In Defense of the Chicago Approach to Economics


REASON readers are aware of a lack of unanimity among libertarians on a variety of issues. In addition to the controversy as to government (compare REASON, March 1972 with March 1973), ecology (compare REASON, August 1972 with January 1973) and abortion (see REASON, September 1972—January 1973), REASON has published articles analyzing the divergent views taken towards economic theory by the Austrian and Chicago "schools" of economic thought.

In REASON's July 1972 issue, Alan Reynolds launched a provocative attack on Murray Rothbard's attack on the views of Milton Friedman, entitled "The Purge of Chicago Economists." Subsequently, a significant critique of Chicago monetary theory by Austrian economist Hans Sennholz was published in REASON's Special Issue of October 1971. Sennholz argued that Milton Friedman's interpretation of business cycles and advocacy of government control of the money supply are erroneous, and dangerous, since they tend to invite inflation and to breed demands for additional governmental control. One main difference between the Austrians and Chicagoites—which is recognized by both sides—lies in their methodology, the Chicago approach utilizing rigorous empirical testing and the Austrians relying on a priori propositions and opposing empiricism.

This month, Alan Reynolds returns for Round Three in the Austrian-Chicagoan debate, by way of rejoinder to the Sennholz piece. Reynolds is associate editor of NATIONAL REVIEW and is a REASON contributing editor. He asked to acknowledge the helpful comments of Professor Roger Miller of the University of Washington, who saw the Sennholz piece (but not Reynolds' reply).

The ongoing controversy has been of special interest to many of our readers, and REASON intends to continue the Austrian-Chicago debate in future issues.

In 1966, Israel Kirzner cautioned us "not to exaggerate differences" between the Chicago and the Austrian approaches to economics. A contrary approach was taken by Murray Rothbard when he asserted that the world's most famous supporter of free markets, Milton Friedman, was in reality a "statist".[1] Now, Hans Sennholz joins the chorus by claiming "Chicago and Austrian Schools are worlds apart" and "the differences are greater than the similarities."[2]

Actually, the two schools are not so much "worlds apart" as Sennholz claims. Except for their divergent methodological approaches,[3] the similarities are really more significant than the differences. However, the Chicago tradition continues to develop from its rough beginning; and economists in the Austrian tradition, by raising the mouldy remains of Chicago economists Irving Fisher and Henry Simons, avoid confronting the live and growing spirit of current Chicago thought.


"To the Chicagoans," says Sennholz, "the ultimate function of money is the measure of values.…If only the price level could be stabilized and thus money be permitted to serve its true function! To the Austrians…individual demand and supply ultimately determine the purchasing power of money.…They reject the quantity theory of money as a manifestation of holistic thought and a tool for government intervention."[4]

This is badly jumbled. To Chicagoans, money functions as a temporary storing place for buying power. The stability of the price level (the value of money) is unimportant if its rate of change is completely anticipated. A Chicagoan would say that the price level is that level at which the demand for money (as a proportion of wealth) equals the money supply, which is essentially identical to the "Austrian" quantity theory.

We might also ask why the aggregation of monetary supply and demand is simply dismissed (without argument) as a "manifestation of holistic thought," while no such reservations prohibit Sennholz from talking about some elusive, aggregated "consumption-investment ratio." Are Chicagoans alone supposed to make no remarks whatsoever about the economy as a whole?

Dr. Sennholz worries that Chicagoans' conclusions "are drawn in the sphere of macro-economics in which the total money supply and a given velocity determine the price level. Here they call on government to take measure to stabilize the level and thus cure the business cycle." This is another distorted caricature of the Friedmanite position. If Chicagoans think velocity is "given", why have they worked so hard to measure and explain its movements?[5] True, Chicago research conclusively shows that the functional relationship of velocity to its determinants is fairly stable and predictable, but this is a long way from saying velocity is "given".

