Our guest economist and respected monetarist John Hearn has this on the volatile start to 2016

Lots of commentators and analysts in recent times have been saying the bubble had to burst at some point but here's John's recap on how, why, and the potential fall-out.

Be sure to follow John on Twitter here and check all his blogs here and as always we encourage your comments and debate in the comments section below.

Says John:

Sad day when I have to say "I told you so"

In April last year I explained on my blog that "The bubble will burst (just don`t ask me when)" and in August I explained "China is only the trigger" Now it is happening I need to explain why. Forget Davos: the reason the world economy is creaking is because of four economic fallacies that are peddled by most economists and which are wrong.

  1. 1st fallacy: most economists consider there is an output gap that can be closed by manipulating aggregate monetary demand and this will increase output, employment and growth.

    There is no output gap that can be closed by manipulating demand. I explained this in 2013 and repeated it on my blog last year when I wrote "Are demand management policies the solution or a mass delusion?" Even though they are a delusion; there is a Keynesian theory to support them but no evidence that demand stimulation by fiscal deficits has ever increased real income, net output or aggregate employment in a sustainable way.

  2. 2nd fallacy: most economists think that a rise in the costs of production can raise the average level of prices.

    There is no such thing as cost push inflation in spite of the fact that every Central Bank uses changes in costs to deflect attention away from the real cause of inflation/deflation which is them (just read a Bank of England inflation report or listen to any Central Bank). Wages, oil prices, energy prices etc. cannot change the average level of prices, they just change relative prices. It can be easily understood by this often tweeted tweet: "By definition inflation is more units of money used in the same number of transactions". So ask yourself where more units of money came from?

  3. 3rd fallacy: if the Central Bank reduces the rate of interest this will have a positive effect on growth and employment.

    Lowering interest rates below market rates cannot stimulate demand and increase output and employment. I explained this situation in "A reappraisal of interest rates and market interest rates" Lowering interest rates can increase the money supply and monetary demand, (although this can be done more effectively, without lowering rates, by Quantitative Easing or Open Market Operations). It is therefore correct to say that monetary policy determines the rate of inflation but nothing else.

  4. 4th fallacy: There is a Phillips curve that explains how higher inflation is correlated with higher employment and vice versa.

    This is incorrect as the original Phillips Curve showed a relationship between wages and employment so it is not correct to use it to explain our only way out of the deflation threatThere is no such thing as a Phillips Curve which is currently being used to explain our only way out of the deflation threat. I explained this fallacy in "Professor A.W. Phillips would turn in his grave if he knew how the Keynesians had corrupted his curve".

So how are the majority of economists explaining our current problems:-

The fall in oil prices gets a lot of press in a negative and damaging way, but equally we could be pointing out the positive effect on petrol prices and energy prices which is just what we need to get the economy growing.

Slowing growth in the Chinese economy is another favourite whipping post, but what is happening in China is what you would expect as an economy starts to mature, wages start to rise and they turn their attention to environmental issues. Again this should be seen as an opportunity to compete with China on a more level playing field.

Governments pursuing austere policies is obviously wrong when you look at the numbers and I explained this in "Austerity or profligacy in government finances" For many years governments have just been more or less profligate with their spending policies

Let us now look at the real cause of the current crisis which was examined in more detail in "The cause of the Eurozone/EU/worldwide continuing crisis" There are two main causes: firstly the fiscal stimuli that have occurred worldwide since the G20 meeting in London in 2009. I wrote about this in 2009 and published it on the blog more recently under "A fiscal stimulus" and "Look at the ticking time bomb in the budget".

Continuing fiscal deficits draw resources away from a more efficient private sector to a more inefficient public sector and this damages growth. We currently have a National Debt of £1.6 trillion which was only £750 billion in 2009. Ask yourself the question have these continuing boosts to demand had any positive effect? Secondly the low/ZIRP interest rate policy around the world has fuelled unproductive purchases of second hand assets and limited the availability of funds to productive investment.

So what are the majority of economists saying should be done? They have one main theory and four fallacies to work with so their solution is more of the same with larger fiscal deficits and even negative interest rates. Of course this may give us brief respite before we dip even further into recession and depression.

Unfortunately there is only one policy that will solve the problem and it does require some "cold turkey" It is counter-intuitive but it is the only long term solution:-

  • Raise Bank Rate to market rate, or avoid using interest rates at all to manage monetary demand and leave rates to settle under market conditions.

  • Governments should be forced by legislation to balance their budgets over a three year term as explained in "A balanced budget: goodbye fiscal policy"

If we accept the four fallacies identified then we may be able to rethink and revise our policy approach to our current problems. Politicians will never vote to do this and economists will not support something that may tip them off the gravy train, but at least I feel I have had my say and tried to improve things.

John Hearn 21/1/16