Simons Articulates the Chicago School of Public Policy

Date 1948

Through his writing and teaching, Henry C. Simons helped shape a “Chicago viewpoint” stressing the virtues of free competitive markets and monetary stability while warning against extensive government involvement in the economy. His Economic Policy for a Free Society provided the clearest and most influential articulation of this viewpoint.

Also known asEconomic Policy for a Free Society

Locale Chicago, Illinois

Key Figures

• Henry C. Simons (1899-1946), American economics professor at the University of Chicago, 1927-1946
• Milton Friedman (1912-2006), American economics professor at the University of Chicago, 1946-1977, and 1976 Nobel laureate in economic science
• W. Allen Wallis (1912-1998), American professor of economics and statistics at Chicago, 1946-1977, and dean of the Chicago Graduate School of Business, 1956-1962
• Frank H. Knight (1885-1972), American economics professor at Chicago, 1927-1952
• George J. Stigler (1911-1991), American economics and business professor at Chicago and Nobel laureate, 1982
• Eugene F. Fama (b. 1939), American professor of finance at Chicago
• Ronald Coase (b. 1910), American economics professor at Chicago and Nobel laureate, 1991
• James M. Buchanan (b. 1919), American Ph.D. recipient at Chicago, 1948, and 1986 Nobel laureate in economic science
• Robert E. Lucas (b. 1937), American economics professor at Chicago
• Gary S. Becker (b. 1930), American professor of economics and sociology at Chicago and Nobel laureate, 1992

Summary of Event

The publication in 1948 of Economic Policy for a Free Society by Henry C. Simons occurred shortly after the author’s death. Publication was arranged for by a group of his former colleagues and students. In his prefatory note, Chicago economist Aaron Director noted that “Through his writings and more especially through his teaching, . . . [Simons] was slowly establishing himself as the head of a school”—meaning a group with strong beliefs on social and political questions. Over the subsequent forty years, the Chicago School became identified with forceful and sophisticated defense of free markets and monetary stability, combined with a carefully reasoned critique of government intervention in economic affairs. A measure of the intellectual depth of this program is the large number of Nobel Prizes in Economic Sciences awarded to scholars identified with the University of Chicago.

Simons, who joined the Chicago faculty in 1927, exerted a powerful influence through his teaching, which combined intellectual brilliance with wit, style, and a gift for simplicity and clarity. Most of the students undertaking graduate work in economics took his course in microeconomics as preparation for the more difficult upper-level required courses in that discipline. As Simons developed expertise in tax policy, he taught in the law school as well as in the regular economics program.

In the 1930’s, Simons was one of several staff members and students closely associated with Frank H. Knight. Others included Milton Friedman and his wife Rose Director Friedman; her brother Aaron Director; George J. Stigler; and W. Allen Wallis. The Friedmans, Stigler, and Wallis left Chicago temporarily, but their return beginning in the 1940’s was an important element in the emergence of the Chicago School.

Although Economic Policy for a Free Society appeared in 1948, much of it consisted of individual essays published previously. Most notable was “A Positive Program for Laissez-Faire,” which originally appeared in pamphlet form in 1934, in the depths of the Great Depression , when the New Deal programs of Franklin D. Roosevelt were in high gear. The New Deal philosophy was that the Depression represented a failure of free markets and competition, and that this failure could be remedied by government intervention to encourage the formation of large-group coalitions in the major sectors of business, labor, and agriculture.

Simons vehemently disagreed with this viewpoint. He argued that the Depression reflected a combination of two factors. The first was an unstable monetary system, which allowed spending for goods and services to fall. The second was excessive monopoly power of business firms and labor unions, which prevented wages and prices from declining, so that output and employment fell instead. Simons urged vigorous government policy to break up existing monopolies and impede creation of new ones. To stabilize the monetary system, he recommended that banks be required to maintain 100 percent cash reserves against their deposits. Simons urged that monetary policy be conducted on the basis of simple, clear-cut rules specified in legislation, thereby minimizing use of discretion by the monetary authorities.

