Toxic economic theory, fraudulent accounting standards, and the bankruptcy of economic policy

Toxic Economic Theory, Fraudulent Accounting
Standards, and the Bankruptcy of Economic Policy


Toxic Economic Theory,
Fraudulent Accounting
Standards, and the
Bankruptcy of Economic
Policy
R. A. Rayman


© Robert Anthony Rayman 2013
Softcover reprint of the hardcover 1st edition 2013 978-1-137-30201-4
All rights reserved. No reproduction, copy or transmission of this
publication may be made without written permission.
No portion of this publication may be reproduced, copied or transmitted
save with written permission or in accordance with the provisions of the
Copyright, Designs and Patents Act 1988, or under the terms of any licence
permitting limited copying issued by the Copyright Licensing Agency,
Saffron House, 6–10 Kirby Street, London EC1N 8TS.
Any person who does any unauthorized act in relation to this publication
may be liable to criminal prosecution and civil claims for damages.
The author has asserted his right to be identified as the author of this
work in accordance with the Copyright, Designs and Patents Act 1988.
First published 2013 by
PALGRAVE MACMILLAN
Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills, Basingstoke,
Hampshire RG21 6XS.

Palgrave Macmillan in the US is a division of St Martin’s Press LLC,
175 Fifth Avenue, New York, NY 10010.
Palgrave Macmillan is the global academic imprint of the above companies
and has companies and representatives throughout the world.
Palgrave® and Macmillan® are registered trademarks in the United States,
the United Kingdom, Europe and other countries.
ISBN 978-1-349-67150-2
ISBN 978-1-137-30450-6 (eBook)
DOI 10.1007/978-1-137-30450-6
This book is printed on paper suitable for recycling and made from fully
managed and sustained forest sources. Logging, pulping and manufacturing
processes are expected to conform to the environmental regulations of the
country of origin.
A catalogue record for this book is available from the British Library.
A catalog record for this book is available from the Library of Congress.


Contents
List of Tables

vii

List of Figures

ix

Preface

x

Acknowledgements

xvi

Part I A Very Dismal Science
1
2

The Greatest Pyramid Scheme since the
Time of the Pharaohs?

3

From Economic Miracle to Credit Crunch:
Thirty Years of Self-Delusion

9

Part II The Microeconomic “Market-Value” Fallacy
3

A Mediaeval System of Accounting

25

4

Fair-Value Accounting and Balance-Sheet Myopia

37

5

The Market-Value Delusion and the Credit Crunch

47

Part III The Macroeconomic “Single-Gear” Fallacy
6

The Topsy-Turvy Wonderland of Single-Gear Economics

65

7

Traffique: The Praeheminent Studie of Princes

76

8

Capitalism and Socialism: The Fatal Conceit

84

9

A Genuine Free-Market Alternative

93

Part IV The Tax that Got Passed by Mistake
10

Income Tax: A Two-Hundred-Year-Old Myth

103

11

The Assessed Taxes

108

12

Not So Much a Tax, More an Anti-Avoidance Provision

116

13

The Growth of the Monster

126

Part V Reform of the Tax System
14

Economic Efficiency or Social Justice?

141

15

Taxation and “The Law of the Market”

149

16

Pay As You Spend

160
v


vi Contents

17

Pay As You Spend: The Social Justification

172

18

Pay As You Spend: The Economic Justification

181

Part VI The Bankruptcy of Economic Policy
19

Toxic Economic Theory and Global Recession

197

Technical Appendices: The Source of the Poison
Appendix A The Fatal Flaw in Accounting Theory:
The Present-Value Fallacy

209

Appendix B The Fatal Flaw in Macroeconomic Theory:
The Single-Gear Fallacy

220

References

242

Index

247


List of Tables

2.1

The United Kingdom economy from the “bad old days”
to the NICE decade

12

3.1

Expected and actual operations of the two companies

29

3.2

Summary of the conventional historical accounts
of the two companies

30

The influence of the volume of activity on the
accounting return

33

4.1

Initial balance sheet of the Fair-Value Company

41

4.2

Balance sheet of the Fair-Value Company
after the “event”

41

The effect on investors of a reported fair-value “gain”
of £100,000

42

The effect of price changes on a home owner
intending to buy a more expensive house

49

5.2

House-price changes: winners and losers

49

5.3

The UK house-price bubble during the NICE decade

51

6.1

From 1960 to 2000: “temporary side-effect” or
“change of gear”?

