Each semester at universities around the world, students in introductory economic classes are generally told the same stories. Perhaps to the surprise of some students who have met human beings, economists teach their classes that human beings are rational creatures who primarily seek to maximize their own utility in making choices. These students are also taught that firms are led by perfectly rational people who can objectively measure worker productivity and respond quickly to new information. In addition, economists teach that the competitive nature of markets forces rational business leaders to provide goods and services that benefit society. And finally—and for some economists this seems to be the most important point—all of these beneficial products are bought and sold by rational consumers and producers without any need for government direction.
Perhaps some students don’t believe these tales. But it must appear to most students that economists have always believed the stories they tell about rational human beings and competitive markets.
Once upon a time, however people writing about economics were less confident about the behavior of people in business. Consider this quote from the 18th century: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
Yes, that is Adam Smith. When Adam Smith’s Wealth of Nations is invoked today, it is often used to convey the magical invisible hand of the market. Smith certainly mentioned the invisible hand. But in reality, Smith only mentioned this concept one time in the entire Wealth of Nations. So, we really can’t believe this was Smith’s central point. As Paul Sagar explains, Smith was primarily concerned with the danger of monopoly power.
About a century later, the economist Thorstein Veblen shared the same concern. Introductory students today are not likely to hear much about Veblen. But once upon a time, it was a different story in economics. In fact, Kenneth Arrow, who won the Nobel Prize in Economics in 1972, argued that “Thorsten Veblen’s ideas pervaded the intellectual culture” at Columbia University when Arrow was a graduate student in economics before World War II.
Veblen’s writings mostly appeared during the Robber Baron era around the beginning of the 20th century. Decades before Veblen, it appears Americans seemed to think that markets did not need much government intervention. This approach to markets, though, didn’t quite work. By the end of the 19th century—just as we can imagine Adam Smith would have predicted a century before—the American economy was dominated by monopoly power. Confronted with the late 19th century economy dominated by the Robber Barons, Veblen found it hard to believe that competitive markets were the norm and what business leaders did always made society better off.
Veblen was also highly skeptical of the idea that human beings were rational utility maximizers. As Veblen sarcastically wrote in 1898:
The hedonistic conception of man is that of a lightning calculator of pleasures and pains who oscillates like a homogeneous globule of desire of happiness under the impulse of stimuli that shift him about the area, but leave him intact.
Veblen was not the only who questioned the idea that human beings were rational “lightning calculators.”John Maynard Keynes, who argued markets were often motivated by “animal spirits,” also noted:
It is not a correct deduction from the Principles of Economics that enlightened self-interest always operates in the public interest. Nor is it true that self-interest generally is enlightened; more often individuals acting separately to promote their own ends are too ignorant or too weak to attain even these.
For a person living before World War II, what Veblen and Keynes argued probably wasn’t very surprising. Many people living at this time probably doubted the existence of competitive markets populated by rational business leaders consistently producing socially beneficial results. The Robber Baron era very much contradicted that story. And the behavior of the Robber Barons led to the enactment of antitrust laws, the federal income tax, government regulations of business, and much of the New Deal. All of this makes clear that many people in the first half of the 20th century certainly didn’t believe that the market, when left to its own devices, always produced outcomes that enriched the lives of everyone in society.
Of course, all of this government intervention didn’t make the wealthy Robber Barons happy. But what could the wealthy do? In the early 20th century, there weren’t many people who believed that unfettered markets were always a great idea.
This all changed after World War II. Led by Milton Friedman and his allies at the Chicago School, the wisdom of Smith, Veblen, and Keynes was gradually pushed aside. Suddenly economists were arguing human beings were rational, markets tend to be competitive, and government intrusion in the marketplace was a bad idea. The question is how did this happen?
One could argue that maybe government policy was too successful. Higher taxes and more government regulation mitigated the power of the very wealthy. Incomes in the middle of the 20th century became more equal. And as time went by, maybe people just forgot how the Robber Barons behaved.