Simons felt strong moral outrage against extreme inequalities of income and wealth, and he urged that the federal tax system be structured to reduce inequality. He favored an income tax with graduated rates, with a minimum of loopholes, and with inheritances and gifts treated as ordinary income for the recipients. He was very critical of the “enormous differential subsidies” involved in tariff duties on imports and also urged “limitation upon the squandering of our resources in advertising and selling activities.”

Simons also sounded a strong warning against the harm that could result from monopoly power of labor unions. Through the Wagner Act of 1935 (the National Labor Relations Act), the federal government strongly encouraged the formation of labor unions. Supporters of this policy believed that union strength would help raise wages, increase the incomes of low-income families, stimulate consumption, and help the country out of the Depression. Simons noted that union wage increases did not go to low-income families, who were in fact more likely to be damaged by higher product prices and by the decrease in job opportunities resulting from higher wage costs. Concern about union power manifested itself in the Taft-Hartley Act of 1947, which took away union power.

Underlying Simons’s economic views was a goal of protecting individual liberty and restricting the power of government officials. He saw that government needed to have a “positive program” if the free market was to yield high productivity and social justice.

Significance

Crucial to the formation of the Chicago School was the return of Friedman and Wallis to Chicago as faculty members in 1946. In 1956, Wallis became dean of the university’s school of business. In 1958, Stigler returned to Chicago with a joint appointment in economics and business. Aaron Director was a faculty member in the law school.

A central element in the Chicago viewpoint was microeconomic theory. Individuals were assumed to seek their own advantage through voluntary economic actions as constrained by competition and by an appropriate legal framework. Contrary to the fashionable views of Edward Chamberlin and Joan Robinson, which stressed imperfections in product markets, the Chicago economists viewed the U.S. economy as a competitive environment, in which the only monopoly problems arose from government intervention rather than private market failure. They believed that the private economy worked well; it would achieve efficient production of the goods and services desired by people and would distribute products on the basis of productive contributions. The major exception that they admitted was the problem of instability, which could result in depression and inflation.

An influential 1948 article by Friedman updated Simons, endorsing his proposals for 100 percent bank reserves, for a monetary policy based on rules, and for a graduated income tax, but adding proposals to use government transfer payments as automatic fiscal stabilizers. Before long, however, Friedman became increasingly identified with “monetarist” ideas. He argued that the private economy would be relatively stable unless disturbed by defective monetary policies, and that a policy to maintain steady, gradual, and predictable growth in the money supply would ensure that major depressions would not occur.

On many specific points, Friedman diverged from Simons, but Friedman’s two major nontechnical books, Capitalism and Freedom (1962) and Free to Choose: A Personal Statement (1980), echoed the central message that Simons had developed, stressing individual freedom, voluntary private activity, and distrust of government intervention. Friedman proposed that income inequality be attacked through a “negative income tax.” Like Simons, Friedman expressed strong opposition to many of the ideas derived from John Maynard Keynes, particularly an emphasis on fiscal policy.

Simons’s strong moral convictions regarding the ethical and functional values of individual liberty were strongly reinforced when F. A. Hayek came to Chicago as a professor of social and moral science in 1950. Hayek’s book The Road to Serfdom (1944) was a powerful warning against collectivism. His best-known contribution to technical economics was a demonstration of the informational efficiency of prices that are determined in free competitive markets.

Within the Chicago law school, emphasis increasingly came to be directed toward evaluating the economic consequences of law, looking at the influence of law on people’s behavior, going beyond simple concerns for fairness or morality. One focal point was the economic analysis of property rights. George Stigler pioneered in developing a novel theory of regulation. He argued that government regulation of a trade or industry was often imposed at the instigation of the regulated industry, which could then influence the regulatory program to keep out competitors and obtain higher prices. Ronald Coase helped show that so-called “externalities” (arising in situations in which property rights are not well defined) such as pollution do not necessarily require government intervention. If transactions costs are not excessive, persons injured by pollution can join together and bargain with polluters to pay for desired improvements. Gary Becker extended economic analysis to crime and punishment, viewing criminal actions as the outcomes of personal choices made on the basis of prospective rewards and penalties. The Journal of Law and Economics, launched in 1957 under the editorship of Aaron Director, reflected the fusion of disciplines.