73

The mutual gains from trade

79

3.3

4.3
5.1

7.1
11.1

38° GEORGII III. Cap.40. (10th May 1798)

109

11.2

38° GEORGII III. Cap.41. (10th May 1798)

110

11.3

38° GEORGII III. Cap.16. (12th January 1798)

112

11.4

Abatement under section IV

113

12.1

Abatement under section III

119

13.1

The British “non-system” of taxation

128

14.1

Two dimensions of “fairness”

142

16.1

Pay As You Spend: alternative methods

163

16.2

Taxes to be replaced under the proposed alternative

167

18.1

Where the whole item of income is consumed
immediately

186

vii


viii List of Tables

18.2
A.1
B.1

Where the whole item of income is saved for one year

187

Fisher’s measure of performance dependent on
investors’ preferences

211

The effect on macroeconomic equilibrium of changes
in microeconomic preferences

227


List of Figures
2.1

Twenty-five years of calm seas – prior to
the storm of 2008

19.1 Annual percentage change in UK GDP

15
202

A.1 Initial market-clearing equilibrium

214

A.2 New market-clearing equilibrium

216

B.1

UK unemployment thousands

230

B.2

Allocation of total resources

232

ix


Preface
Economic Crisis or Crisis of Economics?
Only a crisis – actual or perceived – produces real change. When that
crisis occurs, the actions that are taken depend on the ideas that are
lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the
politically impossible becomes politically inevitable.
[Milton Friedman, Capitalism and Freedom (1982 edn), p. ix]
In a television interview in the autumn of 2011, the Governor of the
Bank of England gave his view of the current economic situation:
This is the most serious financial crisis we’ve seen, at least since the
1930s, if not ever.
[Sky News, 6th October 2011]
Only three years earlier, in his Mansion House speech of 18th June
2008, he had been looking back on the period “since the Monetary

Policy Committee was set up in 1997” as “the NICE decade” of NonInflationary Consistent Expansion. During that period, the market value
of the UK housing stock had tripled from £1.3 trillion to £4 trillion. The
heroes, whose widely acclaimed ingenuity and enterprise had achieved
this apparent gain of £2.7 trillion, were the bankers.
In the summer of 2007, the property market began to collapse. Within
a year, the credit system almost seized up, and the economy was tipped
into recession. The most enthusiastic cheerleaders of one of the greatest
pyramid schemes in financial history became its harshest critics.
The crisis was widely blamed on the banking and financial sector.
Reckless, and occasionally outrageous, behaviour certainly aggravated
the crisis; but it was a symptom, not the cause. The real blame lay with
the bankruptcy of economic policy. The root cause of bankrupt economic
policy was toxic economic theory; and it still is.

The Revival of Classical Economics
The source of the poison can be traced back to the neo-classical consensus which emerged in the late 1970s. What amounted to a theological
x


Preface xi

schism between rival Keynesian and monetarist sects was healed by the
acceptance of a compromise – classical theoretical foundations with a
Keynesian empirical superstructure. It signalled a return to the classical
doctrine of Adam Smith; and it established a fundamentalist belief in
freedom of competition as the sole route to economic salvation and the
promised land of full employment.
Smith, however, had been guilty of a serious oversight. He was an
admirer of François Quesnay (1694–1774) and the Physiocrats, whose
laws were inscribed, as it were, on two tablets of stone. The Law of

Competition was on the tablet that Smith brought back from a visit
to France during the mid-1760s. The tablet containing their Law of
Circulation he left behind.
According to Smith, the Physiocratic system represented “perfect
liberty” as “the only effectual expedient for rendering this annual reproduction [of the wealth of nations] the greatest possible” [(1776) vol.II,
p.176, emphasis supplied]. But he overlooked the Law of Circulation
enshrined in the first of their “maxims”:
That the whole of the … revenue enters into the annual circulation,
and runs through it to the full extent of its course; and that it is never
formed into monetary fortunes.
[Quesnay (1758) p.3]
Disregard of the Law of Circulation is responsible for the widespread
modern error that a perfectly competitive economy in market-clearing
equilibrium is sufficient to guarantee (1) the efficient allocation
of resources, and (2) full employment. This involves two major
fallacies.

