was very distinctive. It was distinctive for its conservatism, for its 1968 fidelity to price theory, for its interest in empirical studies, but not so much in formal modeling. We used to say the difference between Chicago and Berkeley was Chicago was economics without models, and Berkeley was models without economics. But over the years, Chicago became more formal, and the other schools became more oriented towards price theory, towards micro. So, now there really isnt a great deal of difference. Ronald (Coase) is alive, but hes very, very old. Hes not active. Stigler is dead. Friedman is dead. Theres Gary (Becker) of course. But Im not sure theres a distinctive Chicago School anymore. Except there are probably a higher percentage of conservative people here, but not all. Jim Heckmannot particularly conservative at all. Hes very distinguished. Steve Levitthes very famous. I dont think hes conservative. Youve got people like (Richard) Thaler. So probably the term Chicago School should be retired. There were peoplepeople like Stigler and Coase, Harold Demsetz, Reuben Kessel, and people at other schools like Armen Alchian. They were people rebelling against the very liberal economics of the nineteenfiftiesvery Keynesian, very regulatory, very aggressive anti-trust, little faith in the self-regulating nature of markets. Francis Bator, whos a very distinguished Harvard economist, he wrote a famous essay entitled The

Anatomy of Market Failure. And he gave so many examples of market failure that you couldnt believe a market could exist. You have to have an infinite number of competitors, full information, you cant have any economies of scale, and so on. It was too austere. That was what the Chicago people, with their more informal approach, rebelled against. So we had our moment in the sun, but by the nineteen-eighties the basic insights of the Chicago School had been accepted pretty much worldwide. Where the divide continues is in macroin business cycle economics. Thats where you have these very liberal people at Berkeley, Harvard, M.I.T., and so on, and very conservative people like Lucas, Fama, and so on, in Chicago. You are famous for extending economic analysis, and a free-markets approach, to the law. Has the financial crisis undermined your faith in markets and the price system outside of the financial sector? No. But of course one of the more significant Chicago (positions) was in favor of deregulation, based on the notion that markets are basically selfregulating. Thats fine. The mistake was to ignore externalities in banking. Everyone knew there were pollution externalities. That was fine. I dont think we realized there were banking externalities, and that the riskiness of banking could facilitate a global financial crisis. That was a big oversight. It doesnt make me feel any different about the deregulation of telecommunications, or oil pipelines, or what have you. Talking of banking externalities, isnt that an application of traditional price theory? Going back as far as Pigou, economists have talked about externalities in many parts of the economy. Theres nothing inconsistent with basic economic theory in externalities. Of course, you have to know a lot about banking, and that was not the case with economists. Odd in a way, because macroeconomists and finance theorists have always been interested in banking, but I dont think they really understood a lot about it.