FT – Opinion , 30th March 2022

Conventional macroeconomics is mistaken and its errors have profound and adverse consequences for economic policy.

Many economists believe that central banks can stabilise economies by altering real interest rates, as the US Federal Reserve did earlier this month when it lifted its benchmark rate by a quarter of a percentage point amid concerns about rising inflation. Interest rates are thought to decide the cost of capital and levels of investment, which then change levels of economic activity.

Unfortunately, these ideas suffer from a compelling disadvantage: the data show they are wrong.

The conventional view of how economies work was arrived at before we possessed long-term data on the returns from different classes of capital. As the assumptions could not be tested against evidence, consensus theory fell on the wrong side of Karl Popper’s famous demarcation between science and non-science.

Today, however, long-term data on returns are available. They exist for short-term interest rates, yields on long-dated bonds and the real return on equities. Accordingly, we can now test the consensus models, something that was previously impossible. If we do, we find that the basic assumptions of those models are wrong.

If the returns from debt and equity varied and real interest rates determined the level of investment, consensus theory would be correct. We would only have to worry about keeping intentions to save balanced with those for investment in order to avoid high levels of unemployment or inflation and the woes of stagflation.

But investment fluctuates with changes in nominal rather than real interest rates [1]. What is more, the actual relationship between changes in short-term interest rates and share prices shows that the cost of capital varies with short-term interest rates only in the short term [2]. Finally, since we can now calculate the costs of equity and business capital, we know that variations in the cost of capital do not drive investment. [3]

Economics started from our understanding of human psychology and its theories worked when applied to the day-to-day activities that constitute microeconomics. Problems arose when the same approach was applied to macroeconomics and finance. Purchases of goods are discouraged when prices rise but are stimulated for shares. In finance, intuitively reasonable ideas have regularly proved to be wrong, including the assumption that financial returns move together. This is a remnant of the “efficient markets hypothesis”, which economists have been reluctant to discard but must now be thrown out.

The difference between the short-term and long-term effects of changes in short-term interest rates leads to disturbing consequences. It shows that there are at least two relationships whose stability must be maintained, if we are to prevent excessive levels of inflation or unemployment.

One is the balance between savings and investment. The other is the link between actual and equilibrium prices of real assets. The tools of monetary policy currently used to stabilise aggregate demand in the short run may create dangerous imbalances in asset prices and debt ratios, thus destabilising the economy in the long run.

We must stop using consensus theory both because it is wrong and because policies based on it regularly generate financial crises. Above all, we need to take seriously the data now available on returns for the different forms of financial capital.

Many will wish to ignore this because it is incompatible with consensus theory. But it is vital for our future that such intellectual obscurantism does not prevail. Fundamental assumptions of economic theory must be debated and discarded when shown to be wrong.


1. “Reflections on macroeconomic modelling” by Ray C Fair (2015), B E Journal of Macroeconomics ]

2. “Interest Rates, Profits and Share Prices” by James Mitchell (2009) (Appendix 3, Wall Street Revalued: Imperfect Markets and Inept Central Bankers by Andrew Smithers, John Wiley & Sons Ltd)

3. The Economics of the Stock Market by Andrew Smithers (2022) Oxford University Press (Table 15 and Figure 48, Chapter 19)