I’m currently reading Robert Solow’s paper A Contribution to the Theory of Economic Growth in which he lays out his famous Solow growth model. I don’t want to get into the actual model laid out here but instead ask what exactly this paper is trying to address. As readers of this blog will probably know I find so-called ‘long-run’ models to be about as useful for understanding the economy as toy train sets are for understanding the operations of an actual train. But in many instances the reasoning they are based on is poisonous and somewhat dangerous.

Solow starts out the paper by criticising the Harrod-Domar growth model (for an excellent overview of the Harrod-Domar model which is one of the most suggestive in macroeconomics see the following three blogs by Bill Mitchell: I, II, III). He complains that Harrod (and Domar) had assumed that there was no substitution between capital and labour. Speaking of the so-called ‘knife-edge’ assumption of the Harrod-Domar model he writes,

But this fundamental opposition of the warranted and natural rates turns out in the end to flow from the crucial assumption that production takes place under conditions of fixed proportions. There is no possibility of substituting labor for capital in production. If this assumption is abandoned, the knife-edge notion of unstable balance seems to go with it. Indeed it is hardly surprising that such a gross rigidity in one part of the system should entail lack of flexibility in another. (pp65-66)

Solow’s argument is that Harrod’s analysis is all very nice in the so-called ‘short-run’ when there is probably no substitution between capital and labour. But in the long-run there is surely substitution.

But what does Solow mean by the ‘long-run’ here? That is never actually addressed. So far as I can see it is an analytical device — perhaps even a rhetorical device — appealed to on the basis of dogma. Solow says that in the long-run labour and capital will be substituted as a matter of fact. But this is never justified.

By my reading the whole idea behind the Harrod-Domar model was to provide a basis for dynamic analysis. This has a very real means of application. We can do calculations based on this model to see what level of investment is needed to keep the economy at full employment (see a nice example here). Sure, this is a thought experiment, but it has some use. It allows us to conceptualise how a given rate of savings and a given capital-output ratio requires a certain amount of investment to keep the economy in balance. This strikes me as applying, in some way, to the real world where we do indeed encounter such problems.

Solow’s model, on the other hand, appears not to have any application to the real-world at all. The only conclusion one can draw from the model itself is that everything should be kept as flexible as possible so that the economy can tend toward a sort of ‘natural’ equilibrium position. In that way, the Solow model is a sort of moral judgement: “this is how the world should be and if it deviates in some perverse manner then bad things will happen”. The ‘long-run’ in this model is really a prescriptive norm that the economy is chastised for not living up to.

But Solow thinks himself a Keynesian so he doesn’t want to admit this. The last few paragraphs in the paper are among the most disingenuous ever written. In them Solow addresses what happens in the case of various ‘rigidities’ such as sticky wages or liquidity preference. And lo and behold, unemployment appears! Solow’s prescription is that Keynesian measures should be used to keep the economy on a stable growth path at full employment.

Why is this so disingenuous? Because as I have just said: Solow has thrown out a model that might tell us something about how we might keep the economy at full employment and replaced it with a model that tells us absolutely nothing about this! Then he turns around and starts to talk about issues that could have been addressed by the model he rejects but which cannot be dealt with by the model he has put forward.

Harrod and Domar said to us: “here is a dynamic model that assumes we should take short-term problems very seriously; it will give us some insights into how we might overcome these problems to promote stable long-term growth.”

While Solow has said to us: “pay no attention to that silly short-run model by Harrod and Domar; here is an equilibrium model that brushes over short-term problems completely and presents us with a teleological Utopia… but in all honesty the short-term problems probably exist and should be taken seriously, unfortunately given that I have ignored them I cannot really tell you anything of interest about how to manage them.”

Yes, Solow may get a Nobel Prize for his thought experiment but how he has poisoned the well! The implications an honest reader who ignores the extremely weak final section of the paper (as they should, for they get nothing out of it!) should draw from the paper is that rigidities should be removed from the economy so that the teleological Utopia is reached. Labour and capital will substitute automatically when imbalances threaten to build so there is no real need for management. Just make sure those wages stay nice and flexible and everything should be fine!

This is how we should view basically all so-called ‘long-run’ marginalist models. They provide Utopian visions that can never exist in the real world. And implicit in these Utopian visions are harsh moral lessons that make no sense in an imperfect world. When they are applied they cause chaos but this chaos is ignored because the Utopians can tell us that we will reach heaven soon.

This is the type of reasoning that Karl Popper deemed totalitarian. The philosopher and sociologist Ralf Dahrendorf summarised this nicely,

One of the basic assumptions of all utopian constructions is that conditions may be created under which conflicts become superfluous. Indeed, the resulting state of harmony is the theoretical basis of the persistence of the social structure of utopia. But in reality these conditions do not exist. In fact, with the terrible dialectics of the non-rational, it happens that utopia first requires and then glorifies suppression.

Solow may be a liberal in his politics and in his economic policy prescriptions, but he is a totalitarian in his reasoning and his writing. All the marginalists are. Those on the right will hide it behind silly cant about ‘liberty’ while those on the left, like Solow, will hide behind irony and disingenuous nods toward Keynesianism. Their reasoning is Utopian in the Popperian sense (i.e. totalitarian) and the prescriptions such reasoning organically leads to are suppressive and dangerous.

