In EC101 we constantly emphasize that students should not reason from a price change. Higher gasoline prices are not expected to be associated with lower consumption, it depends entirely on whether the price increase was due to less supply (1974) or more demand (2007.)

Here is recent Nobel laureate Robert Shiller making the same mistake:

Real interest rates have turned negative in many countries, as inflation remains quiescent and economies overseas struggle.

Yet, these negative rates haven’t done much to inspire investment, and Nobel laureate economist Robert Shiller is perplexed as to why.

“If I can borrow at a negative interest rate, I ought to be able to do something with that,” he tells U.K. magazine MoneyWeek. “The government should be borrowing, it would seem, heavily and investing in anything that yields a positive return.”

But, “that isn’t happening anywhere,” Shiller notes. “No country has that. . . . Even the corporate sector, you might think, would be investing at a very high pitch. They’re not, so something is amiss.”

And what is that?

“I don’t have a complete story of why it is. It’s a puzzle of our time,” he maintains.

Before considering what’s wrong with Shiller’s analysis, let’s think about when reasoning from a price change might be justified. Suppose an article started off discussing the fact that cigarette taxes had recently been doubled. Then in paragraph two the author mentions being surprised that cigarette sales had not fallen. That would be acceptable, as there would be a tacit assumption that the rise in cigarette prices was caused by the tax increase, a factor that would be expected to reduce sales.

But in Shiller’s case no such evidence is provided. In the credit markets, low interest rates can be caused by less demand for credit or more supply of credit. Only in the latter case would investment be expected to increase. In this case, however, the primary factor was less demand for credit. So there is no “puzzle” to be explained.

And in a sense it’s even worse than I’ve suggested. Perhaps Shiller views this as a puzzle because throughout history the most common cause of changes in interest rates is a shift in the supply of credit. Perhaps in most cases lower interest rates are associated with more investment. If that were true, his mistake would be more forgivable. But the truth is exactly the opposite. Shifts in the demand for credit are usually the dominant factor. In the vast majority of cases, relatively low interest rates are associated with low levels of investment and relatively high interest rates are associated with high levels of investment. So there is no “puzzle” on either theoretical grounds (theory doesn’t predict more investment) or empirical grounds (low interest rates are not usually associated with high levels of investment.)

This sort of mistake is frequently made by economists, even economists that are much more distinguished than I am. Why does it matter? Because it’s one cause of the Great Recession. If the Great Recession had been associated with interest rates rising from 5% to 8% (instead of falling close to zero) most economists would have blamed the recession on a tight money policy at the Fed. Well the recession was caused by a tight money policy at the Fed, but because most economists reason from price changes they did not see this. Hence the Fed was under no pressure to do the right thing. And when big government institutions are under no pressure to do the right thing, they rarely do the right thing.