Or maybe the Robber Barons just used their money to purchase some economists as apologists. Economists teach that people respond to incentives. Maybe that is true for economists as well!
Both of these are great stories. And these stories might very well be true. But neither story is very funny!
For a better story, let’s talk about a show that probably most people don’t know existed.
Back in 2015, Rob Lowe and Fred Savage starred in a sit-com called “The Grinder.”The show only lasted a season. So perhaps not everyone found this as funny as me. Nevertheless, I think the second episode of this show’s only season very much captures what Milton Friedman and his allies did to our understanding of economics.
Let’s start with the show’s premise. Rob Lowe plays a television actor, named Dean Sanderson, who starred as the lead in an over-the-top law drama called “The Grinder.” As the show begins, Lowe becomes dissatisfied with his show and moves to Boise, Idaho. There he moves in with his brother, Stewart, who is married with children. Played by Fred Savage, Stewart is an actual lawyer. At the onset of the show, Dean makes it clear that he thinks his experience as an overly dramatic actor on a legal drama could help his brother argue real cases. (You can watch parts of the trailer here.)
Of course, Lowe is just an actor. And again, an overly dramatic actor. Although Dean knows some legal phrases, he has no idea what they mean. Yet that doesn’t stop him from offering overly dramatic arguments that don’t always make sense.
In the second episode, Dean offers one of the best examples of a nonsensical argument. In the first minutes of the episode, Stewart is discussing which legal case his firm should choose next. Here is how Dean argues the firm should select its next case:
Dean: We don’t choose the case. We let the case… choose us.
Stewart: That’s insane. If we throw out all these cases, we will go out of business. This is a real law firm. We can’t do that.
Dean: But what… if we could!
Stewart: But we can’t.
Dean: But what… if we could!
Yes, Dean generally paused dramatically as he said this. And this is what made it funny (and as you can see here and here and here… people who heard Rob Lowe say this thought this was hilarious!).
Something like this phrase gets repeated several times in the episode. The case Dean chooses turns out to be one where the law firm’s clients don’t have a legal argument to stand on. When Dean is told that the fate of his brother’s clients was perfectly consistent with the law, he responds:
But what… if it wasn’t!
As Stewart notes in the episode: “It’s impossible to argue [with such statements]. You can use it any situation. Because… it means nothing.”
Okay, what does all this have to do with the turn economics took in the 20th century?
I would like us all imagining that once upon a time, Milton Friedman and his colleagues at the Chicago School were told:
Adam Smith knew markets were not always competitive and people in business didn’t always take actions that made society better off. Veblen and Keynes also both knew that people were not perfectly rational, and they both knew markets didn’t always work. We have known all of this for decades. You simply can’t assume markets are competitive and human beings are rational!
Upon hearing this, Friedman and his colleagues effectively said (just like Dean):
But what… if we could!
There were a few economists, like Herbert Simon, who tried to argue at the time human beings weren’t perfectly rational. But each time the Chicago School heard this argument, they simply said:
But what… if they were!
Just like Stewart noted, there is no real response to this line of reasoning. Those who use this technique aren’t providing a real argument. What Milton Friedman and the Chicago School assumed about markets and rationality wasn’t technically true. All they were doing was taking these assumptions to their natural conclusion.
Unfortunately, those assumptions often dictated the conclusions reached. And this intellectual exercise eventually resulted in future generations of students being taught it was okay to start with the assumption of competitive markets and rational actors. And it was okay to build arguments, based on those assumptions, that led economists to argue taxes on the rich should be lower, antitrust laws should be weakened, and government regulations should be dismantled. In fact, given the money rich people would pay to hear such stories, it was in the interest of economists to make such arguments.
Yes, maybe this story is all about people just forgetting what happened and economists responding to their monetary incentives.
Maybe, though, this is just a school of thought in economics doing their best Dean Sanderson impression. Just maybe, once upon a time Milton Friedman and the Chicago School really were told you can’t just assume markets are competitive and human beings are rational. And just maybe, they all just collective said:
But what… if we could!