7. Los Cee-Ca-Go Boys

For a quarter of a century, the Berlin Wall symbolized the difference between the free markets of the West and the socialist economies of the East. On June 12, 1987, speaking at the Brandenburg Gate to commemorate the 750th anniversary of Berlin, U.S. President Ronald Reagan issued a challenge to Mikhail Gorbachev, the general secretary of the Communist Party of the Soviet Union: “Tear down this wall!” On November 9, 1989, the Berlin Wall came down.

At the fall of the Wall, when asked “Who won?”, Western political scientists cited the triumph of capitalism over socialism. The economists’ response was “Chicago.” The University of Chicago radically changed how the world thought about economics, politics, and business, with a system based on: “belief in the efficacy of the free market as a means for organizing resources...skepticism about government intervention into economic affairs and...emphasis on the quantity theory of money as a key factor in producing inflation.”¹

In the early part of the twentieth century, work in theoretical physics was centered around the Cavendish Laboratory (Cambridge, England), Göttingen (Germany), and the Institute of Theoretical Physics (Copenhagen, Denmark). Under Niels Bohr, the Nobel-prize-winning Danish physicist, and his German protégé Werner Heisenberg, the “Copenhagen Interpretation” became dominant. Generations of physicists once asked: “What is Copenhagen’s view of this?” Generations of economists now asked: “What is Chicago’s view of this?” As remote from real life as quantum physics, the Chicago School was highly influential for more than 50 years.

Dismal Science

Thomas Carlyle, the Victorian historian, christened economics the “dismal science.” American satirist P.J. O’Rourke described economics as “an entire scientific discipline of not knowing what you’re talking about.”²

Economics focuses on how production and financial systems work or should work. Macroeconomics focuses on growth, employment, production, inflation, and monetary and government budgetary (fiscal) policy. Microeconomics tries to analyze the behavior of firms or individuals, and how things like prices are determined and markets work.

In his 1776 work The Wealth of Nations, Adam Smith argued for a self-regulating market system in which narrow self-interest could order economic activity:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.³

Capitalism created wealth and progress, but at high social cost. Economic theory was preoccupied with the business cycle—especially painful and disruptive boom-bust cycles.

The 1929 stock market crash brought to an end the long boom of the jazz age. During this period, led by the United States, the world’s dominant economy, there were sharp increases in economic activity and the prices of stocks, commodities, and other assets. The crash was the largest fall in share prices ever recorded, with the U.S. market collapsing by around 90 percent and taking 25 years to recover its pre-crash highs. In the recession that followed, U.S. prices fell by one-third and unemployment reached 25 percent of the workforce. Global trade collapsed. The recession turned into the Great Depression, from which the world would not emerge until after the Second World War.

President Herbert Hoover sought to keep budgets balanced, preserve a sound currency, and avoid interfering in the adjustment process. The U.S. government refused to bail out banks. The Federal Reserve tightened the supply of money to maintain the value of the dollar. Economic orthodoxy dictated that the fall in values and elimination of bad loans or unsound investments would lead to recovery. It was tough love.

As the depression threatened to overwhelm societies, John Maynard Keynes argued for government spending to stimulate demand by supporting income and spending power. He broadened the remit of governments to manage the economy: “[the answer] is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.”⁴

Frederick Hayek, a prominent member of the Austrian School, opposed any interference in markets. Downturns were essential to allow capitalism and markets to purge and renew themselves. If Keynes’ views were shaped by the Great Depression, then Hayek’s quest for idealistic renewal was influenced by the epic collapse of the Austro-Hungarian Empire in the First World War.