Sennholz' objections to "stabilizing the price level" likewise involve a devious simplification. Does Sennholz' rejection of price "stability" mean that if tomorrow most prices are half or double what they were today, there would be no cause for alarm? Does he seriously suggest that erratic, unexpected shifts in prices have no effect on production and employment decisions?

Now, David Friedman once noted a misleading impression in my essay "The Purge of Chicago Economists" (REASON, July 1971) where I implied, in his words, that "no ill effects follow from an increase in the supply of money just sufficient to maintain a stable price level."[6] By that I intended to suggest only that the usual objections to inflation apply only to unanticipated changes in prices (i.e., wealth transfers from debtors to creditors, frictional costs in adjusting to changing prices, and trade-offs between inflation and unemployment). If contracts were to be automatically adjusted to a price index, or if changes in the price level were fully anticipated, it really wouldn't matter much whether we had inflation, deflation, or price stability. It is, however, technically correct to say that even with anticipated inflation, there may be some minor redistribution of wealth, a decline in the real value of cash reserves, and an uneconomic use of productive resources to substitute for holding greater cash balances.

This is one of many instances in which Milton Friedman has evolved beyond the early monetarist tradition described by Sennholz. In his earlier writings, says Dr. Friedman, "I simply took it for granted, in line with a long tradition and near-consensus in the profession, that a stable level of prices of final products was a desirable policy objective." While Friedman has supported a moderate increase in the money supply, as a long-run objective he has suggested that "a policy fairly close to the optimum would probably be to hold the absolute quantity of money constant."[7] This would imply a stable downward trend of prices at the rate of about 4-5% a year (with 3-4% annual output growth).


So, Milton Friedman explicitly advocates zero or negligible monetary growth with price deflation. Where does that leave a tremendous difference between Austrian and Chicago schools? Well, for one thing, Chicagoans (and Hayek—the chief architect of Austrian cycle theory) doubt the feasibility of establishing a genuine and viable gold standard, and deny that if a gold standard were established it would automatically prevent excessive fluctuations in the money supply. There simply isn't enough gold to support the existing structure of prices, nor could velocity be stretched to fill the gap. No one, to my knowledge, has shown how the economy could adjust, in a reasonably short period, from a money supply of 450 billion dollars to one of about 10 billion dollars. Secondly, the wishful thought that instituting free banking would automatically ensure against excessive issuance of bank notes and demand deposits (without central bank control) has not been rigorously demonstrated and contradicts our limited historic experience. And finally, the stock of gold can fluctuate substantially (it more than tripled from 1897 to 1914).

But it appears, contrary to what Sennholz implies, that inflation of the money supply is not the primary concern of Austrians. Mises himself has said, "There is practically no need today to enter into a discussion of the comparatively slight and harmless inflation that under a gold standard can be brought about by a great increase in gold production."[8] Austrians apparently want a gold standard regardless how it performs. While Sennholz presumably accepts his royalties in the form of a check, and then converts that check into currency, he simultaneously denies that such checks and currency are money: "money is a marketable commodity, such as gold or silver." This is yet another example of the Misesian propensity to "solve" problems by definition.[9] If fiat money isn't "money", then only a fool would choose such paper over gold (regardless of their relative purchasing power, stability of value, or convenience in use).

Unlike Rothbard, Dr. Sennholz admits that "Professor Friedman would not deny us the freedom to buy, hold, and use gold in all economic exchanges, but paradoxically he would also impose [sic] a fiat standard." Friedman seems, Sennholz continues, "to be unaware that monetary freedom would soon give birth to a 'parallel standard' that permits individuals to make 'gold contracts' and 'gold clauses' calling for payment in measures of gold." Far from being unaware that some people will use gold to conduct transactions, Dr. Friedman explicitly cites it as a benefit of denationalizing gold.[10] If, as Sennholz prophecizes, freedom to trade in gold "would lead us back to the gold standard," then Chicago and Austrian policy prescriptions may once again lead to the same conclusion. Both camps want free use of gold and elimination of legal limits on interest rates (especially of the zero-interest ceiling on demand deposits), so why not work together for these reforms and see if they prove sufficient to generate a money unit of predictable value?