Professor Solow himself may be a good guy. Smart, able to appreciate nuance, a fine writer, even a good policy economist. But what are his writings used for today? They are used to train students to think in totalitarian modes of thought. They are used to teach Utopias that students then go out and seek out — in vain — in the real world. And as sorry as I am to say it, those totalitarian fantasies are already contained in Solow’s writings. They are contained in the very essence of the way in which he writes and thinks.

Addendum: I just wanted to clarify why I think that Solow’s construction is wholly unrealistic. Very generally speaking we would assume by Solow’s conception that when unemployment rises labour replaces capital as the wage falls. If we look at the data we would thus expect to see unemployment and capital formation move in opposite directions. That is, when unemployment rises then capital formation should fall and vice versa.

When we turn to the data we do see unemployment rise at the same time as capital formation declines. This, however, is due to the fact that unemployment rises at the start of a recession and capital formation tends to also fall at the start of a recession. I have laid out the data below.


Pick out particular periods in this data, however, and we see no evidence of substitution. In times with sustained high unemployment, for example, capital formation tends to pick up after its initial dip. I have laid out two separate periods of sustained high unemployment below.


Note how after the initial dip after a recession capital formation begins to pick up again despite the fact that there is unemployment. What this tells us is that even though many workers remain idle capitalists continue to build new plant and equipment. The reasons why this occurs are highly complex and do not concern us here. But the facts are clear: capitalists will build new plant and equipment even when workers lay idle.

We see the same dynamic at work in the opposite scenario. According to the idea of substitution we should expect that in times of low unemployment we should see a rise in capital formation. But we do not. Take a look at the graph below.


In the mid to late-1960s the unemployment rate was very, very low. According to the substitution hypothesis this should have led capitalists to greatly increase their capital formation to replace the expensive labourers. But we do not see this. Rather capital formation was growing at a lower rate in the later period when unemployment was lower than it was in the earlier period when unemployment was higher. Again, the evidence for substitution is very thin indeed.

When we appeal to the ‘long-run’ it is unclear that we are talking about the real world at all. Where is this ‘long-run’ in the data? Surely the ‘long-run’ is a series of short-run scenarios. But if substitution does not take place in the short-run then when do we conceptualise it taking place at all?


Yesterday I ran a post that briefly delved into the connection between Keynes and the money cranks of the 1920s and 1930s. There I showed that Keynes’ ideas cannot be said to have been influenced in any substantial way by the money cranks. Rather they were an outgrowth of a modifying of his earlier views, put forward in his Treatise on Money and taken from the Swedish economist Knut Wicksell.

In what follows I will draw upon an article by Robert Dimand entitled Cranks, Heretics and Macroeconomics in the 1930s. Dimand’s narrative is centered on a periodical that was started in the US in 1932 entitled Economic Forum. The goal of Economic Forum was to bring together open-minded economists and people who would otherwise be considered money cranks. Keynes was, of course, a contributor, as were the money cranks C.H. Douglas and Frederick Soddy.

It should be noted that back in England the money cranks were already getting a hearing. R.G. Hawtrey, who was then at the British Treasury, publicly debated Douglas and Lionel Robbins — hardly a progressive economic thinker — saw Douglas’ ideas as having enough validity that he devoted a major portion of his British Association address to analyse them.

Clearly the ideas of the money cranks were in the ether at the time, in both the US and in England. This is not surprising because the unemployment situation had become so bad and economists were having a desperately hard time explaining it. So, those who were attempting to explain it were met with attention by the economists — even if the latter often approached the ideas of the former with the intent of discrediting them.

All of this is important to understand because it allows us to see that Keynes was not the only one engaging with the money cranks in this era. Many economists were — including many economists who would be very unsympathetic to easy money policies and fiscal expansion. During the Depression, the money cranks became regulars on the economic circuit.

Those involved with the Economic Forum also launched clever schemes to bring mainstream economists into the fold and engage with money crank theories directly. William Trufant Foster, for example, offered a $5,000 prize to the economist who could best refute his crank book on money and profits which advocated massive public spending. Fifty professional economists responded with entries and Foster’s ideas would go on to have a major influence on the Roosevelt-appointed Federal Reserve president Marinner Eccles.

Many of the theories of the money cranks were flimsy at best, however, and some had markedly negative tendencies. C.H. Douglas’ theories of social credit were influenced by Medieval Scholastic ideas about a ‘Just Price’ and manifested a tendency to blame most of the world’s economic ills on ‘usury’. In the hands of their most famous proponent — the American fascist poet Ezra Pound — they were easily combined with virulent antisemitism and Nazi idealism.

Those like Pound — who was later diagnosed as having a narcissistic, megalomaniacal personality by psychiatrists after his mental breakdown which was precipitated by his incarceration for treason after the war — who supported the theories did not respond well to rational criticism. F.S. Flint, for example, pointed out that there were many technical flaws in the argument — most notably the theory’s inability to recognise that interest paid is also interest income received — and Pound flew into an irrational rage saying that Flint had no right to comment on matters of algebra which were far above him (i.e. Flint). Flint was, of course, a mathematician employed as a statistician by the Ministry of Labour, while Pound was a mentally unstable poet who lived a life of wandering in search of fascist ideals.