Keynes’ General Theory of Employment, Interest and Money, Hayek believed, was primarily motivated by the political and economic problems of the period. Keynesian economics would not solve the problems but would create inflation. Keynes was equally critical of Hayek’s work, commenting that one article started “with a mistake” and then moved on to “bedlam.” Another article constituted “a farrago of nonsense.” Although he got on well with the Austrian personally, and thought Hayek’s 1944 The Road to Serfdom was “a grand book,” Keynes was unpersuaded, concluding: “what rubbish his theory is.”⁵

Joseph Schumpeter’s worldview was shaped by his role as Austria’s minister of finance, paying off debts incurred in the collapse of central European financial institutions. Intending to be the world’s greatest economist, lover, and horseman, the colorful, thrice-married Austrian acknowledged only having to work at his horsemanship. Capitalism’s strength, Schumpeter argued, was creative destruction, where economic incentives encouraged entrepreneurs to develop new ideas to take advantage of profit opportunities, sweeping away old defunct businesses and processes. The destruction was the inevitable and unavoidable cost of a vibrant system that renewed itself periodically.

Schumpeter saw the Great Depression as part of the adjustment that would wipe out unsustainable debts and poor investments, allowing economic renewal. Keynesian economics was legitimizing interference in the natural process.

For many politicians and economists, the severity of the Great Depression, the inability of markets to restore full employment and the rising human cost highlighted the failure of the invisible hand. Keynes gained credence and, for the next four decades, dominated economic thinking and policy. The ability of governments and central banks to fine-tune the economy through a judicious mix of budgetary and monetary policy as well as regulation became accepted faith.

In the 1960s, the University of Chicago’s Milton Friedman challenged Keynes as the foremost public figure in economics of the twentieth century. The Chicago Interpretation updated and reinstated classical economic theory with a dash of pure laissez-faire economics. Proof that markets were self-adjusting was couched in elegant, impenetrable statistical analysis. Like quantum physics, economics now relied on mathematics to describe reality.

The physicist Paul Dirac observed that: “In physics, we try to tell people in such a way that they understand something that nobody knew before. In the case of poetry, it’s the exact opposite.”⁶ Economics, as practiced at Chicago, with its mix of dogma, political fundamentalism, and mathematics, was neither poetry nor physics.

Theories—rational expectations, real business cycle theory, portfolio theory, efficient market hypothesis, capital structure theory, capital asset pricing models, option pricing, agency theory—rolled off the academic production line. Many economists received recognition in the form of the Nobel prize in Economics (technically the “Severige Riksbank [Swedish Central Bank] Prize in Economic Sciences in Memory of Alfred Nobel” founded in 1968). Some historians assert that every recent economics Nobel prize winner was either from the University of Chicago, was at Chicago at the time of doing their prize-winning work, had at some time visited the city or had simply inhaled the campus air—especially bottled and sent to them.

In January 1971, Richard Nixon recanted opposition to budget deficits, borrowing a 1965 line from Milton Friedman: “Now, I am a Keynesian.” Nixon was late; the Chicago Interpretation was already ascendant.

Chicago Interpretation

Founded in 1833, Chicago’s location near a portage between the Great Lakes and the Mississippi river watershed made the city a transportation, trading, and industrial hub. Travelers could smell the stockyards and abattoirs before they actually reached Chicago: “It was an elemental [odor], raw and crude; it was rich, almost rancid, sensual and strong.”⁷ Rudyard Kipling, the British author, described Chicago as: “a gilded rabbit warren...full of people talking about money and spitting.”⁸

Chicago was the ultimate trading city, the middleman to every transaction. The city became a financial hub, especially for derivative trading on the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME or the Merc). The University of Chicago exported the city’s trading and market ethos to the rest of the world.

The Chicago Interpretation emphasized free markets, the primacy of individual rights, economics as a science based on empirical hypothesis testing, and the application of economic theory to all problems, even sumo wrestling. “The market always ‘works’...government is always part of the problem, rather than part of the solution.”⁹ The rough and tumble of Chicago’s markets permeated the university’s teaching methods. Workshops were brutal, referred to as “bullfights” or “gunfights”: “They are a bloodbath.”¹⁰ The economics was ideological, pursued with religious zeal and bigotry.