One final difference does remain: "The monetarists actually have no business cycle theory," according to Sennholz. In a sense, this is certainly true. If it means that monetarists have no explanation for the regular, periodic booms and busts which are supposedly endemic to capitalism, no such explanation is possible because the phenomenon does not exist.[11] The whole idea is an anticapitalist myth. What we do experience is whimsical fluctuations in governmental interventions of various sorts, particularly in monetary affairs.

What we have then isn't "business cycles", but government cycles. So, Friedman proposes not to extend the uncertainty of government discretion over some nonexistent flaw in private markets, but to subject existing governmental authority to the limits of the rule of law. This is a vital distinction between Keynesian and Friedmanite policies.[12] It also refutes Sennholz' strange notion that the quantity theory is "a tool for government intervention." The truth is the exact opposite.

On the other hand, monetarists do, of course, have an extremely well developed and documented explanation of the "real balance" mechanism by which changes in the relationship between money supply and demand affect prices, production and employment. A simplified version of the monetarist explanation of inflation, for example, is as follows: "If the supply of cash balances is increased beyond the amount which people wish to hold, relative to their wealth, they will spend the difference, thereby bidding up prices (which reduces the real value of their cash holdings)."[13] Disappointed expectations, as well as the time and expense required to stay informed about changing job offers, also help to explain how unanticipated money supply changes affect production and employment through unexpected variations in prices and wage rates. These theories have been elaborated with great precision and "sophistication" in many articles and books.[14]

In contrast to the Chicago school, Austrians were unable to mount an effective challenge to Keynesian ideas because both Austrians and Keynesians prefer theorizing in an empirical vacuum, both deny the direct influence of the money stock on aggregate demand (the real balance effect, as opposed to the influence on investment via interest rates), and both claim to find the key to economic fluctuations in the division of national income between investment and consumption.[15]

The Misesian cycle theory hangs precariously on a crude theory of interest rates. Sennholz tells us, "The introduction of fiduciary funds falsifies interest rates and thereby causes erroneous investment decisions." The injection of funds only lowers interest rates if there is an unanticipated inflation of prices. Nominal interest rates will be the same as real interest rates if the money supply is increased just enough to offset increases in real income, population, and the proportionately higher demand for money associated with rising wealth. Sennholz is wrong, then, in claiming that falsified interest rates cause "booms and busts in every case of credit expansion, from one percent to hundreds of percent." Actually, if lenders expect price inflation they will demand correspondingly higher interest rates, as they did in the late sixties, so that monetary injections will indirectly cause nominal rates to be above real rates rather than below. This is the complete antithesis of Mises' theory. In any case, savings and investment decisions are generally made on the basis of real interest rates, adjusted for inflation, so falsified nominal rates are as irrelevant as they are unlikely.

Moreover, in dismissing Friedman's approach to depressions, Friedman's suggestion—that having over one-third of the money supply wiped-out by bank failures created sizable problems—is simply denied by Sennholz as "mistaking symptoms for causes." The money supply causes inflation, the Austrians admit, but it can't possibly cause depression.


To summarize some of the main points:

• Austrian and Chicago quantity theories differ significantly only in the failure of the former to comprehend and keep up with recent developments in analysis and research.[16]

• No discussion of the economy as a whole is conceivable without somewhat imperfect lumping-together of quantities such as "the" demand for money, or "the" interest rate, or "the" level of investment. Since neither Austrians nor Chicagoans can avoid such "macroeconomics", the real issue is which theories have the best predictive power.

• Milton Friedman advocates a restrained increase in the money supply with a constant money supply as a long-run objective; a stable decline in the price level; unrestricted interest on demand deposits; and free trading in gold for all purposes including monetary.

