A major reason for the Chicago School’s enormous public reputation has been Milton Friedman’s advocacy of numerous policy reform positions that subsequently reshaped debate over public policy in many nations. Even those who do not agree with him are impressed by his tireless eloquence, rigorous reasoning, and most of all his enormous courage in putting forward highly controversial positions.
For almost four decades Friedman counseled his fellow economists to recommend what they considered to be sound economic policy, regardless of the perceived political practicability. His argument was that political judgments are seriously defective and that, in any case, it is our professional obligation to give our best advice and let the recipients make decisions as best they can. Without gainsaying the considerable merit in this counsel, it is obviously incompatible with a view of society where economics and politics interact with each other.
A greater appreciation of that interaction came in the 1940s through the research of another Chicago economist, George Stigler, whose empirical studies of government regulation of public utilities, airlines, trucking, crude oil and securities markets concluded that, contrary to their stated intentions of protecting customers, public regulators often ended up protecting and advancing the interests of the very industries they were regulating. In other words, the regulatory bodies were “captured” by industry.
Government Intervention from Bad to Worse
This idea was not novel but what Stigler accomplished was to develop a set of conditions and predictions of when this result was likely, what mechanisms industries could deploy to achieve successful capture, why regulatory bodies were vulnerable to capture, and what the estimated costs would be to society. Economists following Stigler’s lead studied hundreds of regulated industries and occupations. Their empirical estimates of the costs confirmed the Chicago view that the cure was far worse than the disease.
Stigler’s thesis can be illustrated with two examples, one controlling oil imports in the US and the other controlling rice supplies in Hong Kong.
(1) Until 1958, the Eisenhower Administration resisted placing tariffs on imported oil. There were growing concerns that rising imports would undermine the domestic oil industry within the US, but at the same time major US oil companies with international holdings were profiting from the US importation of foreign oil. Under pressure from many high-ranking politicians, the President finally acted, imposing mandatory quotas on U.S. oil imports in 1959. But why, asked Stigler, did Eisenhower choose to impose quotas instead of tariffs?
Tariffs and quotas would have achieved the same effect of restricting foreign oil imports. But tariff revenues are collected by the government, while quota rents are collected by oil importers. Tariff revenues become part of government revenue and in principle benefit the consumer at large through either reduced taxes or increased public spending. By imposing quotas, however, Eisenhower passed the benefits to both domestic and importing oil companies because, on the one hand, there was a limit on foreign imports, and on the other, the importing companies could now charge a higher price. The ones who lost out were the consumers.
Stigler pointed out that a quota system also had the undesirable outcome of establishing a barrier to entry. New companies were less likely to enter the oil importing business because securing a quota was a political process that generally favored existing firms at the expense of prospective new entrants. Public regulation in this instance helped oil producers and importers to cartelize. This system persisted for 14 years until 1973 when the oil shock led to huge pressures to lower oil prices.
(2) The Hong Kong Government introduced a scheme to control rice supplies in 1955. The objective was to stabilize price fluctuations by having a reserve stock that catered for emergency situations or any short term shortage of supplies. Importers were required to hold and manage the reserve stock and in exchange they were allocated rice import licenses, which effectively became a barrier to entry. Government regulation thus facilitated the creation of a rice importing cartel.
The result of this was that for many decades, Hong Kong rice prices were higher than Macau’s. A better alternative would have been to tax rice imports and use the proceeds to finance a competitive private provision of services to hold and manage the reserve stock. But this was not the chosen policy. The rice import quota scheme was maintained until 2003 when it was relaxed to some extent. Government intervention had again ended up protecting industry at the expense of the consumer.
The effect of the Chicago School’s work on the public regulation of industries has in some ways altered the opinions of some regulators on the desirability of regulation, per se. In particular there is growing appreciation that once an industry has been regulated, it creates all sorts of stakeholders who resist future deregulation. As a result, enormous losses created by regulation are difficult if not impossible to reverse even after they have become well recognized and publicized. Chicago’s traditional aversion to government activity is therefore reinforced by Stigler’s positive analysis of public regulation.
Politicians Aim to Stay in Office
Stigler’s work on industries and their regulation, including the adverse effects of antitrust laws on competition, eventually led him to the study of political economy. His first publication on this was in 1970 and the approach he developed assumed that individuals, firms and organizations seek to maximize their own interests by obtaining (1) political wealth through the political system, and (2) market wealth through exchange and production.
