1. The Failures of Economic Policy –
Blame Theory, Not Central Bankers.
Andrew Smithers
www.smithers.co.uk
Pension PlayPen
12th September 2023

2. Slide 1. Possible Causes of Failure.
• Bad luck.
• Bad management.
• Bad theory.

3. Slide 2. Examples of Failure.
• Slow growth with deep recessions.
• Asset bubbles and financial crises.
• Rapid inflation.

4. Slide 3. Can We Blame the Management?
• Only if policymakers have a sound theory to follow.
• And the right policy instruments.
• Today they have neither.

5. Slide 4. One Equilibrium or Several?
• One is the consensus model’s (CM’s) wrongheaded view.
• We have three not one.
• The CM ignores asset bubbles and money supply.

6. Slide 5. The CM’s Logic is Sound – The Errors Lie in
the Assumptions.
• The CM is based on three key assumptions.
• If they were correct, it would be simple to manage the economy.
• They are wrong – wrong assumptions bring wrong conclusions.

7. Slide 6. Models Must be Tested.
• The CM was invented before it could be tested.
• We now have the data and they show that the CM is wrong.
• It must therefore be replaced by a better model.

8. Slide 7. The CM’s Mistakes.
• Short-term interest rates, bond yields and equity returns are not related.
• Investment does not rise and fall with real short-term interest rates.
• Companies do not “profit maximise”.

9. Slide 8. Always Keep a Hold of Nurse.
• Policy must be based on some theory.
• I propose that we use the Stock Market Model.
• Plus pragmatism on money supply.

10. -2
0
2
4
6
8
10
0.45
0.50
0.55
0.60
0.65
0.70
0.75
0.80
0.85
0.90
0.95
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022
%
change
in
CPI
over
12
months.
M2/GDP.
Data sources: Federal Reserve Table H 6., NIPA Table 1.1.5. & BLS.
Slide 9. US: M2/GDP & Inflation.
M2/GDP Inflation
© Andrew Smithers 2023

11. Slide 10. Testability.
• Economics must be a science as defined by Karl Popper.
• Its assumptions must be testable and robust when tested.
• The return on equity is the key to this.

12. -60
-40
-20
0
20
40
60
-60
-40
-20
0
20
40
60
1802 1817 1832 1847 1862 1877 1892 1907 1922 1937 1952 1967 1982 1997 2012
Annual
total
real
return
log
%.
Data sources: Jeremy Siegel 1802 to 1871, Robert Shiller 1871 to 2022.
Slide 11. US: Real Annual Equity Returns.
Annual returns log % Trend Average
© Andrew Smithers 2023

13. -1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
q
and
CAPE
log
values.
Data sources: For q Stephen Wright 1900 - 1952, & Z1 B.103 1952 - 20922. Robert
Shiller for CAPE.
Slide 12. US: Stock Market Value q and CAPE.
q CAPE
© Andrew Smithers 2023

14. Slide 13. The Cost of Capital.
• We know, at any time, the cost of equity, short-term debt and long-dated
bonds.
• We know the proportions of each that companies use.
• So we know the cost of capital.

15. Slide 14. Three Things Can Go Wrong.
• Demand may be too strong or too weak.
• Money supply may grow too fast or too slowly.
• Asset prices may be too high or too low.

16. Slide 15. Three Problems Require Three Separate
Controls.
• Interest rates controlled by Central Banks.
• Budget deficits controlled by Governments.
• Add Tax Policy controlled by Governments.

17. 0
10
20
30
40
50
60
-60
-40
-20
0
20
40
60
80
1802 1817 1832 1847 1862 1877 1892 1907 1922 1937 1952 1967 1982 1997 2012
Corporation
tax
as
%
of
pre-tax
profits.
Return
on
equities
for
year
%
p.a.
Data sources: For equity returns as in Slide 11, for corporation tax
The Tax Foundation for 1802 to 1928 then NIPA Table 1.14.
Slide 16. US: Annual Returns on Equity & Corporation Tax Rate.
Real returns on equities
Corporation tax rate
© Andrew Smithers 2023

18. • Ultra low interest rates cannot stop slumps.
• Budget deficits are then needed.
• But large deficits can’t be permanent.
Slide 17. Keynes’ Incomplete Revolution.

19. • Liquidity traps were assumed to be short-lived (cyclical).
• The 21st Century has shown this is not true.
• An ever-rising debt/GDP is not safe or sensible.
Slide 18. Cyclical and Structural Liquidity Traps.

20. • Subsidising investment boosts it by more than the cost.
• Raising taxes on consumption cuts demand by no more than the rise.
• Tax policy can thus manage demand.
Slide 19. We Need to Manage Demand Another Way.

