Gibson's Paradox

What Is Gibson's Paradox?

Gibson's paradox is based on an economic observation made by British economist Alfred Herbert Gibson regarding the positive correlation between interest rates and wholesale price levels. John Maynard Keynes later called this relationship a paradox because he claimed that it could not be explained by existing economic theories.

Understanding Gibson's Paradox

The foundation of Gibson's paradox is many years of empirical evidence gathered by Alfred Gibson, which showed a positive correlation on the yield of British Consols (perpetual bonds issued by the Bank of England) to a Wholesale Index-Number (an early version of a modern price level index) over the period of over 100 years. Previous research by other economists had also described this relationship, but Keynes was the first to refer to this as the Gibson paradox. Keynes believed that Gibson had discovered this relationship and devoted an entire section in his book, "A Treatise on Money," to Gibson’s figures. 

Keynes did not believe that the tendency of prices and interest to rise together and to fall together during cycles of credit expansion and deflation explained the strong, long-run, positive correlation. He specifically pointed out that he did not think the well-known Fisher effect can explain the positive correlation of prices and interest rates because he (mistakenly) believed that the Fisher effect could apply only to new loans and not to bond yields on the secondary market. He decided to call it a paradox instead and find a way to fit it into his own novel theory.

To do this, Keynes asserted that market interest rates are sticky and do not adjust quickly enough to balance savings and investment. Because of this, he argued, that savings will exceed investment during periods when interest rates are falling and investment will exceed saving when interest rates are rising. According to his theory of how price levels are determined, Keynes says this implies that when interest rates are falling the price level will fall and when interest rates are rising the price level will rise. This, said Keynes, explains the paradox. 

History of Gibson's Paradox

The relevance of the so-called Gibson's paradox in modern economics is questionable because the monetary and financial conditions under which it occurred, and which were the basis of the correlation—namely the gold standard and interest rates that were mostly determined by markets—no longer exist. Instead, the central banks determine monetary policy without reference to any commodity standard and routinely manipulate the level of interest rates. 

Under Gibson's paradox, the correlation between interest rates and prices was a market-driven phenomenon, which can't exist when interest rates are artificially linked to inflation through central bank intervention. During the period Gibson studied, interest rates were set by the natural relationship between savers and borrowers to balance supply and demand. Monetary policies over the last several decades have suppressed that relationship.

There have been possible explanations raised by economists to solve Gibson's paradox over the decades. But as long as the relationship between interest rates and prices remains artificially delinked, there may not be enough interest by today's macroeconomists to pursue it any further. In the end, Gibson’s paradox was neither Gibson’s (having been previously discovered by others) nor a true paradox (as plausible explanations already existed at the time of Keynes's writing and more have been explored since) and is of little interest beyond being a historical footnote to the gold standard era.