Political wealth includes votes, but may also include other sources of influence. Individuals striving to be politicians function like entrepreneurs in seeking to form coalitions of political wealth owners by promising various benefits to voters and supporters. In essence, the players — individuals, politicians, firms, and organizations — are assumed to be rational maximizers of their own interests. The political decision making process is assumed to be driven by rational self-interest rather than altruistic concern with the general welfare of the community, unless these altruistic acts happen to be instrumental in accumulating political wealth.
Stigler hypothesized that politicians often make decisions in response to pressures exerted by their most influential and organized constituents who are, in turn, responding to the perceived effect of possible government action upon their collective interests. This means politicians are incapable of acting on advice to promote the general welfare and unlikely to be much interested in receiving such advice. Their concerns, indeed their only possible concerns, are getting reelected or otherwise retaining office, and advancing in political influence.
Stigler writes: “This new focus of economic studies of regulation changes the economists’ role from that of reformer to that of student of political economy…..Until we understand why our society adopts its policies, we will be poorly equipped to give useful advice on how to change those policies. Indeed, some changes (such as free trade) presumably are unattainable without a fundamental restructuring of the political system which we are unable to describe. A measure of restraint in our advice on policy would seem to be dictated by a sense of responsibility on the economists’ part, and not only by the sense of caution of the body politic to whom we address the advice.”
Stigler’s position is probably extreme. Economists may still have an important advisory function as providers of technical information (e.g., calculation of costs and benefits of legislative measures). However, this is very different from giving advice on the overall desirability of particular policies. By emphasizing the positive analysis of public regulation, Stigler has virtually eliminated the role for normative debate and left reformers (and anti-reformers) with little basis to offer advice or make judgments. The implication of Stigler’s work is that from Smith to Keynes to Friedman, reformers have all been deluded or been agitating for their own amusement or private advantage: economic science and influencing public policy have little synergism, and there is no reason for individuals interested in the former to be engaged in the latter.
Politics on Rent-Seeking
Stigler’s cynicism and aloofness contrasts sharply with Friedman’s passion for policy advocacy. These two towering giants of the Chicago School could not be more different in temperament. They were also different in physical appearance. Stigler was very tall and Friedman very short. Their tennis matches were a sensation on campus. Fortunately, affection and good sense prevented serious intellectual disagreement from causing any breach of personal relations between them.
Chicago was not the only place where scholars developed the rational choice approach to politics. Mancur Olson of the University of Maryland developed a theory of special interest groups in 1965. He noted that individuals in any group attempting to organize collective action to pursue their common interest will have incentives to “free ride” on the efforts of others. Groups that fail to prevent members from “free riding” will fail to organize themselves successfully. Individuals are less likely to “free ride” in groups which can limit benefits selectively to active participants.
Olson showed that smaller groups were more likely than larger groups to overcome “free rider” problems and organize themselves successfully to obtain resources through the political system. His work challenged accepted wisdom at that time that assumed the greatest concern in a democracy is that the majority will tyrannize and exploit the minority. In fact, according to Olson, economic logic shows that smaller groups with narrow special interests are politically more influential. In a democracy, the real fear should be the tyranny of such organized minorities.
In 1982, Olson applied his thesis to interpret the rise and decline of nations, east and west, past and present. He argued that the accumulation of narrow special interest groups in societies over time would lead civilizations into economic decline, a phenomenon he described as institutional sclerosis. Olson was a Harvard graduate who was not directly associated with the Chicago School. His thesis, however, falls entirely within the Chicago Paradigm. Stigler was also an accomplished historian of economic thought and noted that Olson’s ideas had originally been proposed by Italian economist Vilfredo Pareto in the late 19th century.
A concept related to Stigler’s ideas is “rent-seeking”, which was first developed in 1967 by Gordon Tullock. Tullock collaborated with James Buchanan (Nobel Laureate 1986) to establish the Virginia School of Political Economy. Together they developed the theory of public choice to study the behavior of politicians and officials at the University of Virginia, Virginia Polytechnic Institute, and George Mason University. Tullock studied law at Chicago and Buchanan studied economics at Chicago with Knight.
In economics, rent-seeking is an attempt to obtain economic gain by manipulating the social or political environment in which economic activities occur, rather than creating new wealth directly through market activities. An example would be spending money on political lobbying in order to capture a share of the wealth that has already been created. The concept of rent-seeking has also been applied to corruption by bureaucrats who solicit and extract ‘bribe’ or ‘rent’ for applying their legal but discretionary authority to award legitimate or illegitimate benefits to clients. A famous example of rent-seeking is the limiting of access to lucrative occupations by state certifications and licensures.
