Bloomberg runs a long and interesting report this morning on the disarray that Chicago school economists find themselves in as a result of the current financial crisis.

The article explains that “For half a century, Chicago’s hands-off principles have permeated financial thinking and shaped global markets.” But today, “once ascendant free-market acolytes are finding themselves in an unusual role: They’re battling a wave of government intervention more sweeping than any since the Great Depression as the U.S. struggles with the worst recession in seven decades.” So much so that many Chicagoites are now rediscovering the virtues of government regulation and bailouts and are parting with their “free-market” colleagues. Or is this really what’s going on?

The piece begins with the story of economics professor John Cochrane, who was so infuriated by Henry Paulson’s first $700-billion bailout proposal in September that he launched a petition attacking it that eventually collected the signatures of 230 economists from across the U.S.

Cochrane explains that “a rash of bailouts will expand government and kill entrepreneurship.” True enough. But that’s the “fiscal stimulus” aspect of all the government intervention that has been taking place for the past couple of months. What about the “monetary stimulus” side of it? That’s where the free-market principles go out the window in typical Chicago fashion:

Cochrane says he was encouraged by the Fed’s Dec. 16 rate cut and its plan to buy mortgage-backed securities, saying these moves will help unfreeze capital markets. 

“This is exactly the right thing for a central bank to be doing in the midst of a credit crunch,” he says.

So, from the perspective of what we could call the “right wing” of the Chicago school, it’s bad economics when the executive and legislative branches of the governement throw money at failing sectors. But when it’s bureaucrats from a governement monetary planning agency who do it with counterfeit money, no problem, that’s the right free-market thing to do!

This stance is not very surprising of course, considering that Milton Friedman supported government control over money (albeit under the helm of the Treasury instead of the Fed, which he wanted abolished) and inflationary policies (he wanted a stable and modest increase of fiat money in normal times, and big increases during periods of crisis).

That’s still too much free market for some Chicagoites who now find themselves on the “left wing” of the school. Robert Lucas, who

won a Nobel in 1995 for a theory that argued against governments trying to fine-tune consumer demand, says deregulation may have gone too far.

Depression-era laws that separated commercial and investment banks helped depositors decide if they wanted secure accounts or riskier investments. Today, without these distinctions, people can’t be sure if their investments, or those of their customers, are safe.

“I’m changing my views on bank regulation every week,” Lucas, 71, says. “It was an area I saw as under control. Now I don’t believe that.”

Let’s ignore the fact that a 71-year-old economist who won the Nobel Prize can still change his views every week on bank regulation. One would think he would have found a stable theoretical framework to think this through by this time―monetarism has obviously not been very helpful. Note instead the interesting reason he gives for his new scepticism: when they put their money in a bank, depositors cannot know if their money is in a secure account or in a risky investment.

Isn’t this one of the fundamental problems with the current banking system, that is, fractional reserves? You think your money is there and you can retrieve it at any time, but the bank only keeps a fraction of it in its vaults and has lent most of it to someone else. Austrians and others before them have been saying for centuries that this was a sort of fraud that led to unsustainable leveraging and to booms and busts. Mr. Lucas is right to see that there is something wrong here. He just hasn’t found a good explanation of why and what should be done about it, and so he adopts the default position of confused free-marketeers, which is that more regulation must be the answer.

The article tells us about another left-wing Chicagoite, Douglas Diamond, who refused to sign the petition against Paulson’s bailout because he believes governments have no choice but to provide safety nets for banks and tougher oversight. Again, the explanation given by the finance professor for parting with his colleagues is quite interesting:

Diamond began studying bank failures when he was a doctoral student at Yale in the 1970s. The 1963 book that Friedman wrote with Anna Schwartz, “A Monetary History of the United States, 1867- 1960,” provided the foundation. A copy, held together by Scotch tape, sits on Diamond’s desk, even though he concluded at Yale that a main premise was wrong.

Diamond rejects Friedman’s view that banks failed in the 1930s because the U.S. money supply contracted as panicky Americans started hoarding cash and the Fed reacted too slowly. Diamond sees the money supply as less significant than Friedman did.

Banks failed, he says, because their assets weren’t readily converted into the cash that depositors were demanding.

Is it just me or do I see a pattern here? There is no explicit mention of it, but just like Mr. Lucas, Mr. Diamond seems to have realized that the fractional reserve system (that’s what the last sentence is referring to) is a crucial part of the problem. His solution however (if his views are correctly reported in the article) is to have governments impose even more regulation on the banking system and to intervene to save it when it is on the verge of collapse. When it’s precisely because governments control the monetary system, condone banking fraud and constantly save banks from the consequences of their fraudulent practices that we have this problem.