Pound became something of a propagandist for the money cranks in this era. He gave lectures in Italian under invitation by Angelo Sraffa — Pierro Sraffa’s father! Pound’s writings contain bitter vitriol against Keynes; vitriol that comes across as highly personalised and reflective of Pound’s mental instability. But one gets the distinct impression that Pound was threatened by Keynes’ embrace of reasonably similar policies at the time — the narcissism of small differences and all that.

Pound’s presence in the debates shows up two strong traits of money cranks: namely, that when errors in their theories are pointed out they ignore them and get angry with the person making them and also that they have a strong emotional attachment to the theories that borders on zealousness. This is markedly different from the discourse of real economics wherein when people disagree with each other it is generally not over the acceptance or dismissal of logical errors but over the interpretation of various aspects of theory.

For example, New Classical macroeconomists will not argue that fiscal stimulus does not lead to increased GDP by accounting identity but instead will furnish a behavioral theory that negates any impact this might have (i.e. Ricardian equivalence). This gives economic discussion a level of academic rigour that the discussions of the money cranks lack entirely. In the land of the money crank once the theory is accepted as True it cannot be revised in light of evidence, whether logical or empirical, to the contrary.

Other cranks tended to get angry because they saw professional economists as poaching their ideas. Soddy was enraged that Irving Fisher’s proposal for 100% reserve banking was identical in many respects to the one he had put forward ten years earlier. Of course, Fisher never made claims to originality and listed Soddy’s work in the bibliography along with other similar historical work — such as a proposal from 1823! Many of the money crank ideas that were embraced by economists during the Depression had been around since the time when economics as a discipline started.

The Economic Forum also carried a wide range of other authors. Many of these were prominent people working within Treasury departments in major Western powers who had schemes of their own to get the economy moving again. It also carried some work by market socialists who claimed that marginalist equilibrium economics was to be the true functional economics of advanced socialism (an historical point of interest often forgotten in contemporary left-wing critiques of marginalist economics!). By the mid-1930s, however, the periodical had been hijacked by mainstream thinkers from banks who advocated austerity together with newly emerging public relations men like Sigmund Freud’s nephew Edward Bernays.

Funnily enough, the question as to what constituted an economist at this moment in history was slippery at best. Dimand notes that Keynes had a degree in mathematics, Kahn in mathematics and physics and Harrod in the classics. It was not until after WWII, with the emergence of the neoclassical-synthesis, that economics began to become a truly formalised discipline.

But it is also clear that the likes of Keynes and Kahn were seen in the eyes of their peers as actual economists while people like Soddy (a Nobel Prize winner in chemistry) and Douglas (an army engineer) were seen as cranks. Again, I think that this has to do with the manner in which the two groups debated and discussed issues — as well as how they responded to actual logical errors in their doctrines.




Following on from my last piece on the money cranks I thought it might be worthwhile to explore this theme in a little more detail. First we will look in more detail at Keynes’ relationship toward certain money cranks. And then we will look at some of these money cranks in a bit more detail in a separate post.

I recently came across a poorly written and poorly reasoned piece by ‘economist’ Gary North on Keynes’ relationship to the money cranks. First a note or two on North. North is an arch-crank of the Christian fundamentalist variety. Back in the late-90s North was telling everyone that the world was going to come to an end due to the Y2K bug (it appears that North considers himself not just an economist but also a computer expert!) and that Fundamentalist Christians would have to reconstruct the world from scratch.

Thankfully North’s cranky delusions never came to pass because his views on Christianity include advocacy of the death penalty for women who lie about their virginity, children who curse their parents, blasphemers and, of course, male homosexuals. If this doesn’t sound like the sort of “love thy neighbour” and “forgiveness in the eyes of Christ” Christianity which is expounded by the mainstream churches that many of us grew up in it’s because it’s not: this is the lunatic fringe of Christianity; in fact, it’s even the lunatic fringe of the already fairly nutty fundamentalist movement in the US. North also has a close relationship with various conspiracy theories, as he himself admits when he writes in relation to his fringe views on whether the government was involved in 9/11,

I have faced this all of my adult life. I started out in 1958 with a high school term paper on whether Roosevelt knew an attack on Pearl Harbor was coming. I concluded that he knew an attack somewhere in the Pacific was coming. I have not changed my mind. In 1972, when I was awarded my Ph.D. in American history, as far as I knew, I was the only historian age 30 or younger with a Ph.D. in history who believed this.

Anyway, North tells us that Keynes took his ideas in the General Theory from the money cranks Silvio Gesell and C.H. Douglas. North claims that “Keynes’ disciples, deservedly embarrassed by this inconvenient fact, have done their best to conceal it for 70 years”. Of course, many Keynesians — myself included in my original piece — have noted the connection many times. A quick Google search gives us a number of academic sources to choose from in this respect — here is one entitled Keynes’ Political Philosophy: The Gesell Connection, for example.

Noting a link between the ideas is, of course, very different from saying that the source of Keynes’ ideas were the money cranks. This is what North claims. From an academic perspective, this is a very strong claim indeed and would require fairly extensive documentary evidence — letters from Keynes, comments from his close associates and so on. Of course, North provides none of this and instead simply asserts that because the ideas bear some passing resemblance Keynes must have lifted them from the cranks.

