On the money

I often come across the claim that some economic theory or other has been debunked. For example, according to the Times, increases in the money supply don’t cause inflation. That idea, it said, “…has been discredited in theory and practice.”

Of course, if a theory has been refuted, we don’t need to waste time engaging with it. What’s more, refutation is pretty straightforward. When data are at odds with a theory, that theory is refuted and we can move on… or so the story goes.
However, the premature rejection of economic theories is one of the main roots of the dismal performance we’ve seen from so many economists, central bankers, governments, and pundits.

You see, refutation isn’t quite what it seems.

The premature rejection of economic theories is one of the main roots of the dismal performance we’ve seen from so many economists

To illustrate, let’s go back to 1910. A young meteorologist named Alfred Wegener was idly glancing at a map when his attention was drawn to the coastlines of Africa and South America. They seemed to fit together like pieces of a jigsaw. Could they, he wondered, once have been joined in a single land mass? In his own words: “At first I did not pay attention to the idea because I regarded it as improbable.”

But in the autumn of 1911, Wegener chanced upon an article about a growing crisis in the Theory of Evolution. Archaeologists working in Africa had discovered fossils of plants and animals that were identical to earlier finds in South America.

This discovery was explosive. According to Darwin, evolution is driven by the interplay of adaptation and natural selection. Over time, every species will adapt to its environment. One of the most important characteristics of any environment is climate. If Darwin’s theory was correct, identical complex life forms couldn’t emerge in places with radically different climates… such as Africa and South America.

Worse was to follow. Identical fossils were found in the frozen wastes of Antarctica and the arid deserts of southern Australia. For Wegener, the choice was simple: either Darwin’s theory was wrong, or the continents had moved.
This idea was savagely ridiculed. According to leading geologist Arthur Holmes, Wegener’s theory that Africa and South America had once been joined in a single land mass was unequivocally refuted by the data.

How?

Easy: the world’s greatest mountain range is not, as you might imagine, the Himalayas. It’s found beneath the Atlantic Ocean: the Mid-Atlantic Ridge. It’s 10,000 miles long and 500 miles wide. As Holmes pointed out, the distance between South America and Africa could never have been less than 500 miles – there’s a vast sub-aquatic mountain range in the way.

Holmes’ refutation was excellent. It was based on accurate data and valid reasoning.

Nevertheless, it fails.

Wenger was right: Africa and South America had once been joined at their current coastlines.

What’s going on here?

Holmes’ refutation rested upon an important tacit assumption. Namely, that the existence of the Mid-Atlantic Ridge predated any movement of the continents. In fact, the Mid-Atlantic Ridge was formed by the very processes which split and pulled the vast, ancient land mass apart.

Instead of being evidence against Wegner’s hypothesis, the mountain range counted in its favour.

This isn’t a problem peculiar to earth sciences. Every time we think about anything, we rely on a network of unquestioned and unnoticed presuppositions. Without these, thought isn’t possible.

The unsettling upshot is that refutation of a theory isn’t simply a matter of finding incompatible data. As we have seen, a theory may conflict with accurate data yet nonetheless be correct.

This means we must always proceed with extreme caution.

Returning to economics, we were assured last year, by the authorities… and the vast majority of pundits… that inflation wasn’t going to be a problem in 2022.

Wrong!

As things got worse, they jumped on the “it’s transitory” bandwagon.

Wrong!

The current claim du jour has inflation “returning to 2%” in 2023, according to the IMF, or in 2024, according to the Bank of England, the Fed and the ECB.

Wrong? You might very well think that, I couldn’t possibly comment.

The crucial point is this: despite any claims to the contrary, we do not as yet possess a reliable overarching theory of the economy. There’s no general theory that will tell us what will happen in all possible circumstances. Because of that, we need a plurality of theories. Sometimes we have to rely on one theory; at other times on quite another. The rejection of past theories is usually seen as a sign of progress but, in reality, it often serves to diminish our arsenal.

Peter Lawlor is a trustee of the John Hicks Foundation in Oxford. He was formerly the Principal Economic Advisor to the German Stock Exchange (Deutsche Börse), and continues to act as an adviser to senior Wall St figures and political leaders. These are his own views and should not be imputed to any organisations with which he is, or has been, affiliated