The Chicago School was the creature initially of the notoriously difficult and brilliant Frank Knight and the ferocious Jacob Viner. Knight favored laissez-faire systems but regarded capitalism as ethically indefensible. He is best remembered for his work on risk and uncertainty, and his student 1976 Nobel laureate Milton Friedman. If Knight created the first Chicago School, then Friedman created the second Chicago School.

Friedman, in the words of The Economist, “the most influential economist of the second half of the 20th century...possibly of all of it,” made significant contributions in monetary history and theory (known as monetarism), consumption analysis, and stabilization policy. He had a natural affinity to free market economies and individual freedom. Leonard Silk, The New York Times economic writer, observed: “Adam Smith is generally hailed as the father of modern economics and Milton Friedman as his most distinguished son.”¹¹

Fiercely argumentative and a natural debater, Friedman reveled in the role of an influential public intellectual. In a series of popular books, including Capitalism and Freedom and Free to Choose (based on a TV series of the same name), he argued that governments could only provide a framework of enforceable contracts, secure property rights, fair competition, stable money, and limited protection for the “irresponsible.” In Capitalism and Freedom, Friedman listed activities that the American government should not undertake, including farming subsidies, tariffs and trade quotas, minimum wages, rent control, national parks, postal services, and the regulation of various industries, especially banking. The intellectual struggle between Keynes and Friedman shaped the age of extreme money.

Economic Politics

After the Great Depression, Keynesian demand management required economists to adjust taxation and government spending to engineer desired growth levels. There was an accepted trade-off between inflation and unemployment, known as the Phillips curve, named after a New Zealand economist.

The Chicago School favored free markets and limited regulation. Wealth redistribution would take capital from productive sectors, transferring it to less productive activities. There was deep ambivalence about governments. Minimizing taxes would starve the beast, decreasing its ability to fund unproductive programs. The agenda reflected the social conservatism of the principals. The Cold War shaped resistance against socialism, which Keynesian economics was associated with. Chicago Business School Professor Merton Miller’s distrust of behavioral economics was based on an antipathy toward “commies.”¹²

Ayn Rand, the Russian-born philosopher and writer, was a major influence. Her 1943 novel The Fountainhead portrayed the struggle of Howard Roark, a young architect who fought against compromise in a world dominated by “second handers.” The New York Times review was favorable: “a hymn in praise of the individual...this masterful book [raises] some of the basic concepts of our time.” In her 1957 follow-up, Atlas Shrugged, Rand outlined her moral philosophy of “rational self interest.” The book follows a group of industrialists, scientists, and artists who retreat to a mountainous hideaway to build an independent free economy. The heroes demonstrate that without their individual efforts the economy and society would collapse.

Rand’s philosophy influenced conservative and liberal thinkers, including Alan Greenspan, chairman of the Federal Reserve. Greenspan was known in Rand’s circles as “the undertaker” for his serious demeanor and dress habits.

Academic Warfare

The Second Chicago School set about dismantling the Keynesian mixed economy. In 1950, Frank Knight attacked Keynes as having carried “economic thinking well back to the Dark Age.” Keynes’ monetary theory had passed “the keys of the citadel out of the window to the Philistines hammering at the gates.” Jacob Viner attacked Keynes’ lack of objectivity and judiciousness, dismissing him as a prophet and a politician. Henry Simons, another protégé of Knight, saw Keynes as “the academic idol of...cranks and charlatans...and [the General Theory] as the economic bible of a fascist movement.”¹³

Frederick Hayek proved a key figure in discrediting Keynes and in the resurgence of free markets. His Road to Serfdom attacked government intervention in the economy. His 1960 book The Constitution of Liberty argued that the power and role of government should be limited to maintaining individual liberty. Hayek criticized the welfare state and the role of unions. His influence on Chicago was strengthened through the Mont Pelerin Society, a collaboration of 36 like-minded scholars seeking to revive the liberal tradition.