So what is this big split between Misesians and Friedmanites all about? In brief, Sennholz, like Rothbard, appears to be creating distinctions where none exist by not focusing on current Chicago opinion. In the few cases where differences are both genuine and significant, no attempt whatsoever has been made to provide a direct response to the Chicago challenge. To pretend to criticize Chicago economics in a manner so obscure and evasive is surely a backhanded compliment to the formidable nature of Milton Friedman's thought.


[1] M. Rothbard, "Milton Friedman Unraveled," INDIVIDUALIST, Feb. 1971. Compare the more balanced effort of Israel Kirzner, "Divergent Approaches in Libertarian Thought," INTERCOLLEGIATE REVIEW, Jan.-Feb. 1967.
[2] H. Sennholz, "Chicago Monetary Tradition in The Light of Austrian Theory," REASON, Oct. 1971, printed in TOWARD LIBERTY (Inst. for Humane Studies 1971).
[3] See my article discussing "Chicago" and Austrian methodology, "Economics, Ethics, and Epistemology," REASON, February 1972.
[4] This quotation and later textual references to Sennholz are found in his REASON article, note 2. supra.
[5] For a concise survey of research on "velocity," see D. Laidler, THE DEMAND FOR MONEY: THEORIES AND EVIDENCE (Intl. 1969) pp. 89-123 and sources cited therein. Also M. Friedman, STUDIES IN THE QUANTITY THEORY OF MONEY (Univ. of Chicago 1956): "The quantity theory of money is in the first instance a theory of the demand for money."
[6] See David Friedman's letter, and my imperfect reply, in the October 1971 issue of REASON, pp. 35-36.
[7] M. Friedman, THE OPTIMUM QUANTITY OF MONEY (Aldine 1969) pp. 45 & 48.
[8] L. Von Mises, PLANNING FOR FREEDOM (Libertarian Press 1952) p. 80 (emphasis added).
[9] Criticism of other such definitional "solutions" can be found in my reply to William Stoddard, REASON, Oct. 1971 p. 35.
[10] Cf. "A Golden Gift" NATIONAL REVIEW, 8 Oct. 1971, p. 1100.
[11] "That there have been fluctuations in the numerous indices of economic activity is apparent; that these fluctuations have been sufficiently neat and coherent, generated by an automatic mechanism, to warrant the label of 'cycle' is not so apparent."—A. Alchian & W. Allen, UNIVERSITY ECONOMICS (Wadsworth 1964) p. 687n.
[12] J. Culbertson, MACROECONOMIC THEORY AND STABILIZATION POLICY (McGraw-Hill 1968) pp. 535-39.
[13] A. Reynolds, "The Case Against Wage and Price Controls" NATIONAL REVIEW, 24 Sept. 1971, p. 1053. See also my "Unions: Scapegoat for Inflation" IBID., 31 Dec. 1971.
[15] Cf. A. Reynolds, "Epistemology, Ethics and Economics" REASON, Feb. 1972; and D. Patinkin, MONEY, INTEREST AND PRICES (Harper & Row 1965) p. 636. As Friedman implies in THE OPTIMUM QUANTITY OF MONEY, supra note 7, p. 189, Austrian "monetary" theories are actually "credit theories misnamed."
[16] "Such development as has occurred since the twenties has been mainly in the contributions of the Swedish School (spoilt by the Keynesian influence), in those of the Chicago school (particularly Milton Friedman), the works of…Dennis Robertson and in those 'refinements' of Keynesian theory…which have in fact, if not in form, amounted to a recantation." —W.H. Hutt, KEYNESIANISM: RETROSPECT AND PROSPECT (Regnery 1963) p. 90.
Dean Hutt, incidentally, acknowledges the obvious influence of Mises, but also acknowledges an intellectual debt to those in the allegedly antagonistic monetarist tradition: Simons, Fisher and Warburton, IBID., pp. x & 186. Irving Fisher's interest theory, for example, is clearly part of the Austrian tradition: Cf., M. Blaug, ECONOMIC THEORY IN RETROSPECT (Irwin 1962) p. 478.