21. • The CM’s wrong assumptions cause its wrong conclusion.
• We must discard it, both for teaching theory and as a guide to policy.
• We must introduce tax policy as a third policy instrument.
Slide 20. Conclusions.

22. -4
-2
0
2
4
6
8
10
12
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
1831 1851 1871 1891 1911 1931 1951 1971 1991 2011
Real
return
over
previous
30
years
log
%
p.a.
Data sources: Jeremy Siegel & Robert Shiller.
Slide R1. Independence of Real Returns on Cash, Bonds & Equities
over 30 Years since 1801.
Bonds Cash Equities
© Andrew Smithers 2023

23. 6
9
12
15
18
21
24
27
30
6
9
12
15
18
21
24
27
30
1929 1936 1943 1950 1957 1964 1971 1978 1985 1992 1999 2006 2013 2020
Profits
after
deprciation
and
before
interest
&
tax
as
%
of
net
output.
Data source: NIPA 1.14.
Slide R2. US: Probable Mean Reversion of Non-financial Profit Margins.
Profit margins % Average Trend
© Andrew Smithers 2023

24. -10
-8
-6
-4
-2
0
2
4
6
8
10
3.0
4.5
6.0
7.5
9.0
10.5
12.0
13.5
15.0
16.5
18.0
1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 2017 2022
Reel
return
on
3
months
T-bills.
Cost
of
capital,
with
&
without
IP
&
unidentified
items,
log
%
p.a.
Data sources: Federal Reserve Z1 Table B.103, "Fred" & BLS.
Slide R3. US: Cost of Capital to Non-financial
Companies & Real Short-term Interest Rates.
Cost of capital
© Andrew Smithers 2023

25. 11
12
13
14
15
16
17
18
19
20
3.0
4.5
6.0
7.5
9.0
10.5
12.0
13.5
15.0
16.5
18.0
1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 2017 2022
Taangible
fixed
investment
as
%
of
net
output
scale
inverted.
Cost
of
capital
log
%
p.a.
Data sources: Federal Reserve Z1 Table F.103, "Fred" and NIPA Tables 1.1.5 & 1.14.
Slide R4. US: Cost of Capital & Corporate Investment.
Cost of capital
Tangible investment as % of net output
© Andrew Smithers 2023

26. -1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
10.0
11.5
13.0
14.5
16.0
17.5
19.0
20.5
22.0
23.5
1929 1936 1943 1950 1957 1964 1971 1978 1985 1992 1999 2006 2013 2020
Log
q
difference
from
its
average.
Fixed
investment
as
log
%
of
NDP.
Data sources: Z1 Table B.103, NIPA 1.1.5 & BEA Fixed Asset Table 1.3.
Slide R5. US: Corporate Investment and q are Unrelated.
Total investment as log % of NDP q log difference from average
© Andrew Smithers 2023

27. 2.50
2.75
3.00
3.25
3.50
3.75
4.00
4.25
4.50
4.75
5.00
2.50
2.75
3.00
3.25
3.50
3.75
4.00
4.25
4.50
4.75
5.00
1929 1936 1943 1950 1957 1964 1971 1978 1985 1992 1999 2006 2013 2020
Fixed
produced
assets/net
output
(NDP).
Data sources: NIPA 1.1.5 & BEA Fixed Asset Tables 1.1 & 1.3.
Slide R6. US: Mean Reversion of Produced Capital/Output Ratio.
(A) Fixed Assets.
Capital/output ratio Trend Average
© Andrew Smithers 2023

28. 11
12
13
14
15
16
17
18
19
20
21
11
12
13
14
15
16
17
18
19
20
21
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
Inventories
as
%
of
total
fixed
produced
assets
&
as
%
of
fixed
produced
tangible
assets.
Data source: Z1 Table B.103.
Slide R7. US: Mean Reversion of Capital/Output Ratio.
(B) Inventories.
% of Fixed Produced Assets
% of Fixed Tangible Assets
© Andrew Smithers 2023

29. 10
11
12
13
14
15
16
17
18
19
20
10
11
12
13
14
15
16
17
18
19
20
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
Fixed
non-financial
tangible
investment
as
%
of
net
output.
Data sources: ONS (L5YW, L5Z4, L5ZA,FARR,FACQ, JQJW & NSRK),
BEA Fixed Asset Table 1.5, NIPA Tables 1.1.5 & 1.14 & Z1 Table F.103.
Slide R8. US & UK: Business Tangible Investment from 1997 to 2021.
US UK
© Andrew Smithers 2023