A Tale of Two Fallacies
The microeconomic fallacy is the conviction that an increase in the
market-value of an asset (over the general level of prices) necessarily
represents an increase in real wealth. The market-value fallacy has
corrupted the system of accounting and finance by infecting both
practitioners and regulators with “balance-sheet myopia” – the inability
to see beyond a firm’s balance sheet. Home owners – and lenders – have
been deluded into believing that house-price rises can be relied upon to
make increased consumption and borrowing affordable.
The macroeconomic fallacy is the belief that the economy is a
single-gear machine requiring only the lubrication of perfectly flexible

xii Preface

markets to operate efficiently at its full-employment potential. The
single-gear fallacy is responsible for the failure of macroeconomic policy
to shift the economy into the highest possible gear.
The market-value fallacy is the root cause of the financial crisis of
2007/8; but it is the single-gear fallacy that caused the recession and
remains the main obstacle to an effective solution.
Both fallacies have their origin in the artificial split of modern
economic theory into separate micro and macro compartments. The
market-value fallacy is an object lesson in the folly of conducting
microeconomic theory without regard to the macroeconomic repercussions. The single-gear fallacy is an object lesson in the folly of conducting macroeconomic theory without regard to the microeconomic
foundations.
Neglect of the Law of Circulation is the foundation of the modern
“single-gear” policy consensus that the only effective long-term
cure for unemployment is liberalisation of the market structure – to
bring the real world closer to the theoretical ideal of perfect
competition:
Economists disagree about a lot of things but not about how to get
people back to work. Labour markets, they say, need to clear and the
best way to ensure they do is to keep them flexible.
[The Economist, 5th April 1997, p.21]
The policy is misconceived, not because the theoretical ideal is difficult
to achieve in practice, but because it is a flawed ideal even in theory.
Observance of the Law of Competition, though vitally necessary, is not
sufficient. Equally important is observance of the Law of Circulation;
but that is not recognised by the neo-classical consensus.
Exposure of the fallacy proves the point of the Physiocrats’ first
maxim that a monetary economy is a multi-gear machine. To operate at
its full employment potential, there are two basic essentials: (1) freedom

of circulation (to maintain the economy in “top gear”) and (2) freedom
of competition (to keep the economy well lubricated).
The single-gear consensus is only half right. Structural reform is
undoubtedly an essential lubricant for stimulating economic growth;
but it is by no means sufficient:
you cannot lubricate a machine, or an economy, out of second-gear.


Preface xiii

What’s Wrong with Economic Policy?
The Governor of the Bank of England may well be right:
This is the most serious financial crisis we’ve seen, at least since the
1930s, if not ever.
[Sky News, 6th October 2011, quoted on p.x]
Yet the policy response has not changed. It is the same old prescription
as before:
The best recipe for growth is to raise productivity through structural
reforms.
[The Economist, 12th November 2011, Special Report, p.6]
Two and a half centuries ago, the Physiocrats were clearly much more
in tune with today’s problems. Their acute awareness of the multi-gear
nature of the economy is the reason for their warning of the dangers of
foreign trade deficits [Quesnay (1758) p.3], loss of business confidence
[p.4], inappropriate government policy [p.4], and excessive national
debt [p.14].
In their obsession with the Law of Competition, modern single-gear
theorists have blinded themselves to the Law of Circulation. That is the
reason for the bankruptcy of modern economic policy. The conventional wisdom relies on market liberalisation to cure all economic ills.
Anything else is dismissed as a temporary expedient – no more than a

short-term palliative, which in the long run will only do more harm.
Since the root cause of the bankruptcy of modern economic policy is
toxic economic theory, there can be little progress until the two fundamental theoretical fallacies are discarded.

