ECONOMICS:At the University of Chicago, once-ascendant free-market acolytes are finding themselves battling a wave of government intervention across the globe, the most sweeping since the Great Depression

JOHN COCHRANE was steaming as word of US Treasury secretary Henry Paulson's plan to buy $700 billion in troubled mortgage assets rippled across the University of Chicago in September. Cochrane had been teaching at the bastion of free-market economics for 14 years and this struck at everything he - and the school - stood for.

"We all wandered the hallway thinking, 'how could this possibly make sense?'" says Cochrane (51), recalling his incredulity at Paulson's attempt to prop up the mortgage industry and the banks that had precipitated the housing market's boom and bust.

During a lunch held on a balcony with a view of Rockefeller Memorial Chapel, Cochrane and some colleagues made their stand. They wrote a petition attacking Paulson's proposal, sent it to economists nationwide and collected 230 signatures. Republican senator Richard Shelby of Alabama waved the document as he scorned the rescue. When Congress rejected it later that month, Cochrane fired off congratulatory e-mails. The victory was shortlived. Lawmakers approved the plan four days later, swayed by what Cochrane saw as pork-barrel amendments.

"We should have a recession," Cochrane said in November, speaking to students and investors in a conference room by Lake Michigan. "People who spend their lives pounding nails in Nevada need something else to do."

At the University of Chicago, once-ascendant free-market acolytes are finding themselves in an unusual role - they're battling a wave of government intervention more sweeping than any since the Great Depression.

By the end of November, the government had committed $8.5 trillion, or more than half the value of everything produced in the country in 2007, to save the financial system. The EU had put up more than $3 trillion to guarantee bank loans and provide capital to lenders. And China unveiled a $586 billion stimulus and its biggest interest-rate cut in 11 years.

The intrusion is anathema to the so-called Chicago school of economics and its patriarch, the late Milton Friedman.

For half a century, Chicago's hands-off principles have permeated financial thinking and shaped global markets, earning the university 10 Nobel Memorial Prizes in Economic Sciences starting in 1969 - more than double the four each won by Columbi, Harvard, Princeton and the University of California, Berkeley.

Chicago's laissez-faire imprint underpins everything from US president Ronald Reagan's 1981 tax cuts and the fall of communism that decade to quantitative investment strategies. In 1972, Friedman helped persuade US Treasury secretary George Shultz, former dean of Chicago's business school, to approve the first financial futures contracts in foreign currencies. Such derivatives grew more complex after Chicago economists created the mathematical formulas to price them, helping spawn a $683 trillion market that's proved to be a root of today's financial breakdown.

Friedman, who died in 2006 aged 94, defined the Chicago School in 1974: "'Chicago' stands for a belief in the efficacy of the free market as a means of organising resources, for skepticism about government intervention into economic affairs," he said.

Friedman was explaining a movement that had taken hold in the US and was percolating in Europe and South America.

Joseph Stiglitz, who won one of Columbia's economics Nobels, says the approach of Friedman and his followers helped cause today's turmoil.

"The Chicago School bears the blame for providing a seeming intellectual foundation for the idea that markets are self-adjusting and the best role for government is to do nothing," says Stiglitz, who received his Nobel prize in 2001.

Fellow economist James Galbraith says Friedman's ideology has run its course. He says hands-off policies were convenient for American capitalists after the second World War as they vied with government-favoured labour unions at home and Soviet expansion overseas.

"The inability of Friedman's successors to say anything useful about what's happening in financial markets today means their influence is finished," he says.

Instead, Galbraith says policy-makers are rediscovering the ideas of his father, Harvard professor John Kenneth Galbraith, and economist John Maynard Keynes of the University of Cambridge.

Keynes, who died in 1946, argued that governments should spend to combat the unemployment that free markets tolerate. Galbraith, who died in 2006, rejected mathematical models and technical analyses as divorced from reality.

Barack Obama, who will now referee the laissez-faire versus free-market debate as US president, has pledged the largest spending on infrastructure since the 1950s to save or create three million jobs. His proposals have already passed through the lower House of Congress at the time of going to print.

Ironically, the new US president has deep roots on the university's campus in Hyde Park, a middle-class enclave seven miles south of downtown Chicago. His Victorian house is a five-minute walk from the school's northern edge. He taught constitutional law there for 12 years, stepping down when he was elected to the US Senate in 2004.

Obama tapped fellow Chicago professor Austan Goolsbee as staff director of his President's Economic Recovery Advisory Board, which will propose ways to revive growth.