Chicago school economics is in such a mess that it’s hard to decide who we, as Austrians, should sympathize with: the inflationists who are still claiming to defend free-market principles, or those going over all the way to the interventionist side but who may be doing it on the basis of a legitimate preoccupation with the fractional reserve system.

One can’t help but agree with arch-Keynesian James Galbraith, who is quoted in this article as saying that “The inability of Friedman’s successors to say anything useful about what’s happening in financial markets today means their influence is finished.”

Quantitative finance analysts, or “quants” in the financial jargon, played a prominent role in the subprime crisis. Using a blend of mathematics, statistics and computing, they were the Wall Street geniuses who assessed the risks on all those exotic mortgage-backed securities and credit-default swaps. Their models were telling them that the risks were widely spread and that it was safe for the institutions employing them to pour billions of dollars into such financial instruments. This was supposed to be the most up-to-date, scientifically based way to make such calculations. What went wrong? Well, they forgot to include one minor variable… the “human factor.”

An article published two days ago in the New York Times surveys the various defects that have been found in those models.

The models, according to finance experts and economists, did fail to keep pace with the explosive growth in complex securities, the resulting intricate web of risk and the dimensions of the danger. 

But the larger failure, they say, was human – in how the risk models were applied, understood and managed.

Yes, one of the fundamental problems of mainstream neoclassical economics was at play here again: the erroneous belief that one can reduce human action to a set of numbers and formulae, and that these can be calculated and extrapolated just like physicists do when they try to predict the position of some space object a few millions years in the future.

The Wall Street models, said Paul S. Willen, an economist at the Federal Reserve in Boston, included a lot of wishful thinking about house prices. But, he added, it is also true that asset price trends are difficult to predict. “The price of an asset, like a house or a stock, reflects not only your beliefs about the future, but you’re also betting on other people’s beliefs,” he observed. “It’s these hierarchies of beliefs – these behavioral factors – that are so hard to model.” 

Indeed, the behavioral uncertainty added to the escalating complexity of financial markets help explain the failure in risk management. The quantitative models typically have their origins in academia and often the physical sciences. In academia, the focus is on problems that can be solved, proved and published – not messy, intractable challenges. In science, the models derive from particle flows in a liquid or a gas, which conform to the neat, crisp laws of physics.

Not so in financial modeling. Emanuel Derman is a physicist who became a managing director at Goldman Sachs, a quant whose name is on a few financial models and author of “My Life as a Quant – Reflections on Physics and Finance” (Wiley, 2004). In a paper that will be published next year in a professional journal, Mr. Derman writes, “To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.”

Funny how we always tend to reinvent the wheel in economics – or at any rate that’s the impression one gets watching mainstream economists trying to make sense of the world from their confused perspective. I haven’t read Mr. Derman’s book and I don’t know who he is quoting, but that insight is not particularly new. Decades ago, in a book aptly titled Human Action, Mises denounced “those economists who want to substitute ‘quantitative economics’ for what they call ‘qualitative economics’ (…). The impracticality of measurement is not due to the lack of technical methods for the establishment of measure. It is due to the absence of constant relations.”

Human acts of choice, Mises explained, cannot be predicted with certainty because “different individuals value the same things in a different way, and valuations change with the same individuals with changing conditions.”

The quants were blinded by their too complex models. If they had only applied some common sense, they would have noticed that something wrong was going on in the wonderful world of these securities. Of course, the ultimate high-tech device to avoid being caught in this mess would have been a good book explaining the Austrian theory of the business cycle. But sadly, Wall Street is still behind the times when it comes to such sophisticated devices.

Today’s article in the Financial Post:

Some weeks ago, in an editorial about the financial crisis in the main section of this paper, a writer commented approvingly that: “Our currencies are no longer tied to gold, which means central banks can act to mitigate monetary deflation and interrupt the deadly feedback loop of mounting defaults, declining real wages and prices and increasingly onerous dollar-denominated debt. … Today we are no longer in the infancy of macroeconomics.”

Every day that passes contradicts this statement. Central banks and governments around the world have so far tried a variety of means to prevent the collapse of credit markets. They have repeatedly injected cheap liquidity into banks, purchased mortgage-backed securities and commercial paper, nationalized banks, insurance firms and mortgage finance giants, increased the amounts of deposits insured and forced interest rates lower.Nothing has so far succeeded. Stock markets continue to slide down, investors everywhere are fleeing for safer havens and we learn every day of a new major firm on the verge of bankruptcy because it is short of cash. FULL ARTICLE

Hervé de Quengo has put the French edition of Human Action (translation by Raoul Audoin) online.