The Law of Competition and Reform of the Accounting
System
Perfect competition requires accurate information. The market-value
fallacy, however, is responsible for two particularly serious sources of
misinformation. By encouraging the belief that increases in market
value necessarily represent increases in real wealth, it is an incentive
to the formation of asset-price bubbles fuelled by credit pyramids. The
same fallacy has also undermined accounting standards to such an


xiv Preface

extent that real economic losses can be reported as accounting gains –
and vice versa. This gives a totally distorted view of economic reality and
renders financial reports totally unreliable for either assessing or comparing business performance. The obsession with current market values
is a major cause of “short-termism” and “rewards for failure”; and it is a
source of the current controversy over executive pay. Instead of operating as an instrument for corporate governance by well-informed market
forces, the accounting system has become a major stumbling block.

The Law of Circulation and Reform of the Tax System
The single-gear fallacy is responsible for two fatal errors in modern macroeconomic policy for stable economic growth:
(1) structural reform to reduce market imperfections is wrongly accepted
as the only effective long-term policy for economic growth; and
(2) fixing interest rates is mistakenly regarded as a safe method of controlling inflation because of the misconception that any depressing
side-effects are merely “temporary”.
As a result, the gains from microeconomic liberalisation have been thrown

away by stifling the economy in a macroeconomic straitjacket of monetary restriction. The “economic miracle” achieved by Britain in the 1980s
is a myth fostered by apologists for this policy. The reality is thirty years
of lower growth and higher unemployment than in the “bad old days” of
the 1960s when Britain was “the sick man of Europe” (see Table 2.1).

The Bankruptcy of Single-Gear Economic Policy
Perhaps the most useful aspect of the recent economic crisis is that it
has exposed single-gear economic policy as a choice of evils. The choice
on offer is between “single-gear austerity” (with no mechanism to prevent 1930s-type depression) and “single-gear growth” (with no mechanism to prevent 1970s-type inflation).
Rapid economic growth without inflation requires freedom of circulation as well as freedom of competition. The bankruptcy of economic
policy is directly attributable to neglect of the Law of Circulation.

The Multi-Gear Alternative
The case for economic reform is presented in two volumes. This, the
first volume, identifies and seeks to correct, two fundamental fallacies


Preface xv

of conventional economic theory. The policy implications are developed in the second volume entitled A Multi-Gear Strategy for Economic
Recovery.
Economic recovery requires observance of both of the basic laws of
economics. The Law of Competition cannot operate effectively until
corporate governance is brought under the control of market forces.
Accounting reform is vital for curing balance-sheet myopia; and law
reform is essential for correcting highly distorted views of risk. Above
all, the Law of Circulation needs to be established as the core of macroeconomic policy. Freeing interest rates by handing them back to
market forces allows control over the level of prices to be exercised by
a market-related tax system operating as the equivalent of automatic
traffic lights triggered by the flow of traffic itself.

Before these changes can be implemented, however, a major obstacle
to the goals of economic policy needs to be removed.

The Dysfunctional Tax System
The current system of taxation is highly dysfunctional. It achieves neither economic efficiency nor social justice. An essential prerequisite for
the policy proposals in the second volume is wholesale reform of the
system of taxation on the lines suggested in this volume. It is designed
to convert the tax system from a major obstacle to the goals of economic policy into a powerful weapon for their achievement.

The Relevance of Multi-Gear Policy to Current Economic
Problems
The “single-gear” solution to imbalances between member states of
single-currency unions like the euro zone seems to require increased
centralisation and progress towards fiscal uniformity. The “multi-gear”
preference, by contrast, is to allow countries (or even regions within
countries) the fiscal autonomy necessary for freedom to change gear.
In tackling “addiction to debt” it can be counter-productive to
threaten the debtors – the addicts; it may be more effective to penalise
the creditors – the “pushers”.
The Law of Circulation has been neglected for over two and half
centuries. The current crisis may be a perfect opportunity for its
revival.


