Not Cyclical but Secular.

Andrew Smithers
London, 1st October 2021

• Classical economics assumed that interest rates would adjust, or could be adjusted, to ensure that there was no mismatch between private sector intentions to save and invest. Interest rates were therefore assumed to be the sole policy tool needed to maintain full employment.

• Keynes revolutionized economics by postulating the possibility of a liquidity trap in which interest rates could not fall low enough to boost demand and that fiscal deficits would then be needed to prevent large scale unemployment. The consensus today is that demand can be maintained by some mixture of fiscal and monetary stimuli, with the latter including quantitative easing (“QE”) as well as by the management of short-term interest rates.

• The underlying assumption of this consensus is that the private sector’s ex ante net savings surplus is cyclical, at least after allowing for the impact of fiscal policy, i.e. it is purely due to those temporary weaknesses in demand which accompany the business cycle and is thus not a secular problem arising from some structural change in the economy.

• Neoclassical economics, on which monetary policy is based, has no adequate model which explains how private sector savings and investment are determined. The consensus view that the ex ante savings surplus is cyclical has therefore no support in economy theory.

• Neoclassical theory wrongly assumes that the savings/investment balance is the only source of economic disequilibrium. Another is q, which is the ratio between the market value of companies and their net worth. QE drives up q, which is mean reverting through changes in equity prices which, when sharp, have a marked impact on the economy. Falls in q are faster than rises, but their timing cannot be known. The economy is thus unstable and unpredictable when q is high.

• A slowing trend rate of growth, a high ratio of buy-backs to dividends and depressed business investment due to the bonus culture, cause secular surpluses in private sector ex ante net savings. These are present in the US today, so monetary policy has produced a marked economic disequilibrium. Fiscal stimulus would have been a much better policy, as it can be maintained for longer without causing financial crises.

• Alternative policies are available and, without their introduction, another financial crisis is highly probable and is likely to be followed by severe unemployment.

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Not Cyclical but Secular.