North also claims that the prominent monetary economist Irving Fisher is a crank. He also claims that Milton Friedman is a money crank. North’s criteria for being a crank is basically that you don’t agree with Gary North. This is, of course, highly ironic because North is one of the least mainstream people you could possibly come across in his views on just about everything. But that doesn’t matter. The three most prominent monetary economists of the 20th century are cranks and North is not. One could reach for the psychological manual at this point, but I think the intelligent reader will have already recognised what is going on here.

Anyway, what about the question of the influence of the money cranks on Keynes? Well, the evidence we have shows that Keynes recognised that Gesell and Douglas had valid insights but he wholly disagreed with their formulations. He seems to have thought that C.H. Douglas had recognised a fundamental problem of our economic system — not under-consumption, as North insists, but rather a shortfall of aggregate demand (which usually is caused by a shortfall in investment not consumption which is a stable function in basic Keynesian theory) — but he nevertheless thought that Douglas’ theories were pretty crankish and unclear. Keynes wrote,

On the other hand, the detail of his diagnosis, in particular the so-called A + B theorem, includes much mere mystification. If Major Douglas had limited his B-items to the financial provisions made by entrepreneurs to which no current expenditure on replacements and renewals corresponds, he would be nearer the truth. But even in that case it is necessary to allow for the possibility of these provisions being offset by new investment in other directions as well as by increased expenditure on consumption. Major Douglas is entitled to claim, as against some of his orthodox adversaries, that he at least has not been wholly oblivious of the outstanding problem of our economic system.

Clearly Keynes was not taking his cue from Douglas here. Instead he is recognising that Douglas was “not wholly oblivious” of the problem facing the capitalist economic system during a period of depression.

Before we move on it should be worth noting, however, one prominent Keynesian economist who was definitely inspired by Douglas. James Meade stated explicitly that prior to discovering, first, Fisher’s quantity theory of money theorem and later Keynes’ savings and investment theorem he was inspired by Douglas. In his Nobel Prize lecture he said,

My interest in economics had the following roots. Like many of my generation I considered the heavy unemployment in the United Kingdom in the inter-war period as both stupid and wicked. Moreover, I knew the cure for this evil, because I had become a disciple of the monetary crank, Major C.H. Douglas, to whose works I had been introduced by a much loved but somewhat eccentric maiden aunt. But my shift to the serious study of economics gradually weakened my belief in Major Douglas’s A+B theorem, which was replaced in my thought by the expression MV = PT. At Cambridge I made a close friendship with Richard Kahn and became a member of the ‘Circus’ with him, Piero Sraffa and Joan and Austin Robinson, which discussed Keynes’ Treatise on Money and stimulated the start of its translation into the General Theory. Keynes appeared at the weekends when Richard Kahn reported to him our discussions of the week and when we met on Monday evenings at the Political Economy Club in Keynes’ rooms in King’s College. Thus I abandoned the formula MV = PT for I = S.

Given that Meade stated all this in his Nobel Prize lecture really doesn’t support North’s dubious idea that any influence the money cranks did have on the Keynesian revolution was swept under the rug, of course! But people who lean toward conspiracy theories and the like are apt to think that something is always being covered up and so forth.

So, what about Gesell’s influence on Keynes? Keynes actually discusses this at some length in the General Theory. He says that “in the post-war years his devotees bombarded me with copies of his works; yet, owing to certain palpable defects in the argument, I entirely failed to discover their merit.” So it is clear that when Keynes was writing his Treatise on Money he was not under the influence of Gesell. Indeed, for people familiar with this work this should be rather obvious.

Keynes’ early work on monetary theory was influenced primarily by Knut Wicksell, as has been noted many times. Keynes used Wicksell’s distinction between the ‘bank rate of interest’ and the ‘natural rate of interest’ to argue that the central bank should manipulate the bank rate in order to generate full employment. Already implicit in this is the idea that the economy may not ‘naturally’ adjust to full employment. So, in his early work — which he explicitly states was not influenced by Gesell — there is the kernel of the idea that there might be a deficiency of aggregate demand due to a shortfall of investment which is due to the bank rate of interest being too high relative to the natural rate.

And what about when Keynes began to think about this in terms of savings, investment and deficiencies of aggregate demand? Again, we have written evidence that this was not due to Gesell. The key component of the Keynesian theory is that of liquidity preference and Keynes explicitly writes,

[Gesell] fails to explain why the money-rate of interest is not governed (as the classical school maintains) by the standard set by the yield on productive capital. This is because the notion of liquidity-preference had escaped him. He has constructed only half a theory of the rate of interest.

Clearly Keynes thought that the key to whole argument was the liquidity preference theory and Gesell had not formulated it. Thus, the notion that the Keynesian revolution grew organically out of the work of the money cranks is quite simply wrong. That is, unless North can unearth some documentation showing that Keynes was telling lies in the General Theory and all his inspiration had actually come from the cranks rather than Wicksell and his own ingenuity.

At the end of his piece North recommends that the reader consult the work of two actual money cranks. Namely, Henry Hazlitt and Murray Rothbard. Of course, by the criteria laid out in the last piece both of these authors are money cranks and so too is North himself. My definition there involved whether an author could fall into one of two categories. These are:

1. a money crank is a person who views the money system from a position in which they have substantial emotional investment.

2. a person who believe that all, or the vast majority of, social ills are caused by the current money system and thus can be solved by implementing an imaginary money system that they have designed can be safely considered a money crank.