Acknowledgements
This book (together with its companion volume on economic policy)
represents the development of a number of apparently disconnected
articles on accounting, economics, and taxation. Although they contained some highly unorthodox views, they were published in various
professional and academic journals in the late 1960s and early 1970s.
It is unlikely that they would have seen the light of day without

the help of open-minded people who, while frequently not sharing
my views, nevertheless felt that they deserved to be discussed. I am
grateful to Professors Anthony Lowe, Sidney Davidson, and William
Baxter for supporting the publication of the idea of a Segregated System
of Funds and Value Accounting in the Journal of Accounting Research
(1969). I am similarly grateful to Professors John Pinder, Richard Stone,
James Meade, and John Sparkes for their support in the publication of
Price Stability and Full Employment (1975). Particular thanks are due to
Professor Victoria Chick whose enthusiasm for independent ideas was
an inspiration in embarking on Economics Through the Looking-Glass
(1998), and to Professor David Weir who, in addition to his support
during the preparation of the manuscript, was instrumental in its
publication. Dr Allister Wilson (Senior Technical Partner at Ernst &
Young) was a valuable source of encouragement in the preparation of
Accounting Standards: True or False? (2006). It is a sad inevitability that,
during the forty odd years that have elapsed since the late 1960s, some
of those to whom I owe a debt of gratitude have passed away.
Thanks are also due to the following publishers for permission to
reproduce extracts from previously published work. The epigraph
to the Preface, which is a quotation from Capitalism and Freedom
(M. Friedman, 1982 edn. p.ix), is reproduced by permission from the
University of Chicago Press. An extract from Accounting Standards: True
or False? (Rayman, 2006, pp.211–215) is reproduced in Appendix A
with permission from Routledge (Taylor & Francis Group), Abingdon.
In Appendix B, an extract from Price Stability and Full Employment
(Rayman, 1975, pp.51–60) is reproduced with permission from the
Policy Studies Institute, London.

xvi

Part I
A Very Dismal Science


1
The Greatest Pyramid Scheme
since the Time of the Pharaohs?

The value of the UK’s private housing stock rose by
an estimated 9% in 2007 to reach £4 trillion, says the
Halifax. That figure has more than tripled over the last
decade, rising by 208% from £1.3 trillion recorded in
1997.
[BBC News website, 12th January 2008]
In a speech delivered on Wednesday 18th June 2008 at the Lord
Mayor’s Banquet for Bankers and Merchants of the City of London, the
Governor of the Bank of England referred fondly to the period “since
the Monetary Policy Committee was set up in 1997” as “the NICE decade” of Non-Inflationary Consistent Expansion.
What made the decade especially nice for UK home owners was the
tripling of the market value of the housing stock from £1.3 trillion to £4
trillion. The apparent gain of £2.7 trillion was more than twice the size of
the UK National Income for 2007 and four times greater than the National
Debt. It enabled politicians to make the proud boast of the “increase in
the value of your homes” to a largely admiring electorate. Home owners,
who found themselves on the way to becoming millionaires without any
effort of their own, praised the Government and were duly thankful.
The real heroes were the bankers whose widely acclaimed ingenuity
and enterprise had raised the market value, not only of property, but
also of bank shares, to truly astronomical heights.1 For this remarkable

achievement, all they took for themselves were a few paltry tens of

1

British bankers were not alone in this achievement: there were equally strong
contenders elsewhere, particularly in the United States and Spain.
3


4 Part I: A Very Dismal Science

millions in bonuses and pensions as the modest reward for the huge
increase in prosperity that they had conferred on society.
Then all of a sudden, in the summer of 2007, just as everyone was settling
down to live happily ever after with all their nice new wealth, something
nasty occurred. The property market collapsed, the credit system seized up,
and, before long, the global economy was tipped into recession.