Friedman’s 1963 book The Monetary History of the United States, 1867–1960, written with Anna Schwartz, provided the basis for unseating Keynesian orthodoxy. According to Pierre Bayard,¹⁴ there are four types of books: UB (books unknown to the reader); SB (books skimmed); HB (books heard about); and FB (books read but forgotten). The monumental, 900-page Monetary History is a book that is a SB or HB, rarely a UB or FB. Few, even hardened economists, have read the lugubrious and soporific text.

In the Friedman and Schwartz view, the Great Depression was the result of government failure rather than market failure or a failure of capitalism. Friedman and Schwartz argued that the severe contraction in output was caused by a failure of the Federal Reserve, which tightened the availability of money when it should have been loosened, creating shortages of money that triggered bank failures. The Keynesian view of the Great Depression and the need for intervention, Friedman and Schwartz argued, was wrong. Conventional causes of the Great Depression, such as the stock market crash, trade barriers, or classical boom-bust cycles, were incorrect.

The lesson learned was that central banks must not contract money supply in response to a crash. The monetarist view was that when a collapse in financial markets was avoided through a monetary solution, growth would resume after a short recession. The real difference was subtler, as monetarist doctrines owed much to Keynes. But discrediting Keynes made other parts of Keynesian economics, specifically government intervention to manage demand, vulnerable to attack.

In the late 1960s and 1970s, Western economies were gripped by stagflation, a combination of low growth, unemployment, and inflation that resisted Keynesian remedies. In Europe, social welfare state costs proved unsustainable. Election of conservative governments in the United States (under President Ronald Reagan) and in the UK (under Prime Minister Margaret Thatcher) hastened a return to free markets. Asked about her political philosophy, Thatcher produced a copy of Hayek’s The Constitution of Liberty: “This is what we believe.”¹⁵ Reagan identified the nine most terrifying words in the English language: “I’m from the government and I’m here to help.” Efficient markets rather than efficient government was the new battle cry.

The Gipper and the Iron Lady

In 1956, Clinton Rossiter, a political scientist, identified the skills needed by the occupant of the Oval Office: “scoutmaster, Delphic Oracle, hero of the silver screen and father of the multitudes.”¹⁶ Ronald Wilson Reagan, a Hollywood B film actor, possessed one of these qualities. A Democrat who switched to the Republican Party, Reagan was elected governor of California to send welfare bums back to work and to clean up the University of California at Berkeley, a reference to antiwar and anti-establishment student protests.

In the 1970s, growth slowed as a result of the twin oil shocks of 1974 and 1979, leading to higher oil prices. Inflation and interest rates were in double figures. Unemployment was high and there was increasing labor unrest. America’s public finances were in poor shape. The Bretton Woods system of fixed exchange rate collapsed. Since the end of the go-go years of the 1960s, the stock market had been moribund. Americans were racked with self-doubt by the effects of the Vietnam War, race problems, the Watergate scandal, as well as increasing instability and uncertainty.

The presidential race was no contest, as the Great Communicator’s one-liners exposed the weaknesses of Jimmy Carter’s presidency. “Depression is when you’re out of work. A recession is when your neighbor’s out of work. Recovery is when Carter’s out of work.” There was the misery index—the sum of inflation and unemployment rates. In a presidential debate, Reagan delivered the killer blow: “Next Tuesday all of you will go to the polls...and make a decision. ...when you make that decision...ask yourself, are you better off than you were four years ago?” Reagan defeated President Carter easily.

In the UK, Margaret Hilda Thatcher defeated the ill-fated James Callaghan and a tired Labour government in 1979 to become the first woman prime minister of the UK. Ten years earlier Thatcher had said: “no woman in my time will be Prime Minister.” Thatcher became a close ally of Reagan. An aide observed that when together a crowbar was needed to pry them apart.