The advantage of this definition is that we cannot simply label people that we disagree with as cranks. Thus, while I agree with some aspects of what Gesell and Douglas were saying — as did Keynes — they are nevertheless cranks by my definition. So too are Rothbard, Hazlitt and North. That North displays other cranky attitudes — such as his Y2K prophecies and insistence that the US government is covering up something about 9/11 — is not surprising as cranks often hold multiple cranky beliefs simultaneously. This is a phenomenon known in the literature as ‘crank magnetism‘.

North will, of course, insist that I am the crank. This is because anyone who disagrees with him is a crank. In his mind I am a crank. So is Fisher, Keynes, Friedman and most people working at central banks.  Frankly, I’m happy to be in such good company and if North does insist on throwing me in what he thinks to be the crank-basket I will be more than pleased. In the meantime I imagine that he will continue peddling half-baked Austrian economics and conspiracy theories.


I recently came across a very nice lecture series by the philosopher Patrick Maher on Keynes’s discussions of probability (scroll down to the three Keynes lectures in this link — the other lectures are also worth a browse for those interested in the philosophy of probability). The first lecture has some nice quotes from Keynes’ Treatise on Probability about non-measurable probabilities and probabilities that cannot even be compared ordinally. But it is the second and third lectures that I want to focus on here.

In these two lectures Maher lays out, in a particularly clear manner, a problem that Keynes found with the so-called Principle of Indifference. The Principle of Indifference basically states that if there are, say, two possibilities and I have no further knowledge then I should rank these possibilities as evenly probable. Say, there are two cups in front of me and one contains a ball. Given that I have no further knowledge I can assign each cup a 50% probability of having the ball under it.

The Principle of Indifference follows a very simple formula. For n possibilities that we have no further knowledge about we assign a probability of 1/n. So, in our cup example we have two possibilities — two cups — so n = 2 and so the Principle of Indifference tells us that we should assign each cup a probability of 1/2 or 50%.

But Keynes found that this very intuitively reasonable proposition ran into contradictions. To see this consider an urn that contains two balls. We know that the balls are either white or black but we do not know their ratios. But since there are only two of them we can lay out their possible ratios as such:

1. 100% of the balls are white.

2. 50% of the balls are white.

3. 0% of the balls are white.

Now, we have three possibilities — so, n = 3. Since we have no other information we apply the Principle of Indifference and find that the chances of each ratio being true is 1/3 or 33.3333%. That is, the possibility of each ratio being true is one in three.

But, Keynes says, look what happens if we reformulate the statement. Let’s call the two balls A and B. Now let us lay out the possibilities.

1. A and B are both white.

2. A is white, B is black.

3. A is black, B is white.

4. A and B are both black.

Again, we have no further information so we apply the principle of indifference and find that each statement has a 1/4 chance of being true.

Now, apply the findings of the latter example to that of the former — recall that both are identical, we have just stated the problem in a different manner. Note that both (2) and (3) in the second example are synonymous with (2) in the first example. Therefore we get the modified result:

1. 100% of the balls are white. (1/4)

2. 50% of the balls are white. (2/4 or 1/2)

3. 0% of the balls are white. (1/4)

We get entirely different answers by simply framing the question in a different manner!

As Maher notes, Keynes asserts that the latter approach is the correct one. Maher criticises Keynes saying that this is entirely arbitrary. But I think that he’s wrong. The reason that the second application is a correct one with regards the Principle of Indifference is because it breaks down the argument into it’s most elementary parts.

By using the ratio method in the first approach we do not actually examine some of the possibilities and this gives us an incorrect measure of the probability. What happens is that we wrongly aggregate the components of the argument — i.e. the two independently existing balls — into a single ratio (50% of balls are white). The correct approach is to ask in turn “what is the likelihood that each ball is black or white”. We might call the error made in the ratio example the “fallacy of aggregation”.

I think that the manner in which we interpret this is actually at odds with some of the quotes that Maher provides from Keynes in his first lecture. Consider the following,

A proposition is not probable because we think it so. When once the facts are given which determine our knowledge, what is probable or improbable in these circumstances has been fixed objectively, and is independent of our opinion… When we argue that Darwin gives valid grounds for our accepting his theory of natural selection, we do not simply mean that we are psychologically inclined to agree with him… We believe that there is some real objective relation between Darwin’s evidence and his conclusions, which is… just as real and objective, though of a different degree, as that which would exist if the argument were… demonstrative.

As we can see Keynes is very fussed about the idea of some “objective reality” underlying the object of study — one that is “independent of our opinion”. I would be less concerned with this. As Keynes himself shows, it is the manner in which we cast the argument that yields two very different outcomes. It really is the manner in which we formulate our statements that leads to different conclusions. This has very little to do with “objective reality”.

It is not so much that the second formulation is better at aiming at some “objective reality” but rather that it breaks down the components of the argument in a more satisfactory manner. It is not because our reasoning is closer in line with the “real world” that we get better information in the second formulation of the problem but rather that our reasoning is better thought out.

Finally, a word on how this relates to economics. This example shows just how easy it is to fudge an econometric study by simply choosing, say, the wrong method of aggregation. It is a lot easier to detect these logical errors when the argument is made out in the open, in plain English. Trying to unearth them in an econometric study that is replete with tables containing t-statistics and r-squareds is tedious to the point of being unworthy of one’s time.

