The four fallacies of the coming economic apocalypse


Throughout my blogs I have made reference to a number of fallacies that underpin macroeconomic policy and forecasting and these are the main reason why policies do not produce the required outcomes, and why forecasts are often way off the mark. To understand this we need to look at the main macro models used by Central banks, Treasuries and think tanks around the world and see how they are constructed with these fallacies embedded into the assumptions from which the models are constructed. The Dynamic Stochastic General Equilibrium (DSGE) model used by the Bank of England and the Treasury is very similar to the models used by the Federal Reserve, the European Central Bank and the Bank of Japan, and in academic circles the Keynesian and Minsky models assume all or most of these fallacies in their construction. This means that all these models produce forecasts that are wrong along with policy recommendations that have not produced the desired effect. For greater clarification I am going to go through each of these fallacies and this will give anyone the opportunity to tell me why I am wrong, and if they cannot do that, then they need to accept that it is time to ditch these old models and construct more useful models based upon correct assumptions.

1st fallacy: there is an output gap that can be closed by manipulating aggregate monetary demand and this action will increase output, employment and growth.

This is supported by a simple Keynesian model that looks at the current level of employment and a number for a higher level of employment that can be achieved by employing, what they perceive as, idle resources. These economists assume that the output gap exists because there is not sufficient demand to employ those unemployed in the gap. There is then a fairly simple calculation for the income multiplier using the average wage and the number of unemployed people looking for a job. From here it is possible to estimate an amount of demand that can be injected into the economy using fiscal and/or monetary policy. It is then assumed that this will close the output gap and kick start a growth spurt in the economy. It is also great news for politicians as they can spend more money and not raise taxes, or cut taxes and not reduce expenditure.

Despite the fact that macroeconomic models have identified output gaps for almost every year over the last 70 years there is absolutely no evidence that these gaps have ever been 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?” The best example of these policies failing and even having the opposite effect of raising unemployment is in the stagflation of the 1970s and this is explained in more detail in “What really happened in the seventies”

There is of course a solution to closing the output gap. All capitalist economies tend to settle at a natural level of unemployment which is dependent upon their own institutional factors. These may include trade union power, welfare benefits, demand and supply mismatches among many other supply side factors. In order to close these gaps it is necessary to address the supply side of the economy and not try to manipulate aggregate monetary demand for any reason other than to achieve the inflation target. In fact if there is any inflation in the economy then there is already excessive monetary demand and only a Keynesian could argue it is a deficient aggregate demand situation if they accept the second fallacy which is explained next.

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 their monetary policy (just read a Bank of England inflation report or listen to any Central Bank). Wages, oil prices, energy prices and even a depreciating exchange rates cannot change the average level of prices, they just change relative prices. The fact that inflation is always and everywhere a monetary problem, as Friedman pointed out, 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 and the answer is always the Central Bank`s management of monetary demand which is made up of the cash they control directly and the credit creation of private banks that they control indirectly by manipulating cash and interest rates. There is no way that wage increases or commodity prices can increase the supply of money

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 real demand and increase output and employment. I explained this 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. As explained earlier just putting money in to the economy has only the nominal effect of changing the average level of prices and thinking that helicopter money or negative rates of interest will increase employment and output is just another illogical conclusion derived from the wrong thinking already described.

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 research completed by A.W. Phillips showed the relationship between wages and employment and it supported the, not unexpected, conclusion that when unemployment was high wages tended to fall as employers had a ready source of employees; and when unemployment was low then employers had to bid up the price of labour to attract it away from other uses. This obvious relationship was then hijacked by Keynesian economists who had to believe in cost push inflation as they transposed wages for prices and said if we boost demand then there is a point where prices will rise and higher levels of employment can only be achieved if we accept higher levels of inflation. This is not correct as it is already based upon one logical fallacy, cost push inflation, and also that there is no evidence that demand has been used successfully to manipulate prices and employment levels. Currently Janet Yellen is making reference to the Phillips Curve as one reason why the US should produce a more expansionary monetary policy. The curve is also being used to explain why deflation and higher levels of unemployment are linked. More is explained about this fallacy in “Professor A.W. Phillips would turn in his grave if he knew how the Keynesians had corrupted his curve”

A large proportion of economists believe in one or all of these fallacies and their complex modelling is both incomprehensible to non-mathematicians and wrong because when they argue for expansionary policies they find that output gaps are not closed, unemployment may rise and economic growth slows: the very opposite of what their models predict. And then, even worse, they argue that the policies were not expansionary enough or were not pursued for long enough, therefore we need further expansion with helicopter money, negative interest rates and larger fiscal deficits and when this does not work we may see the economic apocalypse and a few of us will know why it occurred.

John Hearn 13/6/16


2 thoughts on “The four fallacies of the coming economic apocalypse

  1. I really like your articles and think they are well constructed. The argument that keeps getting put forward by many mainstream economists is that the answer lies in increased public spending ie infrastructure. As in private debt is the problem not public debt and increased public spending will cure unemployment and decreased spending. My own view as a civil engineer is economists have chosen an elastic tape measure to build a structure, you can pretend measurements of value are correct for quite a long time but what you are building will be inherently unstable. However what is the argument against increased public spending or infrastructure spending as a cure for all ails. thanks for reading any help appreciated


    1. Good comment. Your reaction to what economists say and do is on the button and as you can read I disagree with much of their understanding of macroeconomics. I am OK with infrastructure spending and it is more important than a lot of spending plans. The problem is how you finance it. Finance it by taxation is good, by borrowing means you need to produce a positive return to finance the debt and governments are not very good at that. Finance it by printing money and there is likely to be a real problem in terms of inflation and the crowding out of the private sector. In other places I argue for balanced budgets and that produces more responsible spending.


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