Like Reagan, Thatcher was elected with a mandate to reverse the country’s economic and social decline. She wrote of “a feeling of helplessness that a once great nation has somehow fallen behind.” Charles Saatchi, once owner of The Physical Impossibility of Death in the Mind of Someone Living, created the Conservatives’ successful campaign slogan “Labor isn’t working” and the famous poster image of a lengthy queue of unemployed workers stretching across an empty landscape.

Reagan held firm views on government and the welfare state: “Government is like a baby. An alimentary canal with a big appetite at one end and no responsibility at the other.” Reagan quipped that: “Welfare’s purpose should be to eliminate, as far as possible, the need for its own existence.” Thatcher believed in personal responsibility, thrift, and probity. She was christened “Milk snatcher” for stopping free milk for children at school. She earned the nickname TINA—“There is no alternative.”

Economic reform focused on using monetarist tools to bring inflation under control, restoring sound money, deregulation, balanced budgets, reducing the role of government by tax cuts, and lower government spending.

Paul Volcker, chairman of the U.S. Federal Reserve, played a major part in putting the inflation genie firmly back in the bottle. The 6-foot-7, cheap-cigar-smoking model public servant was said to be able simultaneously to talk down to you and over your head.¹⁷ Restricting the supply of money, Volcker forced interest rates up to brutal levels (above 20 percent per annum) to reduce inflationary expectations. Unemployment rose and bankruptcies increased as the economy slowed. The strategy worked and inflation eventually fell, ushering in a period of growth.

Reagan and Thatcher cut personal income and company taxes. In America the top personal marginal tax rate fell from 70 percent to 28 percent. In the UK Thatcher cut the top rate of British personal income tax rates to 40 percent from 98 percent. The UK tax base was broadened using indirect taxes.

Reagan ended the price controls on domestic oil that had aggravated the 1970s energy crisis. Banking, telecommunications, airlines, electricity, gas, water, and transport were all deregulated to increase flexibility and remove barriers to competition. Thatcher privatized British state-owned companies, reversing decades of nationalization and government ownership.

There was deregulation of the labor markets. Facing a strike by federal air traffic controllers, Reagan, once president of the Screen Actors Guild, declared an emergency and ultimately fired over 11,000 striking controllers, effectively busting the union. In the UK Thatcher and her trusted enforcer Norman Tebbit defeated the National Union of Mineworkers in a bruising, no-holds-barred battle. Reagan and Thatcher took the advice of financier Jay Gould: “hire one half of the working class to kill the other half.”

Reagan cut spending, but not sufficiently to offset the reduction in tax revenue. Reagan reduced nonmilitary spending such as food stamps, federal education, and environmental programs. Politically sensitive entitlement programs, such as Social Security and Medicare, were maintained. America borrowed heavily domestically and abroad to cover large budget deficits. National debt increased from $700 billion to $3 trillion. The President was disappointed at the growing national debt, joking that: “[The deficit] is big enough to take care of itself.” Thatcher balanced the books, largely through the sale of state-owned businesses.

By the late 1980s, neo-liberalism (as the Chicago School ideas were now called) dominated economic thinking. Even in France, home of the dirigiste tradition favoring state control over the economy, Socialist Prime Minister Lionel Jospin reluctantly embraced pragmatic economics: “Yes to the market economy, no to the market society.”¹⁸

Political Economy

Growth recovered after the recession of the early 1980s. Unemployment and interest rates fell sharply, and stocks rose in a new bull market. It is unclear whether the recovery was the result of traditional Keynesian nostrums of large budget deficits, low inflation, and reduced interest rates or the new economics. Friedman grumbled that government and central banks, especially the British, were applying his ideas incorrectly. John Kenneth Galbraith’s criticism was withering: “Milton’s [Friedman’s] misfortune is that his policies have been tried.”¹⁹

