Weekend Reading: John Cassidy's Interview with James Heckman: Selections
H: I want to distinguish between two different ideas.... The part of the Chicago School that has been justified is the claim that people react to incentives.... The other part of the Chicago School, which Stiglitz and Krugman have criticized, is the efficient-market hypothesis. That is something completely different.... I think you could fault the regulators as much as the market. From about 2000 on, there was a decision made in Washington not to regulate these markets. People like Greenspan were taking a very crude and extreme form of the efficient-markets hypothesis and saying this justified not regulating the markets. It was a rhetorical use of the efficient-markets hypothesis to justify policies.
C: What about the rational-expectations hypothesis, the other big theory associated with modern Chicago? How does that stack up now?
H: I could tell you a story about my friend and colleague Milton Friedman. In the nineteen-seventies, we were sitting in the Ph.D. oral examination of a Chicago economist who has gone on to make his mark in the world. His thesis was on rational expectations. After he’d left, Friedman turned to me and said, ‘Look, I think it is a good idea, but these guys have taken it way too far.’... It didn’t have any empirical content. When Tom Sargent, Lars Hansen, and others tried to test it using cross equation restrictions, and so on, the data rejected the theories. There were a certain section of people that really got carried away. It became quite stifling....
C: What about Robert Lucas? He came up with a lot of these theories. Does he bear responsibility?
H: Well, Lucas is a very subtle person, and he is mainly concerned with theory. He doesn’t make a lot of empirical statements. I don’t think Bob got carried away, but some of his disciples did. It often happens. The further down the food chain you go, the more the zealots take over.... We knew Keynesian theory was still alive in the banks and on Wall Street. Economists in those areas relied on Keynesian models to make short-run forecasts. It seemed strange to me that they would continue to do this if it had been theoretically proven that these models didn’t work....
C: What about the efficient-markets hypothesis? Did Chicago economists go too far in promoting that theory, too?
H: Some did. But there is a lot of diversity here. You can go office to office and get a different view.... [Fischer Black] was very close to the markets, and he had a feel for them, and he was very skeptical. And he was a Chicago economist. But there was an element of dogma in support of the efficient-market hypothesis. People like Raghu [Rajan] and Ned Gramlich [a former governor of the Federal Reserve, who died in 2007] were warning something was wrong, and they were ignored. There was sort of a culture of efficient markets—on Wall Street, in Washington, and in parts of academia, including Chicago.... Everybody was blindsided by the magnitude of what happened. But it wasn’t just here. The whole profession was blindsided....
It is what I see as the booster stage—the rational-expectation hypothesis and the vulgar versions of the efficient-markets hypothesis that have run into trouble. They have taken a beating—no doubt about that. I think that what happened is that people got too far away from the data, and confronting ideas with data. That part of the Chicago tradition was neglected, and it was a strong part of the tradition. When Bob Lucas was writing that the Great Depression was people taking extended vacations—refusing to take available jobs at low wages—there was another Chicago economist, Albert Rees, who was writing in the Chicago Journal saying, No, wait a minute. There is a lot of evidence that this is not true.
Milton Friedman—he was a macro theorist, but he was less driven by theory and by the desire to construct a single overarching theory than by attempting to answer empirical questions. Again, if you read his empirical books they are full of empirical data. That side of his legacy was neglected, I think.
When Friedman died, a couple of years ago, we had a symposium for the alumni devoted to the Friedman legacy. I was talking about the permanent income hypothesis; Lucas was talking about rational expectations. We have some bright alums. One woman got up and said, ‘Look at the evidence on 401k plans and how people misuse them, or don’t use them. Are you really saying that people look ahead and plan ahead rationally?’ And Lucas said, ‘Yes, that’s what the theory of rational expectations says, and that’s part of Friedman’s legacy.’ I said, ‘No, it isn’t. He was much more empirically minded than that.’ People took one part of his legacy and forgot the rest. They moved too far away from the data...