Keynes himself came across something very similar in his review of Tinbergen’s early work in econometrics. He wrote,

It will be observed that Prof. Tinbergen includes profits earned and the rate of interest as amongst the factors influencing investment. But, as Prof. Tinbergen himself points out, some economists would argue that it is the difference between these two factors which matters, rather than their absolute amounts. How does that affect matters? Moreover, they would mean the difference between profits measured as a percentage on current cost of capital goods and the rate of interest. Now, Prof. Tinbergen does not seem to care in what unit he measures profit. For the pre-war United States it is the share price index, for the pre-war United Kingdom non-labour income, for pre-war Germany dividends earned as a percentage of capital, for the post-war United States the net income of corporations, and for the post-war United Kingdom net profits earned as a percentage of capital. Thus it is sometimes a rate and sometimes an absolute quantity; and when in the final outcome he multiplies this hotch-potch, sometimes by a large coefficient and sometimes by a small one, and then subtracts from it the rate of interest multiplied (usually) by a small coefficient, I do not know whether there is room here for the theory that investment may be governed by the difference between the rate of profit on cost and the rate of interest on loans, or whether we have merely reached the number of the Beast.(pp562-563)

Of course, the reader interested in defending econometrics will say “oh, but this is just an irresponsible use of the data… we would never tolerate that!”. To which I would say: lies! Almost every econometric study that I have ever examined in detail makes these mistakes. And trying to pick them apart is, as Keynes says later in the paper, “a nightmare to live with”. The formal presentation of econometrics studies can hide all sorts of nonsense in this way.

Keynes even notes — and again, this will chime with anyone who has ever read such studies in depth — that Tinbergen is perfectly aware that all of this is problematic but carries on regardless.

Prof. Tinbergen is by no means unaware of what a difference the way he measures profit can make. He gaily points out as a matter of some interest, but not of any concern, that the series which he takes to represent profits in Germany leads to a regression coefficient for that factor twice as great as the series he takes for the United States, and the series he takes for Great Britain to a coefficient nearly four times as great. (This is an extraordinary example of the candid way in which, if only he is allowed to, get on with all this arithmetic unhindered, he is ready to admit at the end of it what must seem to the reader to be devastating inconsistencies.) He insists that his factors must be measurable, but about the units in which he measures them he remains singularly care-free, in spite of the fact that in the end he is going to add them all up. (p563)

The form of the argument takes over the content in this regard. All sorts of weird stuff gets slipped in under the radar unseen; which is probably why econometric studies are very rarely repeatable. If economists were primarily made to formulate their empirical arguments in plain English and only use econometrics as a presentational supplement to bolster certain very specific points — the applied work of Wynne Godley is outstanding in this respect — then an awful lot less nonsense would pass through the journals and into the halls of power. But econometrics often hides simple incompetence, and those that engage in it would be very reticent to see that exposed.

If Keynes’ fallacy of aggregation shows us nothing else, it should at least show us that when it comes to applied probability theory (i.e. econometrics) it is not so much the tools that are important as it is the person doing the work. And if the tools begin to become a fetish in and of themselves I see no good reason not to get rid of them to a very large extent.


This September the people of Scotland will go to the polls to vote whether or not they should remain in the UK. One of the key motivations for this move is to gain greater economic sovereignty so that Scotland can restructure its economy.

This is much needed as the Scottish economy is currently dangerously dependent on North Sea oil and gas revenues. Not only is North Sea oil and gas a finite resource that will eventually dry up, but it is also subject to substantial price and quantity fluctuations. Swings in the price of oil and gas can have major deleterious effects on the balances within the Scottish macroeconomy. This is because both Scottish exports and tax revenues are heavily dependent on oil and gas revenues.

All of this puts Scotland in a very difficult position — one that is not currently recognised either by the Scottish government or their economic advisers. If Scotland do not take this into account when they move toward independence they risk provoking a Eurozone-style crisis.

Imagine for a moment that Scotland did leave the UK but decided to keep the sterling. Now imagine that the oil price fell substantially. Tax revenues in Scotland would dry up and the government budget would fall into deficit. But Scotland would not have its own currency and so the decision would be left with the Bank of England whether to stabilise the Scottish bond market in the face of speculation.

Does that sound familiar? Well, it should: it’s basically a mirror image of what has been happening in the Eurozone since 2008. The Bank of England — and the UK Treasury — could then demand that Scotland engage in extensive austerity as part of a deal to stabilise the bond market. And we all know where that would lead: unemployment, depression and political turmoil.

If we care to see these problems for what they are they can be dealt with. I have written an extensive report laying out this argument in detail and proposing a solution.

Whether you support Scottish independence or not is really secondary in this respect. The Scottish people will vote how they vote and even if they vote against independence it is unlikely that this issue will fade into the shadows completely. If they do vote to move toward independence these issues will be front and center. And anyone who cares about the general welfare of the Scottish people will have to confront them.

A copy of the report can be downloaded from here: A Sustainable Monetary Framework for an Independent Scotland

Let’s hope that Scottish policymakers can learn from the recent history of the Eurozone in this regard. If history were to repeat itself in Scotland because these issues were overlooked it would truly be a tragedy.