Goolsbee, who was Obama's chief economist during the campaign, has taught at the business school since 1995. Goolsbee says Obama's top priority is to prevent the crisis spiralling into a depression. Yet he insists Obama won't overregulate.

"If the president-elect were not a 'University of Chicago Democrat', then the natural response would be to just try to turn back the clock to what was there before," he says.

"Because Obama comes out of a framework where the market is not the enemy, there's a possibility we can create new institutions to guard against excess without going back to what was wrong in the old regime."

Goolsbee supports bigger capital requirements for banks and other institutions that can borrow from the Federal Reserve, and wants expanded monitoring of hedge fund firms and ratings companies.

Derivatives may need to be traded through clearing houses, like those used in Chicago wheat pits, which act as counterparties for each trade and can suspend traders with insufficient collateral.

"Getting us out of the hole we're in, promoting oversight and making investments so the economy can grow doesn't make you anti-market," Goolsbee says. "It's totally pro-market."

Already, some of the university's top economists have abandoned hard-line Friedmanism for the middle ground.

Douglas Diamond, a finance professor at Chicago since 1979, declined to sign Cochrane's petition damning Paulson's bailout.

Diamond says he knew the September vote against the rescue would spur investors to pull assets from banks. He says governments have no choice but to provide safety nets for banks and tougher oversight.

Robert Lucas, a Chicago economist who won a Nobel Prize in 1995 for a theory that argued against governments trying to fine-tune consumer demand, says deregulation may have gone too far.

Depression-era laws that separated commercial and investment banks helped depositors decide if they wanted secure accounts or riskier investments. Today, without these distinctions, people can't be sure if their investments, or those of their customers, are safe.

"I'm changing my views on bank regulation every week," Lucas says. "It was an area I saw as under control. Now I don't believe that."

Lucas says he voted for Obama, the only Democrat besides Bill Clinton he'd supported in 44 years. He concluded that the candidate was comfortable talking with professional economists. He describes Goolsbee, whom he has met in faculty workshops, as a serious scholar.

Friedman sought to discredit Keynes, who argued that deficits in government budgets could revive demand in recessions. He viewed rising government power as a step toward left-wing totalitarianism and wanted to stop it, says Philip Mirowski, a University of Notre Dame economist.

Friedman challenged Keynesian orthodoxy with work that culminated in a Nobel Prize in 1976. He argued that consumers decide how much to save based on earning prospects throughout their lifetimes, not on short-term government efforts to manipulate demand.

Friedman demonstrated that inflation and unemployment may rise in tandem and that governments cause inflation by printing too much money.

Lucas, the 1995 Nobel Laureate, recalls Friedman convincing him in a 90-minute undergraduate class in 1960 that labour was subject to the same economic laws as other commodities. Friedman argued that minimum wage laws, which Lucas saw as humanitarian, harm workers by reducing demand for their services.

"I never thought I could change my mind like that," says Lucas.

Deirdre McCloskey, now an economist at the University of Illinois, Chicago, remembers laughing with fellow Harvard undergraduates in 1963 at Friedman's claim that free markets allocate resources better than governments. She says Harvard-trained bureaucrats enjoyed prestige following the second World War. She switched her support to Friedman after the Vietnam War destroyed her faith that such bureaucrats knew what they were doing. Friedman was a fierce debater, McCloskey recalls. "He always asks, persistently, 'how do you know?'" McCloskey wrote in the Eastern Economic Review in 2003.

"It's a terrifying question, because most of the time we can't say."

Friedman was chief economic adviser to Republican presidential candidate Barry Goldwater in 1964. He began attracting non-academic audiences with a Newsweek column that ran from 1966 to 1984.

When Reagan was governor of California, Friedman campaigned with him in 1973 for limits to property taxes that had fuelled government growth in the state.

In 1975, Friedman travelled to Chile and met dictator Augusto Pinochet, who'd seized power two years earlier in a coup in which thousands died, including Socialist president Salvador Allende.

Pinochet practised "shock therapy", including monetary controls, to tame inflation.

Friedman's friend Alan Walters, later an adviser to British prime minister Margaret Thatcher, went to Chile to monitor what he viewed as laboratory-like conditions for shock therapy, says Andy Beckett in Pinochet in Piccadilly: Britain and Chile's Hidden History.

Walters taught at the London School of Economics and at Johns Hopkins University in Baltimore, later serving as vice chairman of AIG Trading Group.

He was fascinated by the "Chicago boys" who trained in Hyde Park and became advisers to post-Soviet governments in Eastern Europe after serving in Chile.