Volcker declared himself a monetarist but rarely followed theory. Money supply proved difficult to measure or control. When the government targeted one measure of money supply, other measures changed unexpectedly. As Charles Goodhart, an English economist and central banker, identified: “observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” Christopher Fildes, an English journalist, restated Goodhart’s law: “It’s all very well when anthropologists observe the savages, but all bets are off when the savages start observing the anthropologists.”²⁰

Reaganomics flirted with supply side theory, advocated by little known economist Arthur Laffer. Large tax cuts would stimulate economic growth, expanding the tax base and offsetting the lost revenue from lower tax rates. Armed with a flipchart and pointer, Reagan used a presidential TV address to introduce a bemused nation to the Laffer curve. Half a century earlier, Cornell University Professor George Warren had convinced Franklin Delano Roosevelt to raise prices for agricultural produce by boosting gold prices to try to end the Great Depression. Warren’s credentials included formulas for getting chickens to lay more eggs.²¹

Politics dictated that governments were unable to rein in spending to match the tax cuts to balance the budget. Spending was the basis of political patronage and purchased votes. In Atlas Shrugged, the politicians come to John Galt, the heroic businessman, for assistance to help repair the economy. Galt: “You want me to be economic dictator?” Mr. Thompson: “Yes!” “And you’ll obey any order I give?” “Implicitly!” “Then start by abolishing all income taxes.” “Oh no!” screams Mr. Thompson, leaping to his feet. “We couldn’t do that.... How would we pay government employees?” “Fire your government employees.” “Oh, no!”²²

Governments actually became larger. Deregulating industries concentrated market power and reduced competition, necessitating renewed state intervention. Technological innovation, encouraged by free markets, rapidly reshaped industries, creating noncompetitive monopolies requiring regulation. The neo-liberal program encountered an old problem recognized by Keynes: “Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone.”

Thatcher was not interested in pure agendas: “Economics are the method; the object is to change the soul.” Conservative politician Enoch Powell ridiculed Thatcher’s monetarist policies: “A pity she did not understand them!” Reagan never fully engaged with his economic program: “I have left orders to be awakened at any time in case of national emergency, even if I’m in a cabinet meeting.”

Only tiny New Zealand, under Roger Douglas, finance minister in a left-of-center government, attempted the full Chicago program. Rogeronomics entailed large spending and tax cuts, sale of state-owned assets, cuts in subsidies and tariffs, and deregulation of industries. There were plans for a flat low rate of taxation. The program was ultimately aborted in a wave of business collapses and bank failures.

In 1973, General Augusto Pinochet, with the active support of the U.S. CIA, removed the elected left wing Allende regime in Chile in a military coup. The Pinochet regime undertook systematic and widespread human rights violations in Chile and abroad, including torture, kidnapping, illegal detention, and mass-murder of suspected opponents, as well press censorship. Pinochet was accused of enriching himself and his family. Chile imported a team from the University of Chicago—“los Cee-Ca-Go boys”—to advise on restructuring its economy. Milton Friedman visited Chile in 1975 and met with Pinochet.

Although never implicated in human rights violations, Friedman’s association with Chile and Pinochet cast a shadow over his career. British Labour Prime Minister Tony Blair mocked the Conservatives as “the party of Pinochet,” pointing to the Chilean dictator’s close relationship with Thatcher. The New York Times asked: “if the pure Chicago economic theory can be carried out...only at the price of repression, should its authors feel some responsibility?”²³

Frank Knight was suspicious of any “ism”—communism, socialism, capitalism, and liberalism, even neo-liberalism. He believed that any attempt to improve public policy was doomed to failure:

The probability of the people in power being individuals who dislike the possession and exercise of power is on a level with the probability that an extremely tender-hearted person would get the job of whipping master in a slave plantation.²⁴

