Vienna and Chicago: Friends or Foes?

CHAPTER 1: INTRODUCTION In late September, 1994, Henri Lepage asked me to address the Mont Pelerin Society in Cannes, France. The title was "I Like Hayek," an appreciation of the principal founder of the Society in 1947. I thought the subject would be well received, but I was mistaken. Over a dozen attendees lined up to take issue with my favorable comments about Hayek's capital theory and macroeconomic model of inflation and business cycles. It turned out that the critics were followers of Milton Friedman and the Chicago school. Anyone who has ever attended a Mont Pelerin Society meeting will quickly attest that this international group of freedom- fighters are divided into two camps: followers of the Austrian school and followers of the Chicago school. I say "divided" guardedly because these two camps undoubtedly have more in common than disagreement. In general, they are devout believers in free markets and free minds. Yet they seem to relish the rivalry that exists regarding fundamental issues of methodology, money, business cycles, government policy, and even who are the great economists. The first group is known as the Austrian or Vienna school, founded by Carl Menger, who taught economics at the University of Vienna in the late 19th century. Menger's disciples, Ludwig von Mises and Friedrich Hayek, left Vienna during the Nazi era and established an Austrian following in England and the United States. In 1974, a year after Mises died, Hayek received the Nobel Prize in Economics, the first one given to a free-market economist. It was a long battle toward recognition. In 1947, Hayek invited a small group of classical liberals from around the world to a conference at the Hotel du Parc on the slopes of Mont Pelerin, Switzerland. Hayek was alarmed by the rapid advance of socialism in the post-war era, and decided to establish a society aimed at preserving a free civilization and opposed to all forms of totalitarianism. He dedicated the meeting in the spirit of Adam Smith and his "system of natural liberty." Among the 38 participants were the Austrians Ludwig von Mises, Fritz Machlup, and Karl Brandt. It also included the Americans Milton Friedman and George Stigler, who would become leaders of the market-oriented economics department at the University of Chicago. The quasi-market tradition at Chicago actually began earlier with the works of Frank H. Knight, Henry Simons and Jacob Viner. Friedman and Stigler were the second generation of free-market economists at Chicago. Both went on to win the Nobel Prize (Friedman in 1976, Stigler in 1982). Milton Friedman in particular has so dominated the department that Friedmanite economics has become practically synonymous with the Chicago or monetarist school. His prestige is felt on the campus even today, a generation after his retirement. The Chicago school has continued to have enormous influence, both in the United States and around the world. Friedman is considered one of the most eminent economists living today. Points of Common Ground As members of a free-market association, how could these two camps disagree so vehemently? The reality is that they don't disagree on most issues. Generally speaking, members of the Austrian and Chicago schools have much in common and, in many ways, could be considered intellectual descendants of laissez faire economics of Adam Smith, philosophical cousins rather than foes.' * Both champion the sanctity of private property as the basis of exchange, justice, and progress in society. * Both defend laissez-faire capitalism and believe firmly in Adam Smith's invisible hand doctrine, that self-motivated actions of private individuals maximize happiness and society's well-being, and that liberty and order are ultimately harmonious (Barry 1987:19, 29, 193). * Both are critics of Marx and the Marxist doctrines of alienation, exploitation, and other anti-capitalist notions. * Both support free trade, a liberalized immigration policy, and globalization. * Both generally favor open borders for capital and consumer goods, labor, and money. * Both oppose controls on exchange, prices, rents, and wages, including minimum wage legislation. * Both believe in limiting government to defense of the nation, individual property, and selective public works (although a few in both camps are anarchists, such as Murray Rothbard and David Friedman). * Both favor privatization, denationalization, and deregulation. * Both oppose corporate welfarism and special privileges (known as rent seeking or privilege seeking). * Both reject socialistic central planning and totalitarianism. * Both believe that poverty is debilitating but that natural inequality is inevitable, and they defend the right of all individuals, rich or poor, to keep, use and exchange property (assuming it was justly acquired). They do not join the chorus of pundits bashing the rich, although they frequently condemn corporate welfarism. * Both refute the Keynesian and Marxist interventionists who believe that market capitalism is inherently unstable and requires big government to stabilize the economy. * Both are generally opposed to deficit spending, progressive taxation, and the welfare state, and favor free-market alternatives to Social Security and Medicare. * Both favor market and property-rights solutions to pollution and other environmental problems, and in general consider the environmentalist crisis as overblown. Israel Kirzner rightly concludes, "It is important not to exaggerate the differences between the two