In this article British economist Andrew Smithers writes exclusively for Smithers studied economics at Cambridge and used to run the fund management business at S G Warburg which is now BlackRock. He also used to write for the Financial Times and is ofcourse an author, with his latest book being released earlier this year, entitled ‘The Economics Of The Stock Market’.

This places him in a very unique position to disseminate his views and in this piece Smithers talks about the state of the U.K Housing Market, the Economy and Consensus Theory.

‘Sharp rises and falls in house prices cause great harm to the economy and are a cause of pain and unfairness to many. They are also unnecessary, being the result of the incompetent way the economy has been managed. We must stop this and, to do so, we need to understand why economic policy has been so bad and how it should be changed.

For many years house prices in the UK have risen much faster than incomes. The cost of accommodation for those who, like me, bought their homes many years ago is a fraction of what my grandchildren must pay. This is obviously unfair and we should seek to make houses more affordable and their prices less volatile; to do this, however, will initially cause more unfairness and create serious trouble for the economy. Falling house prices will produce major problems for those owners who have mortgages. They will not only feel poorer, but they will have to realise a loss if they wish to move and people seem on average to move about every six years. Even if they stay put, they will be at the mercy of higher interest rates or rising unemployment, both of which are likely to accompany falling house prices. High inflation with stable nominal house prices will allow incomes to catch up, but many people will still be unable to keep up their mortgage payments as these will have risen much faster than their incomes, because incomes respond to inflation much less than interest rates. A rise of one percentage point in inflation will usually be matched by an equal rise in incomes, but if interest rates go up one percentage point from say three to four, the cost of a mortgage rises by 33%, while incomes will have risen by only 1%.

The damage done cannot easily be remedied and it would be better if it hadn’t happened. To stop it occurring again we need to understand how it did. The answer of course is that demand for homes rose faster than the rate at which new ones were built. It’s said that you can make a parrot into an economist by teaching it to say two words – supply and demand. In my experience, a parrot who could do this and understand what it said, would be an above average economist.

The supply of houses depends on planning restrictions. The stronger NIMBY power is, the higher will be the cost of houses and the fewer the number of first time buyers who can afford them. Some years ago a niece of mine stood in a local council election. Her policy was affordable houses for all and no new development. Both these ideas were popular and, though not perhaps as a result, she was elected. We would like many problems not to exist, but it is neither helpful nor honest to pretend that they don’t and wishing that affordable housing does not require lots of new development is one of them.

But NIMBYism is only part of the problem. If lettuce prices shoot up, we can eat other greens but there is no such alternative for a home and it takes time to plan and build new houses, so supply cannot quickly catch up with a rise in demand. There is an additional problem, however, in the way demand responds to prices. When the prices of consumer goods rise faster than incomes, people must cut back on either the amount of their income they spend or the amount they save and, as the need for savings hasn’t changed, they usually spend less even if they also reduce the amount they save.

Changes in house prices have a different effect, however, as people feel richer when house prices rise and believe that they don’t need to save so much. The more expensive a house the more it costs to live in it, so owning a home is a form of consumption and the more we spend on living in it the less we can spend on other things. But houses are also valuable assets and, unlike motor cars, their value does not fall every year. Houses are unusual therefore because they are both capital assets and ways of spending our incomes. The value of capital assets, both houses and shares, tend to rise when interest rates fall and, once this process starts, it often continues for months and sometimes years.

So, when their prices rise, demand for houses does not decline but even rises as people often, quite reasonably, expect the increases to continue. When interest rates fall more houses can be bought with the same annual outlay on mortgage payments and, when house prices rise, demand is more likely to rise further than fall off. When interest rates fall demand rises both because we can afford more expensive homes and because we expect to make more money by owning them. The demand for houses thus responds strongly to changes in interest rates and prices move sharply when demand changes.

To avoid the evils of booms and busts in house prices we need to have only moderate swings in interest rates. If sharp fluctuations in them were necessary to keep unemployment and inflation at low and stable levels, we would have to accept the ups and downs of house prices as part of the price of having a stable economy in other ways. But, as we can see all too clearly today, economic policy has not produced low and stable inflation and I fear that we will soon find that it won’t have produced stable employment either. We need better economic management to avoid boom and busts in employment and inflation as well as in house prices and the stock market. It is not that we must sacrifice one of these desirable results to achieve the others; bad management of the economy sacrifices all of them. It results in large swings in both incomes and asset prices.

