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This was posted by Geoffrey Gardiner on credec.org on 5 March 2008 He has asked me to bring it to your attention.
'Gibson's Paradox' is the belief that interest rates and prices are positively correlated, not negatively correlated as most academic economists have accepted since 1832 when a Parliamentary Committee chaired by Lord Althorp studied the banking system as part of discussion leading to the renewal of the Bank of England's Charter. The 5300+ questions put by the Committee and answers are recorded in the Minutes of the Secrecy Committee of the Bank. The question which led to the accepted theory was No. 678, and it was answered by J. Horsley Palmer, the Governor of the Bank.
678. What is the process by which the Bank would calculate upon rectifying the Exchange, by means of a reduction of its issues?
The answer was:-
The first operation is to increase the value of money; with the increased value of money there is less facility obtained by the commercial Public in the discount of their paper; that naturally tends to limit transactions and to the reduction of prices; the reduction of prices will so far alter our situation with foreign countries, that it will be no longer an object to import, but the advantage will rather be upon the export, the gold and silver will then come back into the country, and rectify the contraction that previously existed.
This answer was taken to mean that if one raises interest rates ('increase the value of money') there are fewer borrowers, therefore less money available to pay for goods and services, and therefore prices fall.
According to Joseph Schumpeter, Palmer's argument was challenged by Thomas Tooke, who argued that if interest rates are higher than in other countries, money will be attracted from abroad and prices may rise in consequence. There is much empirical data to support Tooke's argument.
J. M. Keynes accepted the belief that the correlation of prices and interest rates was negative until he read in the Bankers' Magazine of January 1923 an article headed The Future Course of High Class Investment Values. It was written by A. H. Gibson of Harrogate, author of a textbook about Bank Rate. The title gave no indication of the importance the article would have for monetary theory. Perhaps Keynes read it only because he was interested in stock market investment. Gibson argued that the price of gilts would depend on the long-term interest rate, and that in turn would be determined by the level of wholesale prices for his research indicated that the long-term interest rate and the trend of inflation were positively correlated. To substantiate his point he produced statistics for 131 years, 106 years of which were illustrated by a graph in a later article in 1926. The 131 years includes periods when the Gold Standard was in force but also long periods when it was not, so the argument which has been put forward that Gibson's theory only applied to the era of the Gold Standard seems invalid. Indeed it may be more valid in periods when there is no Gold Standard.
Keynes studied the relationship of prices with short-term interest rates and found Gibson's theory was valid for them to, but to a lesser degree. A study of the period 1983-2005 has shown that inflation and the three-month interbank interest rate correlated very well in the United Kingdom (Gardiner 2006). For United States experience see Hannsgen 2004. Keynes kept interest rates low while he was at the Treasury 1940-45 as part of his anti-inflationary strategy. Bank Rate remained at 2 per cent. The official annual rate of inflation during that period was 1.8 per cent giving a total of 9.5 per cent for the five years..
Gibson had an explanation for the phenomenon. Briefly his argument was that low interest rates encourage equity investment which would give a better yield, and such investment would bring lower costs of production to be reflected in lower consumer prices. He could also have said that low interest rates also encourage real investment with borrowed money. Gibson explained away quite convincingly any departures his graph made from a positive correlation.
Keynes publicised the theory in his 'Treatise on Money' (Keynes 1930). On page 198 of Volume Two he wrote:- I The Gibson Paradox - as we may fairly call it - is one of the most completely established empirical facts within the whole field of quantitative economics though theoretical economists have mostly ignored it.
One of many reasons put forward to explain Gibson's findings is that interest is a cost and if it is raised, businessmen will raise prices in order to preserve the level of profit. Modern monetary theorists may therefore refer to 'The cost channel of monetary policy.' The cost channel is particularly important in countries, such as the United Kingdom, where mortgage loans pay interest at variable rates.
References
- Barth III, Martin J. and Ramey, Valerie (2001), The Cost Channel of Monetary Transmission, Washington, Federal Reserve Board.
- Gardiner, G. W. (2006), The Evolution of Creditary Structures and Controls, pages 56–61 and Appendix B, page 250, Palgrave Macmillan.
- Gibson, A. H. (1923), The Future Course of High Class Investment Values, Banker's Magazine, pages 15–34.
- Gibson, A. H. (1926), The Road to Economic Recovery: Some Reflections, Bankers' Magazine, pages 595-612, plus graph.
- Hannsgen, Greg (2004), 'Gibson's Paradox, Monetary Policy, and the Emergence of Cycles', Working Paper 410 of the Levy Economics Institute.
- Keynes, J. M. (1930), Treatise on Money, Vol 2, page 198, Macmillan.
- Schumpeter, Joseph A. (1994), History of Economic Analysis, London, Routledge, (Allen and Unwin 1954).
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