Chicago School of Economics

The Chicago School of Economics is a highly influential school of thought, born from the economics department at the University of Chicago, that champions the virtues of capitalism. Its core philosophy rests on a deep faith in free markets, the power of monetarism, and the logic of rational human behavior. Think of it as the intellectual counterpoint to the more government-centric Keynesian economics. The Chicago School argues that competitive markets, left to their own devices, are the most efficient way to organize an economy, and that most government intervention, however well-intentioned, often creates more problems than it solves. Pioneered by intellectual heavyweights and Nobel laureates like Milton Friedman and George Stigler, its theories have not only shaped global economic policy for decades but also laid the groundwork for some of the most fundamental concepts in modern finance that every investor must reckon with.

At the heart of the Chicago School is a profound belief in laissez-faire capitalism. Proponents argue that the free market, guided by what Adam Smith famously called the invisible hand, is a marvel of efficiency. Prices act as signals, guiding resources to where they are most needed without any central planner. In this view, government actions like price controls, excessive regulation, and subsidies distort these signals, leading to shortages, surpluses, and general economic sluggishness. The Chicago School’s prescription is simple: get out of the way and let competition and consumer choice work their magic.

One of the Chicago School's greatest battles was fought over the cause of inflation and the role of government spending. In an intellectual boxing match against Keynesianism, Milton Friedman championed the theory of monetarism. He argued that the primary driver of economic activity and inflation is the supply of money in an economy. His famous declaration, “Inflation is always and everywhere a monetary phenomenon,” is the monetarist mantra. This directly challenged the Keynesian focus on fiscal policy (government spending and taxation) as the main tool for managing an economy. For monetarists, the key to a stable economy is not a big government spending program, but a predictable, slow-growing money supply managed by a central bank.

The Chicago School also revolutionized how economists think about people. The Rational Expectations Hypothesis posits that individuals are not fools; they make economic decisions using all available information and a logical understanding of how the economy works. This means you can't easily trick the public with predictable policy moves. For instance, if the government announces a stimulus plan, rational people will anticipate its inflationary effects and adjust their behavior accordingly, neutralizing much of the policy's intended impact. This theory challenges the idea that governments can consistently fine-tune the economy, suggesting that markets adapt to and absorb policy changes far more quickly than previously thought.

Perhaps the Chicago School's most direct and controversial contribution to the investment world is the Efficient Market Hypothesis (EMH), developed by Chicago professor Eugene Fama. The EMH is a direct extension of the rational market worldview. It asserts that asset prices—like stocks and bonds—fully reflect all available information at any given moment. The implication is groundbreaking and, for many, demoralizing:

• If prices are always “right,” then it's impossible to consistently find undervalued stocks or time the market to earn above-average returns.
• Trying to beat the market is a fool's errand, more a matter of luck than skill.

This theory provided the intellectual foundation for the rise of passive investing and index funds, which don't try to beat the market but simply aim to match its performance.

Here at Capipedia, we have a healthy respect for the EMH, but as value investors, we fundamentally disagree with its strong conclusions. While the Chicago School provides a powerful model for how markets should work, we focus on how they actually work—with all their messy human emotions. Warren Buffett, a student of Benjamin Graham, famously quipped that if markets were always efficient, he'd be a “beggar with a tin cup.” Value investors believe that the market is far from a perfectly rational machine. Instead, we see it as a manic-depressive business partner, whom Graham personified as Mr. Market. Some days he is euphoric and will buy your shares at any ridiculously high price; other days he is terrified and will sell you his shares for pennies on the dollar. It is precisely this irrationality that creates opportunities for disciplined investors to purchase wonderful businesses at prices far below their true intrinsic value. In short, the Chicago School built the temple of market efficiency, but value investors make their living by betting on the cracks in its foundation.

The Chicago School's legacy is immense. Its ideas fueled the wave of deregulation and privatization that swept across the globe from the 1980s onward and cemented the role of central banks as inflation-fighters. However, the school has faced its share of criticism. Critics argue that its elegant models often fail to account for real-world complexities like information asymmetry (where one party has more information than another) and behavioral biases that lead to irrational bubbles and devastating crashes. The 2008 Global Financial Crisis, for example, was a stark reminder that markets are not always self-regulating and that human psychology can drive them to dangerous extremes, a reality that the Chicago School's framework can struggle to fully explain.