New Old Deal

Politicians and governments, irrespective of ideology, accepted market fundamentalism. Free markets were considered better at regulating competing forces, allocating resources, and meeting consumer demand. The role of government was to remove impediments to and ensure the proper institutional framework for free and competitive markets. Harvard economist and U.S. Treasury Secretary Lawrence Summers “tried to leave [his] students with...the view that the invisible hand is more powerful than the [un]hidden hand. Things will happen in well-organized efforts without direction, controls, plans. That’s the consensus among economists.”²⁵

Tony Blair’s New Labour government’s unalloyed support for the City reflected this belief. Upon succeeding Blair as the UK prime minister, Gordon Brown even invited Thatcher to No. 10 Downing Street for tea, seemingly to lend authority to his economic credentials. Enthusiastic embrace of markets and deregulation shaped Bill Clinton’s presidency. James Carville, Clinton’s political adviser, summed up this attitude in an oft-quoted remark: “I want to come back as the bond market. You can intimidate everybody.”²⁶ Politicians everywhere learned the truth of Thatcher’s words: “You can’t buck the markets.”

Money, highly mobile capital flows, the financial sector, and financialization were the core of the new economy. Economic growth was powered by ever-larger amounts of borrowing and spending. Investors and traders moved money into and out of investments and countries with alarming rapidity, to take advantage of the latest opportunities. Lawrence Summers loudly stated his approval: “In this age of electronic money investors are no longer seduced by a financial dance of a thousand veils. Only hard accurate information...will keep capital from fleeing precipitously at the first sign of trouble.”²⁷

Economic historians debate the influence of the Chicago School but contradictions abound. Ronald Reagan, the beatified doyen of conservatives, ran substantial budgets deficits that had a distinct Keynesian taint. Blair and Clinton’s social democrat administrations presided over the aggressive dismantling of banking regulation, which looks distinctly neo-liberal and ill-conceived. Then no pure economic model has been implemented in living memory, except perhaps in North Korea.

The Monetary Lens

The shift to a monetary focus increased the importance of money and the power of central banks. Politicians and the public were traditionally deeply suspicious of a powerful central bank. A prime mover in the creation of the American central bank was Paul Warburg, a Jewish German financier, who formed an unlikely partnership with Rhode Island Senator Nelson Aldrich. The idea of an American central bank was formulated at a secret meeting in 1910 on Jekyll Island off the Georgia coast. Participants traveled to the island pretending to be duck hunters. To ensure secrecy, they referred to each other only by their given names, giving rise to the sobriquet “The First Name Club.”²⁸

The Federal Reserve System (known generally as the Fed) was created in 1913 to implement banking and currency reforms to prevent periodic banking crises, such as the panic of 1907. It was a government entity with private components, consisting principally of the president-appointed board of governors of the Federal Reserve System in Washington DC, and 12 regional Federal Reserve banks located in major cities. The Fed was destined to play both Dr. Jekyll and Mr. Hyde in financialization.

In theory, central bank authority focused on ensuring that the value of money was not undermined by inflation. Hayek argued for mechanical rules to reduce the central bank’s discretion.

The cult of the all-powerful central banker emerged in the 1920s. Neurotic and prone to bouts of mental collapse, Sir Montagu Norman, governor of the Bank of England, dabbled with spiritualism, apparently once informing a colleague that he could walk through walls. On central banking matters, Norman reputedly observed: “I don’t have reasons. I have instincts.” Hjalmar Schacht, a fierce nationalist with the stiff gait and moustache of a Prussian reserve officer, headed Germany’s Reichsbank and went on to serve Hitler until a celebrated falling out. Paul Volcker’s success in dealing with inflation made him immensely powerful and invested the role of chairman of the Fed with great authority. When Volcker retired in 1987, his successor Alan Greenspan expanded the role of the central bank.