The Hunt for Scapegoats
Almost overnight, those who had been the most enthusiastic cheerleaders of the greatest pyramid scheme in British history became its sternest
critics. According to the House of Commons Treasury Select Committee,
it was all the fault of the bankers:
Bankers have made an astonishing mess of the financial system.
[Report (HC 416) 1st May 2009, p.3]
Bonus-driven remuneration structures encouraged reckless and
excessive risk-taking.
[Report (HC 519) 15th May 2009, p.3]
This verdict, though widely accepted, entirely misses the point; and it runs
the risk of turning into one of the most successful (albeit unintended)
cover-ups in the history of finance. The point that it misses is that, even if

every single banker had behaved impeccably by acting “strictly according
to the book”, it was the wrong book – the crisis would still have occurred:
Personal greed is often the explanation given for the disastrous forays
of the world’s banks into America’s subprime mortgages. In Germany,
however, many of the worst decisions were made not by the bonusdriven crowd in Frankfurt but by ostensibly well-intentioned public
servants in the country’s public banks, or Landesbanken.
[The Economist, 9th May 2009, p.79]
“Reckless and excessive risk taking” certainly aggravated the financial crisis, but it was not the root cause. The massive losses sustained
ten years earlier by Long-Term Capital Management, an investment
fund founded by two Nobel-Prize winners, had shown what could be
achieved by academic scholarship alone.2
2

The loss, in 1998, of over $4,000 million within a few months is described
in Chapter 5. It is a dreadful warning of the danger of relying on sophisticated
mathematics.


Ch. 1 The Greatest Pyramid Scheme since the Time of the Pharaohs? 5

The real culprit was not bad practice, though there was no shortage of
outrageous examples (ranging from negligence to downright criminality), but bad theory.

The Market-Value Fallacy and Pyramid Lending
The root cause of the credit crunch is toxic economic theory, which has
corrupted the textbooks of accounting and finance. The poison lies in
the apparently innocuous proposition that an increase in the market
value of an asset (in excess of any increase in the general level of prices)
necessarily represents a genuine increase in real wealth. Although it is
firmly entrenched as part of the conventional economic wisdom, the

proposition is totally false.
An increase in the price of houses (unaccompanied by an increase
in their quantity or quality) cannot benefit the economy as a whole; it
simply creates winners and losers. It represents an inflationary bubble,
rather than a genuine increase in real wealth. The widespread abuse of
the “wealth effect” argument to encourage the explosion of credit during the NICE decade – by a multiple of 2.4 [Office for National Statistics,
series VZRI] – was therefore wholly unjustified.
The market-value fallacy makes mortgage lending appear to be
responsible as long as the loans are adequately covered by the market
value of the property. It therefore erodes the normal income constraint
on borrowing and lending. The inevitable result is a spiral of everincreasing property values making possible ever-increasing loans pushing up ever-increasing property values.
Pyramid schemes are normally against the law, but pyramid lending has been made respectable by the market-value fallacy. Yet it is
unlikely that the pyramid could have expanded to its enormous size, if
the corruption of international accounting standards had not crippled
the (already seriously defective) mechanism for keeping the financial
system under control.

The Market-Value Fallacy and Fraudulent Accounting
Standards
Provided that it is carried out with due diligence, conventional
accounting is ideal for stewardship reporting on the custody and safekeeping of enterprise resources. For performance reporting on their
efficient and profitable use, however, it has a fatal flaw: the profitability of activities which produce returns relatively quickly is routinely
overstated. This provides a perverse and almost irresistible incentive to