One of the nicest stylised facts in applied economics is that if the Fed inverts the yield curve it will cause a recession. Inverting the yield curve basically means that the Fed hikes the short-term interest rate goes higher than the long-term interest rate. In theory this should lead to long-term lending drying up, investment falling significantly (usually in housing and inventories) and, ultimately, a recession.

The track record of this as an indicator of recessions in the US is too impressive to dismiss. Take a look at the chart below. The shaded areas are recessions. As you can see, every time the short-term interest rate (blue line) climbs about the long-term interest rate (red line) we see a recession within around 12 months or so.


The question, however, is whether this is universal economic constant. And when we turn to the data from other countries we quickly see that it is not.

All the data that follows if from the St. Louis Fed but I have done the graphs myself so that I could include lines indicating British and Japanese recessions.

Okay, so let’s take the UK first. This graph is pretty rough but the green lines are the starts of recessions and the thinner black lines are points when the short-term interest rate rose above the long-term interest rate without causing a recession. The short-term interest rate is the blue line and the long-term interest rate is the red line.


As we can see, the story here is a bit more complicated than in the US. Only three out of the five recessions were precipitated by an inverted yield curve. Meanwhile the yield curve inverted seven times without causing a recession.

This does not bode well for the notion that this correlation might be constant across time and space.

So, let’s turn to Japan. Unfortunately, the data available for Japan is only from during the so-called Lost (Two) Decade(s) and so we will be dealing with a rather unusual period. Nevertheless, it should still prove interesting.


As the reader can see I have not bothered to mark the recessions in this chart. Why? Because it is quite clear that the yield curve never inverted in this period. The short-term interest rate (blue) always stayed below the long-term interest rate (red). What’s more, in this period Japan had five recessions. Including a massive one at the beginning of the 1990s. Clearly these were not correlated with and therefore not caused by an inverted yield curve.

So, the question remains: why is this correlation so strong in the US? This is impossible to answer without some doubt but allow me to shoot from the hip a little and throw out some potential causes. (Suggestions welcome in the comments!)

1. The US is a very insulated economy: due to this recessions are caused largely by internal factors.

2. The US economy is more credit-driven than other economies: hence, the interest rate plays a larger role in investment and consumption decisions.

3. The US has tended to use monetary policy more consistently than its neighbors: which is why the economy has become more ‘used’ to falling into recession when monetary policy is aggressively tightened.

4. There is a self-fulfilling belief in the US that an inverted yield curve leads to recessions.

Frankly, I think that the answer lies somewhere in between the four reasons listed above. I think that reason number four is also probably the most important. Folks in the US get very hot and bothered about inverted yield curves — reflecting the American love for projecting engineering-like causality into just about every field — and this likely has a sort of ‘self-fulfilling prophecy’ effect.

Anyway, whatever the reason the facts are clear: the rule-of-thumb that a recession will generally follow on the back of an inverted yield curve is a good one for the US — whether it is based on hocus pocus or otherwise — but it is probably useless to apply outside of the US. Once again we learn that time-tested lesson: there are no universal laws in that all-too historical field known as economics.

Update: Mark Sadowski has linked to an interesting BIS paper in the comment section entitled Does the Term Structure Predict Recessions? The International Evidence. It provides a very nice table of the probability of having a recession four quarters ahead of interest rate hikes.


The authors explain how to interpret this table as such,

To interpret the results in Table 2, consider first the case of Germany, the country for which the predictive power of the spread appears the strongest. Suppose first that long interest rates are 4% above short interest rates, so that the spread is 4%. The table indicates that the probability that a recession will occur in four quarters’ time is 0%. However, as short rates rise relative to long rates, the probability of a recession increases as well. Thus, when the spread is 2%, the probability is 7%, and when the spread is 0% the probability is 41%. Note, furthermore, that as the spread turns increasingly negative the probabilities rise quickly. When short rates are 1% above long rates, the probability of a recession rises to 66%. When the spread is -2%, the probability is 85%. Finally, at a spread of -4% the probability that the economy will be in a recession in four quarters is 99%. (p10)

I think that the results of this study pretty much confirm what I said in the above piece: the relationship between an inverted yield curve and recessions in the UK and Japan is not as solid as in the US and should be treated with caution (in Japan’s case, with extreme caution).

Beyond that, one or two more comments. Germany seems to be another country, ala the US, where the relationship holds. I am somewhat suspect of the Belgian and Dutch data because all the data was taken from the years 1972-1993. In 14 of these 21 years the Belgian franc and the Dutch guilder were pegged to the Deutschmark under the ERM arrangement. So too was the French franc, but given that France is a bigger country we do not see quite as much of a pass-through effect. Finally, the Canadian data confirms my view that we should treat inverted yield curves with a bit more care than they are usually treated.


Tom Palley has an interesting paper out on the Fed’s attempt to taper its QE program. I have written about the tapering program before here and here and I have written about how QE works here.

