This is the fifth in a series of interviews with Chicago School economists. Read “After the Blowup,” John Cassidy’s story on Chicago economists and the financial crisis. (Subscribers only.)

I interviewed Heckman by telephone in late October. I began by referring to a piece in the University of Chicago Magazine in which he appeared to absolve Chicago economics of any blame in causing the financial crisis. How did he react, then, to the recent criticisms of Chicago School economics from Joseph Stiglitz, Paul Krugman, and others?

James Heckman: Well, I want to distinguish between two different ideas. The Chicago School incorporates many different ideas. I think the part of the Chicago School that has been justified is the claim that people react to incentives, and that incentives are important. Nothing in what has happened invalidates that idea. People did react to incentives—clearly they did. It turned out that the incentives they were reacting to weren’t socially beneficial, but they definitely reacted to them. The other part of the Chicago School, which Stiglitz and Krugman have criticized, is the efficient-market hypothesis. That is something completely different.

I think it is important to put it into historical perspective. In the late nineteen-forties and nineteen-fifties, when Keynesianism was really dominant, that sort of Keynesianism—so-called hydraulic Keynesianism—completely ignored incentives and the way people reacted to them. What Chicago did—Milton Friedman, George Stigler, and others—was to redress that balance. They did a whole lot of empirical studies that showed how people did react to incentives, such as changes in taxes or prices. That was incredibly influential, and it is still is.

In the early nineteen-seventies, Martin Feldstein, of Harvard, showed how changes in unemployment benefits had a big impact on labor supply. That had an enormous impact on policy, and it was an application of Chicago economics. Feldstein said he read [Friedman’s] “Capitalism and Freedom” when he was at graduate school in Oxford, and it had an enormous influence on his thinking. That was the Chicago influence, and it still stands up. Linking empirical work to theory, and showing how things like taxes and government programs impact behavior.

O.K. People were reacting to incentives—the mortgage lenders, the Wall Street bankers, the homebuyers—I agree. But weren’t market prices sending them the wrong signals, and isn’t that an indictment of Chicago economics, which, going back to Hayek, at least, has stressed the role of prices in coordinating behavior?

I tend to think of it more in terms of the market reacting too slowly. Certainly, from the end of 2007 onwards, when it was clear that problems were emerging, many Wall Street professionals steered away from mortgage securities. For a long time, though, the market was sending the right signals. People made a lot of money—the traders, and so on. It turned out not to be socially optimal, but that is a different issue.

[Heckman then criticized behavioral economists, such as Berkeley’s George Akerlor and Yale’s Robert Shiller, for suggesting that the roots of the crisis lay in irrational behavior: overconfidence, animal spirits, and so on. For the most part, individuals responded to market incentives and reacted rationally, he insisted.]

Look, I could subsidize people to murder children, and if I offered enough money I don’t think I would find much trouble finding a ready supply of murderers.

Also, I think you could fault the regulators as much as the market. From about 2000 on, there was a decision made in Washington not to regulate these markets. People like Greenspan were taking a very crude and extreme form of the efficient-markets hypothesis and saying this justified not regulating the markets. It was a rhetorical use of the efficient-markets hypothesis to justify policies.

What about the rational-expectations hypothesis, the other big theory associated with modern Chicago? How does that stack up now?

I could tell you a story about my friend and colleague Milton Friedman. In the nineteen-seventies, we were sitting in the Ph.D. oral examination of a Chicago economist who has gone on to make his mark in the world. His thesis was on rational expectations. After he’d left, Friedman turned to me and said, “Look, I think it is a good idea, but these guys have taken it way too far.”

It became a kind of tautology that had enormously powerful policy implications, in theory. But the fact is, it didn’t have any empirical content. When Tom Sargent, Lard Hansen, and others tried to test it using cross equation restrictions, and so on, the data rejected the theories. There were a certain section of people that really got carried away. It became quite stifling.

What about Robert Lucas? He came up with a lot of these theories. Does he bear responsibility?

Well, Lucas is a very subtle person, and he is mainly concerned with theory. He doesn’t make a lot of empirical statements. I don’t think Bob got carried away, but some of his disciples did. It often happens. The further down the food chain you go, the more the zealots take over.

What about you? When rational expectations was sweeping economics, what was your reaction to it? I know you are primarily a micro guy, but what did you think?

What struck me was that we knew Keynesian theory was still alive in the banks and on Wall Street. Economists in those areas relied on Keynesian models to make short-run forecasts. It seemed strange to me that they would continue to do this if it had been theoretically proven that these models didn’t work.

What about the efficient-markets hypothesis? Did Chicago economists go too far in promoting that theory, too?

Some did. But there is a lot of diversity here. You can go office to office and get a different view.

[Heckman brought up the memoir of the late Fischer Black, one of the founders of the Black-Scholes option-pricing model, in which he says that financial markets tend to wander around, and don’t stick closely to economics fundamentals.]

[Black] was very close to the markets, and he had a feel for them, and he was very skeptical. And he was a Chicago economist. But there was an element of dogma in support of the efficient-market hypothesis. People like Raghu [Rajan] and Ned Gramlich [a former governor of the Federal Reserve, who died in 2007] were warning something was wrong, and they were ignored. There was sort of a culture of efficient markets—on Wall Street, in Washington, and in parts of academia, including Chicago.

What was the reaction here when the crisis struck?

Everybody was blindsided by the magnitude of what happened. But it wasn’t just here. The whole profession was blindsided. I don’t think Joe Stiglitz was forecasting a collapse in the mortgage market and large-scale banking collapses.

So, today, what survives of the Chicago School? What is left?

I think the tradition of incorporating theory into your economic thinking and confronting it with data—that is still very much alive. It might be in the study of wage inequality, or labor supply responses to taxes, or whatever. And the idea that people respond rationally to incentives is also still central. Nothing has invalidated that—on the contrary.

So, I think the underlying ideas of the Chicago School are still very powerful. The basis of the rocket is still intact. It is what I see as the booster stage—the rational-expectation hypothesis and the vulgar versions of the efficient-markets hypothesis that have run into trouble. They have taken a beating—no doubt about that. I think that what happened is that people got too far away from the data, and confronting ideas with data. That part of the Chicago tradition was neglected, and it was a strong part of the tradition.