streams... there is an almost surprising coincidence between their views on most important policy questions... both have basically the same sound understanding of how a market operates, and this is responsible for the healthy respect which both approaches share in common for its achievements" (Kirzner 1967:102). Speaking of achievements, both can claim separate victories in the battle of ideas during the past two centuries: the Austrian school for introducing the subjective Marginalist Revolution in the late 19th century, and then dissecting the inevitable collapse of the Marxist/socialist central planning paradigm in the 20th century; and the Chicago school for mounting a successful counterrevolution to Keynesian macroeconomics and the "imperfect" or monopolistic competition model in microeconomics. Members of both schools have won Nobel prizes in economics, although the Chicago school has a clear lead. And both have sometimes been viciously attacked by their opponents, including Keynesians, Marxists, and institutionalists. It is the thesis of this book that both the Austrian and Chicago schools played significant and largely successful roles in correcting the errors of classical economics and countering the critics of capitalism'socialists, Marxists, Keynesians, and institutionalists'during crucial times in the battle of ideas and events. The early chapters outline the focal points in history where the Austrian and Chicago economists played major roles in defending and advancing Adam Smith's system of natural liberty. Without their vital place, world history may well have been vastly different, and not for the better. Then Come the Disagreements Yet with so much to celebrate, where do they disagree? Surprisingly, on quite a few points. While they may be considered followers of Adam Smith's invisible hand of laissez faire, the descendants are divided into two wings of free-market economics. The Austrians and the Chicagoans differ in four broad categories: First, methodology. The Austrians, following the writings of Ludwig von Mises, favor a deductive, subjective, qualitative, and market-process approach to economic analysis. The Chicagoans, following the works of Milton Friedman, prefer historical, quantitative, and equilibrating analysis. Friedman and his followers demand empirical testing of theories and, if the results contradict the theory, the theory is rejected or reformed. Mises denies this historical approach in favor of extreme apriorism. According to Mises as well as his disciples Murray Rothbard and Israel Kirzner, economics should be built upon self-evident axioms, and history (empirical data) cannot prove or disprove any theory, only illustrate it, and even then with some suspicion. Second, the proper role of government in a market economy. How pervasive are externalities, public goods, monopoly, imperfect competition, and macroeconomic stability in the market economy, and what how much government is necessary to handle "market failure"? The Austrians have consistently supported laissez faire policies while the Chicago school has shifted gears over the years. (One might say that both are "anti-statist" but the Austrians are more "anti-statist.") Is Adam Smith's system of natural liberty sufficiently strong to break up monopolies through powerful competitors, or is government necessary to impose antitrust policies when appropriate? The Austrians have always favored a naturalist, non-interventionist approach. On the other hand, the first Chicago school, led by Henry Simons, took a strong interventionist view, favoring the break-up of large utilities and other natural monopolies. The second generation at Chicago, led by George Stigler, initially supported Simons' interventionism, but ultimately reversed course in favor of a Smithian belief in the power of competition and non-interventionism. According to Israel Kirzner, Peter Boettke and other Austrians, the difference between the two schools is even more fundamental: the Chicago school employs an "equilibrium always" pure competition model (what Chicago economists call an "as if" competition model) that assumes costless perfect information and the Austrians employ a more dynamic "disequilibrium" process model of market capitalism that takes into account institutions and decentralized decision making (Kirzner 1997, Boettke 1997). The debate over the most appropriate competitive model also spills over into issues of political economy, public choice, law and economics, and the efficiency of democracy. Third, sound money. What is the ideal monetary standard? Both schools favor a stable monetary system, but they differ markedly on the means. Most Austrians prefer a gold standard, or more generally, a naturally-based commodity standard created by the marketplace. Some go further and demand "free banking," a competitive system whereby private banks issue their own currency, checking accounts and credit services with a minimum of government regulation. The Chicago school, on the other hand, rejects the gold standard in favor of an irredeemable money system, where the money supply increases at a steady or neutral rate (the monetarist rule). Both ideally desire 100% reserves on demand deposits as a stabilizing mechanism, though here again, there is a difference'the Austrians want demand deposits backed by gold or other suitable commodity, the Chicagoans by fiat money. Fourth, the business cycle, capital theory, and macroeconomics. Mises and Hayek developed the "Austrian" theory of the business cycle, maintaining that expanding the fiat