Governments and central banks control economic policy and have done it badly. It may be an impossible job. If it’s not, their mistakes are either because they know what to do but make bad decisions, or they don’t know what they should do. My view is that it’s not easy, but it’s not impossible, so the choice is between ignorance and incompetence. In the past I have put most of the blame on central bankers’ bad judgement, because they had failed to realise that their policies were creating bubbles in asset prices, including both houses and shares, and I explained this in a book I published in 2009 called Wall Street Revalued: Imperfect Markets and Inept Central Bankers (1). This failure led to the last financial crisis and, as the same mistakes have been made again in recent years, another one in the next year or two has become highly probable.

It is, however, reasonable to argue that the real problem lies in the mistakes of economists rather than those of central bankers. They must decide when and by how much to change interest rates and they can’t announce changes just because they feel like it. They have committees who debate what to do based on how they expect the economy to behave and they rely in their debates on economic theory as well as economic data. If the theory they use is wrong they will be very lucky not to make mistakes. They don’t have to use the theory which is generally accepted among economists, but if they don’t they face enormous political problems. The current threat of another financial crisis is the result of central banks cutting back interest rates too far but they did this to avoid unemployment rising when inflation was low and stable. Had they been less gung ho we would not have the high risk of a financial crisis, but we would have had higher unemployment. Central bankers were gung ho and kept interest rates too low; as a result we have high inflation and to rein that back we will probably have high unemployment as well. Inflation would probably have picked up due to Putin’s invasion of Ukraine and the consequent fall in the supply of food, oil and natural gas, but it would be much lower than it is.

It would also slow down of its own accord, and not require the increases in interest rates that are now needed. Central banks are not always able to keep unemployment down, sometimes their choice is between a small increase in unemployment when inflation is low or a much larger increase later, to bring inflation under control. Recently they chose to keep interest rates at rock bottom levels because increasing them when inflation was low would have been unpopular. We must now expect that unemployment will rise much more than it would have done had they had a tougher policy. It is not within the power of central banks on their own to produce an economy with low and stable levels of inflation and employment; there are times when government action is also essential to achieve this.

Keeping inflation and unemployment low and stable is not just a matter of maintaining the correct level of demand, it also requires the absence of bubbles in house and share prices. The economy can become unstable for other reasons. One is when current demand for goods and services doesn’t match the supply available to meet it. If demand is too low, we then have unemployment. If it’s too strong, we then have inflation. But the economy also becomes unstable, as we saw in 2008 and are seeing again now, if there are bubbles in asset prices. Nobel Laureate George Akerlof (2) and Professor Ricardo Caballero of MIT (3) have pointed out that consensus economic theory assumes that if demand and supply are in balance the economy will be stable. Economic theory thus claims that there is no reason why good judgement over the management of demand cannot achieve a stable economy. But it’s obvious to most people that this is simply not true. It isn’t just bad judgement that makes low and stable levels of inflation and unemployment hard to achieve, it is the fact that monetary policy on its own cannot achieve this aim however clever central bankers are. It is impossible to keep the economy in steady conditions of equilibrium without using something else in addition to the tools of monetary policy that central bankers have available to them.

To some extent this problem has been accepted by economists since the ideas of John Maynard Keynes became agreed. Economic theory now accepts that there are conditions, known as liquidity traps, in which monetary policy cannot boost demand enough on its own and we will have too little demand and rising unemployment even when interest rates are down to zero. Governments as well as central banks can boost demand by increasing their spending on cutting taxes. When they do this their budget deficits go up and demand rises with it. According to the conventional wisdom of consensus theory, an economy running a sufficiently high budget deficit to avoid a liquidity trap can be managed with low and stable levels of inflation and unemployment by controlling interest rates. It shifts the problem of running the economy away from being purely a job for central bankers to being one in which governments must ensure that the budget deficit is big enough to avoid very low interest rates being needed to maintain demand. If that condition is met then central bankers can produce a stable economy provided that their judgement is sound.

Consensus theory was changed by Keynes and it has thus been dubbed neo-Keynesian. But, as I have pointed out in my most recent book (4), it still assumes that in the absence of a liquidity trap there is only one balance, that between supply and demand, which central bankers must achieve to keep inflation and unemployment low and stable. According to consensus theory the economy cannot become unstable if demand and supply are in balance. It assumes that we cannot have a financial crisis because asset prices and debt levels are too high. I don’t believe this and I don’t think many people do. We are thus operating in a world in which those who try to manage the economy debate their policies based on a theory in which they don’t believe – a state of mind known to psychologists as cognitive dissonance.