Within the business school, the Chicago approach was particularly visible in finance. Eugene Fama helped popularize the concept of “efficient markets,” in which open competitive trading in assets such as stocks and bonds produces asset prices that reflect efficient use of available information. In this view, asset prices change only in response to new information, which is unexpected and random in nature. This leads to the argument that stock prices follow a “random walk” in the short run. This finding helped dramatize the fact that stock-market “experts” had on average no better than a random chance to beat the market, a view that helped bring about the creation of index funds, mutual funds that simply invested in a wide sample of stocks, for example those in Standard and Poor’s index of five hundred stocks.

Analytically, the Chicago School was a major source of innovations in economic analysis, often with powerful policy overtones. Friedman’s monetarism alerted the economics profession to the importance of the money supply, particularly as a cause of inflation. This influence helped prompt the Federal Reserve System to use policies in the 1980’s that were less likely to cause inflation. The strong Chicago emphasis on the virtues of free markets and the dubious virtue of regulatory programs helped spark the deregulation movement begun under President Jimmy Carter.

Two major developments in economic analysis emerged from the Chicago milieu. One was the theory of public choice, associated with James M. Buchanan. This theory stresses the notion that government officials are self-interested and that their actions as legislators, administrators, politicians, and civil servants can be analyzed as transactions with voters, taxpayers, and lobbying groups. The theory leads to strong doubts that government economic policies will reflect some “public interest.” The other novel theory was based on the concept of “rational expectations,” associated with Robert Lucas. Starting with the familiar proposition that people’s economic actions are based on their expectations, the theory argued that those expectations would be based on appropriate use of economic information and economic theory, insofar as individuals could make profits by such appropriate use. An implication of the theory is that free markets can predict and respond to any nonrandom government policy.

Bibliography

Breit, William, and Barry T. Hirsch, eds. Lives of the Laureates: Eighteen Nobel Economists. 4th ed. Cambridge, Mass.: MIT Press, 2004. Includes autobiographical sketches by Chicago laureates Friedman, Stigler, and Buchanan. Each gives his own recollections about the Chicago environment. Readable, personal, and sometimes contradictory.

Breit, William, and Roger L. Ransom. The Academic Scribblers. 3d ed. Princeton, N.J.: Princeton University Press, 1998. Chapter 13 is devoted to Simons’s ideas and is a good balance of brevity and detail. Chapter 12, on Frank Knight, and Chapter 14, on Friedman, help give a general view of the Chicago persuasion.

Friedman, Milton. Capitalism and Freedom. Chicago: University of Chicago Press, 1962. A good introduction to Friedman’s philosophy and analysis. Develops his monetarist, anti-Keynesian view of economic stabilization and his support for a negative income tax to reduce income inequality.

‗‗‗‗‗‗‗. “A Monetary and Fiscal Framework for Economic Stability.” American Economic Review 38 (1948): 254-264. An early and somewhat Keynesian macroeconomic program showing obvious influence from Simons, who is cited frequently. Friedman’s monetarism developed later and is not much in evidence here.

Friedman, Milton, and Rose Friedman. Free to Choose: A Personal Statement. New York: Harcourt Brace Jovanovich, 1980. This book evolved in connection with a television series spotlighting Friedman’s views on many issues relating to economics and to individual freedom and choice. The title highlights the view that people have choices and responsibilities and are not helpless victims. Written for a general audience.

Reder, Melvin W. “Chicago Economics: Permanence and Change.” Journal of Economic Literature 20 (March, 1982): 1-38. Reder writes as a longtime participant in the Chicago environment. Identifies the central viewpoints associated with the Chicago School and comments on many of the individuals involved. Written for professionals, but not highly technical.

Stigler, George J. The Citizen and the State: Essays on Regulation. Chicago: University of Chicago Press, 1975. This short book of essays presents Stigler’s general views on the role of government with his customary wit and style.

‗‗‗‗‗‗‗, ed. Chicago Studies in Political Economy. Chicago: University of Chicago Press, 1988. This volume demonstrates the power and persistence of the Chicago persuasion, particularly the overlap between law and economics, as exemplified in the work of Richard Posner, a U.S. appeals court judge and lecturer in the Chicago law school. Fairly advanced.