money supply and artificially lowering interest rates create an unsustainable, unstable boom that must eventually collapse. Friedman and his colleagues reject most aspects of the Mises- Hayek theory of the business cycle in favor of an aggregate monetary model. The Chicagoans praise Hayek's political theory in The Road to Serfdom and The Constitution of Liberty, but they reject much of his capital theory and Austrian macroeconomics. (Thus, they took issue with me after my speech in 1994.) Friedman contends that a steady increase in the money supply equal to the average economic growth rate will provide a sustainable non-inflationary environment for the economy. But the Austrians dissent and maintain that a given rate of monetary inflation is never sustainable, whatever the level. Many Austrians also deny the validity of "macroeconomics" and aggregation (such as national statistics or price indexes) as useful pedagogical tools. Austrians and Chicagoans argue over the cause and cure of the Great Depression of the 1930s, what level of aggregation is appropriate in macroeconomic model building, and even disagree at times on their views of Keynes and Keynesianians, Adam Smith and classical economists, and other schools of thought. They even differ on their goals and how far they should reach out to influence the intellectual community and the public. This book will analyze all these issues, deciding which camp has the most convincing arguments for each. At the end of each chapter, I'll give my opinion as to which school has the upper hand, concluding with either "Advantage: Vienna," or "Advantage: Chicago." After reviewing the differences between the two schools, the final chapter will assess if there are any gains in trade, to quote Chicago economist Sherwin Rosen. How far is Chicago from Vienna? Is the distance between the two a bridge too far? Over time and dialogue, the answer will be clearer. Hopefully through this book, the reader may see the intellectual distance narrow, although by the very nature of the argument (as I shall try to show) the separation is not likely to disappear completely, nor should it. In the final chapter, I outline my own views as to the direction both schools should go to benefit the profession and the cause of economic science. My Travels to Vienna and Chicago I am in an unusual position to analyze each school, having studied the two philosophies thoroughly for many years and developed close friendships with leaders of both camps. My first introduction to free-market economics was through the Austrians in the 1960s. My father's library contained dozens of books about anti-communism and free-market capitalism. Among them was a copy of Human Action, by Ludwig von Mises, although I found it long and heavy-going for a teenager. I was soon reading Henry Hazlitt's Economics in one Lesson, monthly issues of The Freeman, and bi-weekly issues of William F. Buckley's National Review. When I took my first college course in economics at Brigham Young University in the mid-1960s, the textbook was Paul Samuelson's Economics. I was surprised, given the university's conservative bent. Recognizing the textbook's Keynesian bias (espousing the paradox of thrift, deficit spending, progressive taxation, and welfare state), I asked Larry Wimmer, one of my professors, for alternative readings. As a recent graduate from the University of Chicago, he recommended Milton Friedman. I read Capitalism and Freedom from cover to cover, and found it to be a powerful antidote of interventionism, although his analysis of Keynesian economics seemed incomplete. (Friedman's views on Keynes have always been controversial'see chapter 8.) It was at this point, in the early 1970s, that I discovered the libertarian economist Murray Rothbard, who introduced me to a whole new vision of Austrian economics. He was the first "American" Austrian economist who could write in clear, persuasive prose, as opposed to the often heavy, pedantic writings of Mises. I was especially impressed with his readable booklets, What Has Government Done to Our Money? and The Essential Mises. I read with great interest America's Great Depression, an introduction to the Austrian theory of the business cycle as it applied to the Great Depression of the 1930s. Rothbard's works were a life-changing eye-opener. Discovering Rothbard was, in my mind, similar to how Paul Samuelson must have felt reading Keynes. I devoured everything Rothbard had to say. I read his magnum opus, Man, Economy and State; its sequel, Power and Market; and all his other writings. In short, I was hooked on Austrian economics. My passion for Austrian economics continued throughout my college days. My doctoral thesis at George Washington University was partially financed by my employer. Published initially as a book by the Mises Institute and later by the Foundation for Economic Education, The Economics of a Pure Gold Standard was deeply influenced by Rothbard's support of a 100% gold reserve standard. When I left the CIA to work for Robert D. Kephart and his financial newsletter empire in the mid-1970s, I developed a close relationship with Rothbard and other Austrian economists such as Peter Boettke, Richard Ebeling, Roger Garrison, Hans Sennholz, and Walter Block. In 1986, Gary North and I spent three hours in a formal interview with Professor Hayek at his summer home in the Austrian Alps. It was the last extensive interview he gave before his death in 1992.' I never met Ludwig von Mises. I've spent many hours with economists sympathetic to Mises, including