Rent-seeking is analogous to the entry barriers created by government regulation of market competition that lead to artificial monopoly privileges. A Hong Kong example is taxi medallions. Hong Kong has about 15,000 urban taxis and 3,000 non-urban taxis. An urban taxi medallion is valued at about $5 million, making the total value of this rent in excess of $75 billion. Profit-seeking by firms creates wealth, but rent-seeking only redistributes existing wealth. It is a negative-sum activity since real resources would still have to be spent on political lobbying activities, thus wasting resources.
Tullock’s concept of “rent-seeking” and Stigler’s concept of “regulatory capture” are two sides of the same coin, where collusion between firms and the government agencies assigned to regulate them enables rent-seeking behavior. Olson’s concept of “interest groups” seeking their common interest through collective action has essentially the same idea.
Chicago and the Chilean Reforms
Similarly, William Riker, the founder of positive political theory, was the first scholar to systematically applied game theory and mathematics to the study of political science, and recognized the significance and relevance of economic theories to the theory of democracy. Riker’s contribution was described in my HKEJ 28 December 2011article titled “Liberalism versus Populism”. His rational choice approach has since become the mainstream approach to the study of political science .
Allen Wallis who together with Friedman and Stigler had been younger members of the Knight affinity group, later became in turn President, CEO, and Chancellor of the University of Rochester during 1962-1982. In 1962, immediately upon his appointment Wallis recruited Riker to be Chairman of the Department of Political Science. Wallis strong support fostered the rise of the positive study of politics.
The emergence of positive political theory and its rise to mainstream status demonstrate the enormous vitality of the study of political economy and the influence of the Chicago School (or more broadly the Chicago Paradigm) in the development of political science.
The work of the “Chicago Boys” in Chile provides a rare illustration of the role of the economist as reformer. In 1973, the military coup led by General Augusto Pinochet ended the elected Marxist presidency of Salvador Allende. The military government first tried to solve the economic crisis left by Allende but failed. It then tried to recruit economists associated with the center-oriented Christian Democratic Party, but this too failed because the Party did not wish to be associated with the government’s radical right-wing politics.
Finally in 1975 the government turned to a group of economists mostly from the Universidad Catolica de Chile, many of whom had been trained at the University of Chicago. “Los Chee-Ga-Go Boys” accepted the task to end the economic crisis, then went far beyond this mandate to reshape the Chilean economy and society in the image of the Chicago School, for example, by introducing the world’s first mandatory private pension scheme.
A press report recounts the attitude of an economist towards the University: “He speaks of the years spent at Chicago with true inspiration, as if he had entered into a total commitment with society, as if a model which extends beyond economics was being created there, one which offers answers to a wide range of existential issues.” Another economist is quoted describing Chicago as having “absolute respect for rationality and empiricism as applied to the study of economic science and also to the policies it recommends…..I would add that in Chile we are trying to apply to a very specific political context the principles established by the Department of Economics at the University of Chicago.”
The Basis of Moral Responsibility
Milton Friedman defended the role of the “Chicago Boys” as rendering technical scientific advice to a government, a role he had all along urged his fellow economists to take up. Criticism nevertheless was widespread that such “professional service” was being rendered to a brutal regime whose human rights record was abysmal. Stigler’s positive analysis would have pointed out that the Chilean experiment was possible precisely because a brutal authoritarian regime was in charge that could brush aside all opposition, a rare event.
The ethical debate over the role of an economist in rendering policy advice revolves around whether positive economics is value free, and whether the economist is a social engineer or a preacher of freedom. I was in Chile in the 1990s and spoke with some of the Chicago economists who had been in public office. One of them said their work helped Chile to become a freer society despite the Pinochet regime. I was reminded that Lord Acton once said: “at all times sincere friends of freedom have been rare, and its triumphs have been due to minorities that have prevailed by associating themselves with auxiliaries whose objects often differed from their own; and this association, which is always dangerous, has sometimes been disastrous.”
Younger Chicago economists are now quite apolitical. Many have moved towards becoming disengaged analysts of the political-economic-social process rather than defenders of laissez-faire. Despite his cynicism, Stigler firmly believed that increasing scientific knowledge of the political-economic process would ultimately improve public policy making. Present day Chicagoans are now a long way from Henry Simons who held that it was “immoral to accept as inevitable what is itself immoral”.