The pivotal event was the stock market crash of Monday, October 19, 1987. Despite volatile stock prices during the previous week, Greenspan traveled to Dallas to speak at the American Bankers’ Convention to maintain an appearance of calm and business as usual. Upon arriving in Dallas, Greenspan was told that the stock market was down “five oh eight.” The Fed Chairman assumed that it meant 5.08 points, only to learn that the market had fallen 508 points, or more than 22 percent.²⁹

Drawing on Friedman’s criticism of the Fed’s actions during the Great Depression, Greenspan announced the Fed’s willingness “to serve as a source of liquidity to support the economic and financial system.” The strategy worked, with the economy suffering only modest effects. The stock market stabilized and recovered quickly, establishing Greenspan’s credentials.

Half a century earlier, the longest-serving chairman of the Federal Reserve William McChesney Martin stated that the job of the Fed was to take away the punch bowl just as the party gets going.³⁰ Alan Greenspan reversed the emphasis, believing that bubbles were difficult to identify, and the central bankers’ task was not to try to prevent them. Central bankers now administered fluids to the casualties of irrational exuberance.

In 2002, at a dinner celebrating Friedman’s 90th birthday, Ben Bernanke, Greenspan’s successor as Fed chairman, swooned obsequiously: “I would like to say to Milton and Anna. Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”³¹ The audience sat in the manner of sinners, heads slightly bowed and the eyes moist and a bit glassy, amid the murmurs of “Amen, Brother” and “Praise the Lord.”

Unstable Stability?

Friedmanites argued that Reagan and Thatcher’s policies reinvigorated the economy, paving the way for the Great Moderation. Coined by Harvard economist James Stock, the term referred to an era of strong economic growth, increased prosperity, and the perceived end to economic cycles and volatility.

Prosperity was increasingly based on financial services and the speculation economy. The cycles were still there, papered over by the free money from central banks when necessary. Speculation and risk-taking behavior were almost risk free, as long as everybody, especially large, too-big-to-fail institutions, bet on the same color.

Manufacturing, which provided significant employment and prospects of social improvement for millions, was wound back, with production and jobs shifting to cheaper locations. Workers inhabited an insecure world of part-time or casual work or temporary contracts. Public services and public spaces were degraded. Heavily indebted consumer cultures focused on consumption. The socially unequal and atomized structures spilt over into binge drinking and casual violence in the nongentrified parts of great cities.

Hayek understood the dynamic, amoral, and unpredictable forces that underlie free markets. Like the Austrian, Knight considered free markets to be unjust because they distributed wealth based on luck and inheritance rather than capability and effort. Hayek and Knight were wary of the tendency of free markets to speculation, frenzy, and fraud. Greed, credulity, and herd instinct were likely to overwhelm economic rationality. Knight and Hayek did not consider markets an ideal tool for satisfying demand as they inevitably molded themselves to the desires of active participants and ignored other factors, like the environment and quality of life.

Knight argued that the economy is too complex and unstable to be controlled by simplistic government intervention. Intervention, he argued, is dangerous, rejecting the economic prescriptions of both the Keynesian and Friedman schools. Knight’s criticism of Friedman’s Second Chicago School was typically wry: “the emotional pronouncement of value judgements condemning emotion and value judgements which seems to [me] a symptom of a defective sense of humor.”³²

In his 1986 book Stabilizing an Unstable Economy, Hyman Minsky, an American economist, outlined a hypothesis as to why modern economies are liable to fluctuate and how obvious instability can be masked for a time. Minsky’s thesis was that stability in financial markets engenders instability as a result of inherent tendencies in the financial system—stability is itself destabilizing.

Minsky viewed modern financial markets as “conditionally coherent” and characterized by “periods of tranquility.” Excessive risk taking—driven in part by assumptions about the level of risk, inherent investment biases as asset prices increase, and increased leverage—led to market breakdowns. Minsky’s caution about “balance sheet adventuring” presciently anticipated the crisis that was to bring the Great Moderation to its end in 2007. Ben Bernanke, a follower of Friedman and student of the Great Depression, found himself facing the type of crash that the theory said could not happen again.