Students reacted differently. After the coup, a generation of Latin Americans refused to study at Chicago, says James Heckman, an economist at the university who won a Nobel in 2000.

McCloskey, who taught in the Chicago economics department for 12 years starting in 1968, says several professors played bigger roles than Friedman in Chile. His opposition to training economists for Shah Mohammed Reza Pahlavi of Iran shows that he didn't coddle dictators, she says. McCloskey still trusts Friedman's teachings.

"The big event of the last 20 years is the success of free markets in India and China," says McCloskey. "This is more important than any financial crisis and makes it really hard to argue for a return to central planning."

In 1977, Friedman reached the then mandatory retirement age of 65 and left for the Hoover Institution at Stanford University. While wrapping up his Hyde Park career, he reviewed the early research of professors Fischer Black and Myron Scholes, who gave Chicago theories a bigger and more direct role in financial markets.

The pair provided a foundation for trading call options on stocks by creating a formula to link the value of the options to share price and volatility, time remaining on the option and interest rates. The Black-Scholes model helped spark the global derivatives market.

At the time, Fama was positing that securities prices reflect the collective wisdom of all participants.
This "efficient market" theory helped pave the way for the recent economic crisis by sanctioning limited government, Mirowski says. "Fama taught that no human being knows enough to understand how resources should be allocated," he says. "All you can do is let the market have greater and greater ability to repackage information and risk. The result is, people bought mortgage-backed securities with no idea whether borrowers could repay."

Fama says he never denied the possibility of unexpected events even though he'd spent a
lifetime showing that markets effectively digest information. He was stunned that AIG, once
the world's largest insurer, sold $441 billion in unhedged and undercapitalised insurance on
securitised debt, much of it tied to mortgage values.

"No one expected a player like AIG to take a long position and not hedge themselves,"
Fama says. He says the government may have been able to stabilise the US financial system at
a lower cost by letting AIG collapse. Bailing out Detroit automakers will simply postpone their demise as they reel from expenses promised for employee retirement plans, he says.

Cochrane, who circulated the anti-rescue petition, says a rash of bailouts will expand
government and kill entrepreneurship. "People don't notice businesses that didn't start,"
he says. For now, he says, when a US bank fails, a hedge fund in Denmark may bear the brunt,
which is an improvement from the Depression era, when neighbourhoods surrounding
a bank were devastated. "That's risk being spread all around the world," he says.

Cochrane says he now represents a minority viewpoint among Chicago's business faculty.
He says Diamond, who declined to sign the petition, holds a majority view, which posits financial institutions must be rescued and regulated. Diamond rejects Friedman's view that banks failed in the 1930s because the US money supply contracted as panicky Americans started hoarding cash and the Fed reacted too slowly. Diamond sees the money supply as less significant than Friedman did. Banks failed, he says, because their assets weren't readily converted into the cash that depositors
were demanding. During the 1980s, Diamond's research was similar to that of Federal Reserve chairman Ben Bernanke, whom he calls a good friend.

The two postulated that, because bankers accumulate experience in assessing risk, they
play a key role in the economy. In the past decade, bankers failed properly
to grasp risk because of a "witch's brew" of mistakes, Diamond says.
Former Fed chairman Alan Greenspan's 1 per cent interest rate in 2003 – a 45-year low – flooded Wall Street with so much cash that banks could increase profits with shortterm borrowing to service long-term liabilities, Diamond says. The mismatch grew more dangerous as Greenspan resisted regulation of off-balance-sheet structured investment vehicles, which banks used to circumvent capital requirements.

Reagan's $4.5 billion rescue of Continental Illinois National Bank in 1984 convinced bankers
that bailouts would come if things turned bad, Diamond says. By 2007, a quarter of assets held by big US investment banks came from short-term borrowing, up from 12 per cent three years earlier.
Goolsbee describes the plan Obama is advocating – tax relief for workers, investment in technology and infrastructure and more oversight of financial markets – as pragmatic and data-driven.

He says Friedman would approve of Obama's determination to keep policy-making rooted in the economic methodologies developed at Chicago. The University of Texas's Galbraith compares
Obama to pragmatic philosopher John Dewey, whose ideas sparked educational reform in the 20th century. While on the Chicago faculty in 1896, Dewey started the school that the Obama and Goolsbee children attend.

Obama faces a real-life experiment in organising financial markets amid turmoil few presidents have navigated. His success will be measured partly by how he uses the University of Chicago as an intellectual anchor – and whether he can meld its free-market heritage with today’s nonstop intervention to bring order to uncharted times.