Central banks cannot unaided keep the economy stable. Without the help of governments they will find that their attempts to support demand produce excessive levels of debt and asset prices and are thus liable to engender recurring financial crises. Consensus economics accepts that this is only true if there is a liquidity trap, in which case the problem can be solved by increasing the budget deficit. But we can’t have government debt for ever rising faster than GDP, so high deficits can only be a temporary solution. The two policy tools we have today are monetary policy and the government’s budget deficit and they are evidently not enough and we must therefore have another policy instrument if we are to achieve a stable economy.

There is one available, but it’s not currently understood by those who rely on consensus theory, because they do not realise that corporation tax is a tax on investment and not, as is widely believed, a tax which is paid by shareholders.  If you reduce the tax on investment, you get more of it and if you increase the tax on incomes and consumption you get less saving. Higher investment and lower savings both boost demand; switching taxes from corporation tax to income tax and VAT will increase demand without having to increase the budget deficit.

We can therefore have stable levels of unemployment and inflation if we discard the errors of conventional economics and use The Stock Market Model (5). I am therefore trying to alter economists’ views. This is hard, but not unexpectedly hard, work, as the obstacles to changing people’s minds are well known. One is the resistance of academics. The sociology of this has been well explained by T.S. Kuhn in his book The Structure of Scientific Revolutions (6). Academics are understandably reluctant to acknowledge that the past papers they have written, and on which their current reputations are based, are wrong. Kuhn’s sociology has been wittily captured in the phrase “Science advances obituary by obituary”. Economists are even more resistant to change than academics in other sciences. Two leading physicists, David Deutsch and Artur Ekert, have remarked on how much science in their field is conducted unscientifically (7). Sadly I am sure that in this respect economists are even worse than physicists. Medicine remained unscientific long after physics had accepted Newton’s ideas and economics is way behind medicine.

When ideas on economics were set out by Adam Smith and others they did so on the basis of their observations about human behaviour. They had, however, virtually no statistics so that they could check whether the economy behaved as they expected. Nonetheless their ideas, which were mainly concerned with small scale activities, known as microeconomics, generally proved correct. This gave economists the strong impression that such methods were a sure route to success but this expectation proved sadly awry when economists turned their attention to macroeconomics and sought to explain inflation, unemployment, and interest rates. That the models of the economy that they then produced did not work became sadly obvious in the 1930s and Keynes argued that this was due to policies which followed from the consensus theory of the time. His ideas met great resistance but slowly crumbled in response to the unemployment and misery which unreformed policy had produced.

A big obstacle to changing the accepted wisdom of today is that the change needed is so great. Current theory depends on many assumptions which are self-consistent. If you change one you must alter many others, so the shock that will be involved when a new theory becomes at last accepted is going to be a very big one. It is rightly said that “It takes a new theory to kill an old one” and the greater the change involved the greater the number of new ideas that need to be understood and the harder it is for the change to be accepted.

On the other hand, there are today things which should help to overcome the resistance to change. One is that few people seem to believe several of the fundamental assumptions that underlie current conventional wisdom. Most people, and most central bankers, believe that we should worry about asset prices. The assumption that asset bubbles are impossible is known as the Efficient Market Hypothesis. Before the last financial crisis most, though certainly not all, economists thought this was correct. Few do today, but it remains a central plank of consensus economics and thus another example of cognitive dissonance in that many economists no longer support this hypothesis but adhere to consensus theory which requires it to be correct.

Sadly the most likely way for consensus theory to be replaced by my Stock Market Model, is another financial crisis followed by a bad recession. As was shown by the change in economic thinking after the slump, events persuade more powerfully than rational debate. It is said that “You should never waste a crisis.” I hope that we will not have another financial disaster but I think one is likely. If we have one, I hope we do not miss the opportunity to throw away the follies of consensus theory and use a better one, such as The Stock Market Model, which will enable us to follow economic policies which achieve low and stable unemployment and inflation without excessive fluctuations in debt and asset prices.’

Andrew Smithers (London, July 2022)

 (1) John Wiley (2009). (2) What They Were Thinking Then: The Consequences for Macroeconomics during the past 60 years by George Akerlof (2019) Journal of Economic Perspectives Volume 33 Number 4 – Fall 2019. (3) Macroeconomics after the crisis by Ricardo Caballero (2010) Journal of Economic Perspectives 24 (4) 85-102. (4) The Economics of The Stock Market (2022). Oxford University Press. (5) In addition to explaining this in The Economics of the Stock Market I put the argument, in a much shorter form, in an article I wrote for American Affairs (Vol VI N0.I Summer 2022) entitled The Stock Market Model. (6) University of Chicago Press (1962). (7) Beyond the Quantum Horizon by David Deutsch & Artur Ekert (September 2012) Scientific American.