6 Part I: A Very Dismal Science

short-termism – the pursuit of quick returns to the detriment of longterm profitability.
Fair-value accounting, imposed without adequate debate on a largely
unwilling profession by the International Accounting Standards Board,

does nothing whatsoever to remedy the fatal flaw. On the contrary,
because the market-value fallacy has been incorporated as a fundamental theoretical principle, fair-value accounting makes matters
worse. Increases in market value are reported as gains, and decreases
are reported as losses. Although this feature appears eminently plausible, it is based on the dangerous fallacy which is discussed more
fully in Chapter 4. By exaggerating the news, whether good or bad,
it reinforces swings in the economic cycle and acts as a destabilising
influence.
In refusing to answer objections from the business community and
the accountancy profession, the International Accounting Standards
Board has given the impression of dealing with difficulties by pretending
that they do not exist. It has also ignored explicit warnings of the dangers of fair-value accounting (FVA) – even from bodies like the European
Central Bank:
FVA … can lead to a misallocation of resources and sub-optimal
investment behaviour because, in an economic upturn, non-viable
projects may get financed, while in a downturn even very promising
projects may be rejected. In addition, systemic risk could increase,
an illustration being the fuelling of an asset bubble during economic
upturns through generous credit conditions and higher collateral
values. The subsequent bursting of the bubble may result in a banking crisis and a credit crunch.
[European Central Bank, Monthly Bulletin, February 2004, p.78]
Financial reports drawn up in accordance with International Financial
Reporting Standards are liable as a matter of normal routine to present
actual economic failure as accounting success and actual economic
success as accounting failure. Some of the most outrageous “rewards
for failure” have been made possible, not by the flagrant violation of
accounting standards, but by their strict observance.
The market-value fallacy is responsible, not only for encouraging the
house-price bubble, but also for corrupting the standards-setting process
so thoroughly that accounting standards themselves have become inherently fraudulent. Their implementation may result in “false accounting”
within the meaning of section 17 of the Theft Act 1968: the production

Ch. 1 The Greatest Pyramid Scheme since the Time of the Pharaohs? 7

of accounts known to be “misleading, false or deceptive in a material
particular”.
Perhaps the market-value fallacy can be seen in a clearer perspective
if the news item quoted at the head of this chapter is restated in terms
of the “tulipomania” which ravaged Holland in the 1630s:3
The value of the UK’s private tulip stock rose by an estimated 9% in
2007 to reach £4 trillion. That figure has more than tripled over the
last decade, rising by 208% from £1.3 trillion recorded in 1997.
[BBC News website, 12th January 2008 (slightly amended)]
So powerful and popular is the illusion of real wealth that, even in some
of the best-informed quarters, the penny has still to drop. Members of
the Treasury Select Committee have concurred with the chairman of the
International Accounting Standards Board in expressing the hope that
property (and tulip?) prices will return to their former heights.
The market-value fallacy does, however, have one redeeming feature:
the bad news is not quite as bad as it seems.

The Not-So-Bad News
A house-price bubble (even as one as large as £2.7 trillion) is like any
other economic bubble. When it inflates, no real wealth is created; there
is simply an illusion of overall gain. When it deflates, no real wealth is
destroyed; there is simply an illusion of overall loss.
The illusion can, nevertheless, be extraordinarily powerful:
Total mark-to-market losses across the [UK, USA, and EU] currency
areas … have risen to around US$2.8 trillion.
[Bank of England, Financial Stability Report,

28th October 2008, p.14]
Difficult though it may have been to believe, however, the Earth had
not been hit by an asteroid which had wiped out most of its wealth. The
real economy was perfectly sound.
In spite of the astronomical sums involved in the inevitable collapse
of the lending pyramid, no real wealth was directly involved. It was a
3

For an account of the tulip-price bubble from 1634 until its collapse in 1636,
see Mackay (1841) pp.89–97. As a result “the commerce of the country suffered a
severe shock, from which it was many years ere it recovered” [p.97].


8 Part I: A Very Dismal Science

question of circulation. All those billions and trillions had not been lost;
they were merely stuck in the financial pipelines. Even in the real world
of sub-prime mortgages, no real wealth had been destroyed. Property
values might have fallen, but the houses and apartments were still
standing. They had not been bombed.

