What is the Chicago School of Economics? Definition and Aspects

What Is the Chicago School of Economics?

Chicago School is an economic school of thought, founded in the 1930s by Frank Hyneman Knight, that promoted the virtues of free-market principles to better society.

Understanding the Chicago School of Economics

Chicago School is a neoclassical economic school of thought that originated at the University of Chicago in the 1930s. The main tenets of the Chicago School are that free markets best allocate resources in an economy and that minimal, or even no, government intervention is best for economic prosperity. The Chicago School includes monetarist beliefs about the economy, contending that the money supply should be kept in equilibrium with the demand for money. Chicago School theory is also applied to other disciplines, including finance and law.

The Chicago School's most prominent alumnus was Nobel Laureate Milton Friedman, whose theories were drastically different from Keynesian economics, the prevailing school of economic thought at the time. The theories developed there were based on intense mathematical modeling to test disparate hypotheses.

One of the bedrock assumptions of the Chicago School is the concept of rational expectations. Friedman's quantity theory of money holds that general price levels in the economy are determined by the amount of money in circulation. By managing general price levels, economic growth can be better controlled in a world where individuals and groups rationally make economic allocation decisions.

Also beneficial to an economy, according to the Chicago School, is the reduction or elimination of regulations on business. George Stigler, another Nobel Laureate, developed theories regarding the impact of government regulation on businesses. Chicago School is libertarian and laissez-faire at its core, rejecting Keynesian notions of governments managing aggregate economic demand to promote growth.

Important Contributions

The Chicago School is also known for its contributions to finance theory. Eugene Fama won the Nobel Memorial Prize in Economic Sciences in 2013 for his work based on his well-known efficient market hypothesis (EMH). In awarding the prizes, The Royal Swedish Academy of Sciences said, "In the 1960s, Eugene Fama demonstrated that stock price movements are impossible to predict in the short-term and that new information affects prices almost immediately, which means that the market is efficient. The impact of Eugene Fama's results has extended beyond the field of research. For example, his results influenced the development of index funds."

Criticisms of Chicago School of Economics

The Chicago School enjoyed prestige and loyal adherents before the financial crisis and Great Recession. Former Fed Chair Alan Greenspan was thought to be a proponent of the Chicago School—a monetarist in his thoughts about the money supply, and a follower of Ayn Rand-style libertarianism. In a similar vein, the efficient market hypothesis may have colored former Fed Chair Ben Bernanke's views when he appeared before U.S. Congress on March 28, 2007, and stated that "the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

If markets behave efficiently, the Chicago School theory goes, then there would unlikely be any major imbalances, let alone a crisis like the one that unfolded in the last few years of that decade. During the conflagration of the financial crisis, there were questions about why Chair Bernanke and others in top positions did not adequately regulate the banking sector. Other academics turned on the Chicago School. Paul Krugman, a Nobel Laureate himself, was critical of the basic tenets of the Chicago School. Another notable economist, Brad DeLong of the University of California, Berkeley, said that the Chicago School had suffered an "intellectual collapse."