Anyway, I will deal with the main policy proposal that Palley lays out in a moment but first I want to address a passage that I think slightly misleading. Palley thinks that the Fed’s tapering program gives an effective “tax cut for banks”. His reasoning runs as such,

Third, the payment of higher interest rates on excess reserves promises to be very expensive. It is also expansionary, which runs counter to the purpose of raising interest rates. The expense is very clear. Given banks hold $2.6 trillion in total reserves, every one hundred basis point increase in interest rates costs the Federal Reserve $26 billion. If the Fed’s policy interest rate returns to 3 percent, that would cost $78 billion. That is an effective tax cut for banks because the Fed would pay banks interest, which would reduce the profits it pays to the Treasury. The banks, which were so responsible for the financial crisis, would therefore emerge winners yet again. Taxpayers, who bailed out the banks, would once again bear the cost. Paying interest to banks would also run counter to macroeconomic policy purpose since it would be pumping liquidity into the banks when policy is explicitly trying to deactivate liquidity. That smacks of policy contradiction. (p4)

Frankly, I think this is nonsense. It’s not just the banks that would benefit from higher interest rates on reserve holdings at the Fed. It is basically any saver in the economy — pension funds and so on included. The Fed would effectively be offering a perfectly safe asset — that is, a deposit at the institution that creates the money — upon which savers can get an interest rate. Will the banks benefit from this? Yes. But so will other savers.

I also don’t think that this “smacks of policy contradiction”. By this criteria all changes in interest rates would “smack of policy contradiction”. Whenever the Fed moved to raise interest rates to quell aggregate demand they would simultaneously be increasing aggregate demand among savers. In this sense all monetary policy is “contradictory”. I suppose this is true in some sense but the question is one of net effects: does raising interest rates increase or decrease aggregate demand generally? The answer, I think, is that generally speaking raising interest rates works to decrease aggregate demand.

These points tie into Palley’s proposal to have what he calls Asset Based Reserve Requirements (ABRR). Basically, the idea is that banks should have to hold reserves against assets. This would effectively function as a tax on banks. Holding assets would become more expensive in the sense that the banks would have to hold reserves in order to keep the asset on their books. But Pally forgets to mention that this tax would affect anyone who holds assets — again, that is basically all savers in the economy.

Palley’s proposal would also have enormous effects on exchange rates. As Post-Keynesian economists stress time and again, a key determinate of exchange-rates are capital flows. Given that Palley’s proposal would impose a cost on holding assets in, say, the US this would affect capital flows into the US and could lead to a depreciation of the dollar. Palley actually recognises this when he writes,

…imposing ABRR might even cause some US outflows by financial capital seeking to avoid reserve requirements. (p7)

All that said, I actually like Palley’s idea because it allows central banks to steer asset markets in a far more direct manner than they currently do. Palley highlights this when he writes,

The specific effects on bond and stock markets would depend on the particulars of how reserve requirements were assessed. The stock market would likely strengthen if stocks were assessed with a zero reserve requirement while bonds had a positive requirement. This is because stocks would become relatively more attractive compared to bonds. Conversely, stock prices would likely drop if stocks were subjected to a positive reserve requirement and bonds were zero-rated. (p7)

I really like this aspect of Palley’s proposal. At the moment central banks use a very unfocused sort of monetary policy. This can lead to enormous contradictions.

Take the Greenspan years as an example. In the 1990s and 2000s the US economy was extremely weak and required low interest rates to get investment rolling. But this led to low mortgage rates and an explosion of mortgage lending. The Fed was thus caught between a rock and a hard place. On the one hand, if they wanted to quell mortgage lending they had to raise interest rates across the economy. On the other, this would dampen real investment and risked leading to a slump.

What’s more the Fed actually lost control of mortgage rates in this period. Take a look at the graph below which shows how mortgage interest rates didn’t respond to increases in the Fed’s overnight rate.

Overnight Rate vs. Mortgage Rate in the US 2002-2007

With Palley’s proposal, however, if the central bank ever found itself in this position again it could raise reserve requirements on mortgage-based asset classes. This would have the effect of raising the mortgage interest rate without raising other interest rates.

The problem with implementing Palley’s policy now is that the US economy, as I have written elsewhere, is highly dependent on savers and investors spending money. You can see this clearly in the following graph that I’ve taken from Steven Fazzari and Barry Cynamon’s excellent paper Inequality, the Great Recession, and Slow RecoveryThe chart graphs consumption-to-income rates in the US based on income — specifically the bottom 95% of the population versus the top 5%.

Income Inequalities Graph 1

As we can see it was a rise in consumption-to-income of the top 5% of the population at a time when the consumption-to-income ratio fell off for the bottom 95% and failed to recover.

My interpretation of this is that the top 5% have buttressed their spending with income made from capital gains. By this logic, any policy that hurts savers and asset investors could have enormously damaging effects on consumption. This could then lead to a fall-off of domestic investment as corporations and businesses saw a fall in demand for their goods and services.

I’m not saying that Palley’s proposal shouldn’t be enacted. But the current recovery is likely tied very immediately to the financial sector. And if the fall-off in demand that Palley’s proposal would cause is not replaced by some other source it could lead the US economy back into recession. Given the political situation in the US right now around the government budget it seems highly unlikely that policymakers could step in to fill this gap.

So, if we’re going to talk about Palley’s proposal we should do so with our eyes wide open. The fact that these are the conditions under which we have to make policy decisions is tragic and attests to decades of poor economic management (some of which reeks of class war). But the situation is as it is. And we have to ask ourselves the question: is it worth risking another recession to beat up on the banks? Because surely it will not be the banks that are hurt most if a recession occurs.


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