How a Manageable Financial Problem Turned into a Real
Economic Crisis
The lesson supposed to have been learned from history – particularly
from the Wall Street Crash of 1929 – was the necessity for the central
bank to step in as “lender of last resort” and for the government to step
in as “spender of last resort”. It was the failure to act immediately and
decisively, not only when the warnings were issued by the European
Central Bank in 2004, but even after the dangers had clearly begun to
materialise in the summer of 2007, that allowed important areas of the

credit system to seize-up and spending to drop. What should have been
a manageable financial problem was allowed to develop into a serious
global economic crisis.
Although “moral hazard” was put forward as an excuse, the cause of
the policy paralysis was a different – even more virulent – strain of toxic
economic theory.
Following its revival in the last quarter of the twentieth century,
the false nineteenth-century view of the economy as a “single-gear”
machine has been re-established as an article of faith in the textbooks of
macroeconomics. It owes its present stranglehold over economic policy
to the widespread, but totally misplaced, belief in what has come to be
known as “the economic miracle”.


2
From Economic Miracle to
Credit Crunch: Thirty Years of
Self-Delusion

In the “bad old days” of the 1960s, Britain was plagued by restrictive
practices on both sides of industry. Economic growth was described as
“miserable”, inflation as “ruinous”, and unemployment as “intolerable”.
Then things took a turn for the worse. Industrial strife characterised the
“crisis years” of the 1970s. Britain was said to be “ungovernable” and was
portrayed as the “sick man of Europe”. The three-day week in 1973 culminated in the fall of a Conservative government. The “winter of discontent”
in 1978 led to the fall of its Labour successor. One of the most enduring
images of the 1979 election campaign was a winding dole queue displayed
on Conservative Party posters under the slogan “Labour isn’t working”.
The message was irrefutable: with over one million people out of work,
unemployment had gone beyond levels not seen since the 1930s.

But, barely noticed amid the fierce political controversy of those times,
there occurred what can only be described as an economic miracle.

The End of Sectarian Conflict: the Revival of the Old
Orthodoxy
The economics profession, which had for over a generation been riven
by sectarian conflict between Keynesians and Monetarists, reunited in
a fundamentalist revival of the ancient classical free-market religion. It
was based on a strict interpretation of the purist theology published in
1874 by Léon Walras in his Éléments D’Économie Politique Pure.
According to the Old Classical Orthodoxy, any unemployment in the
real world was a “natural rate” determined by imperfection and inflexibility in the market structure. Any deviation from the natural rate
could only be temporary – during the time that it took for responses to
change to overcome frictional resistances in the market structure.
9


10 Part I: A Very Dismal Science

Economic policy became delightfully simple: the only lasting cure
for unemployment was to get rid of restrictive practices (on both sides
of industry and in the professions) and to make markets more flexible.
This has now re-emerged as the modern consensus:
In most areas of public policy, such as crime or education, governments
at least have the excuse that experts give conflicting advice. Not so
with unemployment. Economists disagree about a lot of things but not
about how to get people back to work. Labour markets, they say, need
to clear and the best way to ensure they do is to keep them flexible.
[The Economist, 5th April 1997, p.21]
It follows with apparently inexorable logic that “spending one’s way

out of a recession” (whether by increasing government spending or by
encouraging private spending through reduced taxation) is no more
than a temporary expedient. It can push unemployment below its natural rate for a short time, but the only lasting result will be an increase
in the level of prices.
By the same token, a policy of monetary restriction to control price
inflation appears to be safe. Although it is freely admitted that it may
produce a “fairly protracted, period of economic recession or slowdown
and of relatively high unemployment”, this is dismissed as a “temporary … side-effect” [Friedman (1974) p.9].
The economy is treated as a “single-gear” machine which requires:
(1) lubrication by free competition to keep it fully employed; and
(2) regulation of its monetary fuel to prevent inflationary overheating.
This toxic fundamentalist theory is responsible for the modern lethal
two-pronged economic strategy for price stability and full employment:
(1) a laissez-faire microeconomic policy of market liberalisation to control unemployment; in conjunction with
(2) an interventionist macroeconomic policy of monetary restriction to
control inflation.

From Old Orthodoxy to the New Economic
Fundamentalism
Introduced with reluctance by a Labour prime minister in September
1976, the Old Orthodoxy was embraced with enthusiasm by the