Sad day when I have to say “I told you so”

P1030980In April last year I explained on my blog that “The bubble will burst (just don`t ask me when)” and in August I explained “China is only the trigger” Now it is happening I need to explain why. Forget Davos: the reason the world economy is creaking is because of four economic fallacies that are peddled by most economists and which are wrong.
1st fallacy: most economists consider there is an output gap that can be closed by manipulating aggregate monetary demand and that this will increase output employment and growth.

There is no output gap that can be closed by manipulating demand. I explained this in 2013 and repeated it on my blog last year when I wrote “Are demand management policies the solution or a mass delusion?” Even though these policies are a delusion there is a Keynesian theory to support them but no evidence that demand stimulation by fiscal deficits has ever increased real income, net output or aggregate employment in a sustainable way.

2nd fallacy: most economists think that a rise in the costs of production can raise the average level of prices.

There is no such thing as cost push inflation in spite of the fact that every Central Bank uses changes in costs to deflect attention away from the real cause of inflation/deflation which is them (just read a Bank of England inflation report or listen to any Central Bank). Wages, oil prices, energy prices etc. cannot change the average level of prices, they just change relative prices. It can be easily understood by this often tweeted tweet: “By definition inflation is more units of money used in the same number of transactions”. So ask yourself where more units of money came from?

3rd fallacy: if the Central Bank reduces the rate of interest it will have a positive effect on growth and employment.

Lowering interest rates below market rates cannot stimulate demand and increase output and employment. I explained this situation in “A reappraisal of interest rates and market interest rates” Lowering interest rates can increase the money supply and monetary demand, (although this can be done more effectively, without lowering rates, by Quantitative Easing or Open Market Operations). It is therefore correct to say that monetary policy determines the rate of inflation but nothing else.

4th fallacy: there is a Phillips Curve that explains how higher inflation is correlated with higher levels of employment and vice versa.

This is incorrect as the original Phillips Curve showed a relationship between wages and employment and it is not correct to use it as an explanation of our way out of the current deflation threat. I explained this fallacy in “ Professor A.W. Phillips would turn in his grave if he knew how the Keynesians had corrupted his curve”

So how are the majority of economists explaining our current problems:-
The fall in oil prices gets a lot of press in a negative and damaging way, but equally we could be pointing out the positive effect on petrol prices and energy prices which is just what we need to get the economy growing.
Slowing growth in the Chinese economy is another favourite whipping post, but what is happening in China is what you would expect as an economy starts to mature, wages start to rise and they turn their attention to environmental issues. Again this should be seen as an opportunity to compete with China on a more level playing field.
Governments pursuing austere policies is obviously wrong when you look at the numbers and I explained this in “Austerity or profligacy in government finances” For many years governments have just been more or less profligate with their spending policies.
Let us now look at the real cause of the current crisis which was examined in more detail in “The cause of the Eurozone/EU/worldwide continuing crisis There are two main causes: firstly the fiscal stimuli that have occurred worldwide since the G20 meeting in London in 2009. I wrote about this in 2009 and published it on the blog more recently under “A fiscal stimulus” and “Look at the ticking time bomb in the budget”. Continuing fiscal deficits draw resources away from a more efficient private sector to a more inefficient public sector and this damages growth. We currently have a National Debt of £1.6 trillion which was only £750 billion in 2009. Ask yourself the question have these continuing boosts to demand had any positive effect? Secondly the low/ZIRP interest rate policy around the world has fuelled unproductive purchases of second hand assets and limited the availability of funds to productive investment.
So what are the majority of economists saying should be done? They have one main theory and four fallacies to work with so their solution is more of the same with larger fiscal deficits and even negative interest rates. Of course this may give us brief respite before we dip even further into recession and depression.
Unfortunately there is only one policy that will solve the current problems and it does require some “cold turkey” It is counter-intuitive but it is the only long term solution:-
• Raise Bank Rate to market rate, or avoid using interest rates at all to manage monetary demand and leave rates to settle under market conditions.
• Governments should be forced, by legislation, to balance their budgets over a three year term as explained in “A balanced budget: goodbye fiscal policy”

If we accept the four fallacies identified above then we may be able to think our way out of our current problems. Unfortunately it is unlikely that politicians will ever vote to do this and economists will not support something that may tip them off the gravy train, but at least I feel I have had my say and tried to improve things.
John Hearn 21/1/16


10 thoughts on “Sad day when I have to say “I told you so”

  1. What evidence is there for “unproductive purchases of second hand assests”? Are secondhand assests necessarily less or unproductive ( like your “leather” jacket?) Is any more of this purchasing going on now than in times of stronger growth and if so where is the evidence?
    Is the public sector “ineffficient” eg USA healthcare system vs NhS. Would UK rail transport be more efficient with solely private funding than the current mix? I’d like to know that general assertions can be backed up by evidence from specifics and see examples that representative.


    1. Asset bubbles are the evidence of unproductive investment. It would have been better if this money was expanding the capital base rather than used to speculate on the price rise of assets that already exist. Because of external costs and benefits there are good reasons for government intervention in the provision of merit and demerit goods, and because no one else will produce them and they are required the government needs to produce public goods. Other than this it is a waste for government to be involved in the production of marketable products like coal,steel, leather jackets etc


  2. I’ve been struggling to compose a reply to you that gives either of us any chance of learning anything. I thought had had asked a couple of straightforward questions, but you did not begin to answer them. By diverting onto talking about asset bubbles and merit goods you seemed to presuming I lacked some basic theory. Theory is fine if it can stand Popper’s test of falsifiability. Can your’s?


  3. One thing at a time: “What evidence is there for unproductive purchases of second hand assets?” Low interest rates have made it attractive for people to buy already existing assets in the hope that their price will go up. The housing market and, until recently, stock markets have risen sharply in value, This a bubble which has been caused by people buying unproductive assets. For an economy to grow it would have been better if this money had gone into new factories, hospitals, schools etc. Therefore the bubble is evidence of money being directed into the purchase of second hand assets. Let me know if this is clear and we can move to the next point.


  4. Guns and butter are usually used to illustrate that our actions have an opportunity cost. The ONS statistics are one data point that is not likely to be sustained and, as you know, I like to base my arguments on logic rather than rogue statistics. I can of course justify all my assertions, one at a time, if required.


    1. Ah Ha – thanks for explaining “opportunity cost” – Doh!
      “Logic” now that would appeal to me, if it were present in any form except general abstract concepts.
      “not likely to be sustained” – impossible to falsify – like your 30 year notion.
      Where logic works to a usable degree with general concepts is when, and only when, each concept is defined, distinct from other concepts, as well as meaning and context invariant.

      You might be right about interest rates – I see that at least Mervyn King is talking about the ‘prisoner’s dilemma” over raising interest rates, but I don’t seem to be able to enjoy or learn anything from your entrenched assertions. Maybe I will review some more of your stuff . but for now I think I shall withdraw. Good luck, Kimosabi!


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