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February 3, 2009

Booth professors take center stage in debate over fiscal policy

Booth School professor of finance John Cochrane signed a petition from libertarian think tank the Cato Institute last week expressing concerns about President Obama’s pending fiscal stimulus package. The petition appeared as a full-page advertisement in The New York Times.

The petition is the latest sign of the University of Chicago’s role in a debate about the nature of government intervention in the economy that has escalated since the first bank bailouts last spring. Economics professors John Huizinga, Robert Lucas, and Kevin Murphy also voiced reservations about Obama’s planned stimulus package at the January 16 Myron Scholes Global Markets Forum in Ida Noyes, arguing that public debt will limit economic growth.

Cochrane said he fears that new government expenditures will crowd out private investments. “The money has to come from somewhere,” he said. “Not all government spending is a bad thing. There’s nothing wrong with borrowing money and filling the potholes around here, but don’t say that’s going to stimulate the economy.”

Cochrane expressed his frustration over new government interventions into the economy. “I’ve been astonished by this whole business; I’ve been looking through graduate course outlines and textbooks, and I can find nowhere in the last 50 years that anybody in economics has said that fiscal stimulus is a good idea,” he said. “What are we doing giving advice based on beliefs where there’s nothing that we teach our graduate students that says fiscal stimulus works?”

The stakes of the argument are high for intellectual bragging rights as well as economic recovery. The Chicago School of economics rose to prominence in part by revealing weaknesses in Keynesian orthodoxy in the 1970s. But as debate over Obama’s stimulus package continues, fiscal policy—a key prescription of Keynesian economics that advocates using government spending to boost aggregate demand—is making a comeback.

The Chicago School of economic thought has come under scrutiny during the fiscal crisis, becoming a popular target among some economists who believe that government intervention could have prevented the meltdown.

Joeseph Stiglitz, a professor at Columbia and the 2001 Nobel Prize winner, is a noted critic of Chicago. “The Chicago School bears the blame for providing a seeming intellectual foundation for the idea that markets are self-adjusting and the best role for government is to do nothing,” he said in a Bloomberg.com news article.

Paul Krugman, a professor at Princeton and the 2008 Nobel Prize winner, has singled out Cochrane and finance professor Eugene Fama, known for his theories on market efficiency, in his blog. Under the title “The Sorrow and the Pity,” he wrote that Fama’s thinking “is painful to watch.”

But Cochrane said that the Keynesian notion that government spending can stimulate the private sector largely disappeared from economics not because of an ideological bias, but because “[they] didn’t make sense and lacked empirical support.” He added, “We’ve returned to a fairy tale of our youth.”

Even at the University of Chicago, nothing is black and white. Lucas, a 1995 Nobel Prize winner, described his mixed reactions to the Bloomberg.com article: “I’m changing my views on bank regulation every week. It was an area I saw as under control. Now I don’t believe that.” Lucas has also expressed concern over new fiscal policies, arguing that there is still a role for monetary policy to alleviate the current downturn.

Douglas Diamond, professor of finance at Chicago Booth, explained his support for the government bank bailouts earlier this fall.

“Basically, we had no choice but to do something,” he said. “We’ll probably have to do more. Of course, the details, that’s interesting, but essentially, the question was: Should we have let the world’s financial sector collapse?”