Henry Hazlitt, Benjamin Rogge, John Chamberlain, Israel Kirzner, and Mises's wife Margit. I became involved with the Mises Institute and helped finance conferences at Harvard University and the University of Vienna. In the 1980s, I spent half my time researching and writing an updated macro model of the economy based on the Austrian time-structure of the economy, culminating in The Structure of Production, which was published by New York University Press in 1990. (Mises taught at New York University for decades and Israel Kirzner, one of his students, has been a mainstay at NYU until his retirement in 2001.) Shifting Ground By the 1990s, my views had become more eclectic as I expanded my horizons and spent more time researching other schools of economics, including supply-side, public choice, and the Chicago traditions, for my text on the history of thought, The Making of Modern Economics (M. E. Sharpe, 2001). During the process I learned to appreciate the value of these parallel universes and, in some cases, I've changed positions. For example, I have come to the conclusion that empirical work, which the Chicago and supply-side schools emphasize, has done much good in converting the world to the free market and rejecting socialism. There is no question in my mind that Milton Friedman and Anna J. Schwartz's A Monetary History of the United States did more than any other work to dispel the conventional wisdom that unfettered capitalism was responsible for the business cycle, and especially the Great Depression. Friedman produced compelling evidence that it was the government's monetary policies, not the free market, that caused the business cycle, and that the Federal Reserve blundered repeatedly and caused the collapse of the banks and the economy in the 1930s. Granted, the Vienna school blamed government, too, for the Great Depression, but did so in a qualitative way without relying on empirical evidence; Friedman and Schwartz told the story in a way that convinced many non-believers. Many other statistical works conducted by freemarket economists have changed the minds of scholars and government officials regarding the application of market economics to policy decisions. One of the most interesting studies is the annual survey of economic freedom conducted by Florida State's James Gwartney and others, demonstrating that the more a nation adopts liberalized market reforms, the higher their standard of living becomes. Such studies have done more to reverse the tide from socialism to capitalism than a thousand books in deep philosophy. In the 1990s I have broadened my perspective by attending meetings sponsored by the Mont Pelerin Society, the Foundation for Economic Education, the Cato Institute, and numerous other think tanks. At the same time, I have studied the works of Milton Friedman, George Stigler, Gary Becker, Thomas Sowell, Allan Meltzer, Armen Achian, Roger LeRoy Miller, and other members of the Chicago school. I have spent many hours with Milton Friedman, Gary Becker, and other Chicagoans, both in correspondence and personal meetings, regarding the Chicago viewpoint. The Author's Biases Where do I stand on the great issues dividing the Austrians and the Chicagoans? Perhaps a story will best illustrate. When I became president of the Foundation of Economic Education in 2001, I had an interesting encounter at my first board meeting. After the meeting, Bettina Greaves, a long time FEE employee and devoted Misesian, approached me privately and said, "I support you in every way as the new president of FEE, but may I make a suggestion? You need to be more critical of Milton Friedman!" I nodded my head and thanked her for her support. Then, no less than half hour later, Muso Ayau, past president of the Mont Pelerin Society and founder of the Universidad Francisco Maroquin in Guatemala, pulled me aside to give me some advice as the new president. He whispered in my ear, "I support you in every way as the new president of FEE, but could you do me a favor? Please stop being so critical of Milton Friedman!" I have come to appreciate the Hegelian method, that truth is achieved through conflict. Some dislike the intellectual arguments. I enjoy them, as long as they generate more light than heat. Regretfully, sometimes the disagreements have become personal and vindictive, resulting in some colleagues not talking to each other for years. But for the most part, the result of the debate has been closer understanding and sometimes a change of heart. I personally have shifted ground over the years as I have listened and read intently the various controversies and the evidence.

' Libertarian philosopher Norman P. Barry notes that although Mises and Friedman oppose each other on methodology and other issues, "they may both be called children of the Enlightenment" and their intellectual lineage goes back to Adam Smith and David Hume (Barry 1987:19, 45). ' Extensive quotations of this interview can be found in Hayek on Hayek (1994). Strangely, we were never given credit for these interviews, which represented half'over forty percent'of the interview exchanges in Hayek on Hayek. They were attributed to the "W. W. Bartley III audiotape archive, 1984-88" (Ebenstein 2003). _____________________________________________ To go to our full review, or to go to purchase the book, CLICK HERE. ________________________________________________ Reprinted with permission from the author, Mark Skousen, ' 2005. CLICK HERE TO GO NOW TO PURCHASE BOOK

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