Scott Sumner  

Reasoning from a price change, example #341

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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.


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COMMENTS (18 to date)
Mark Bahner writes:
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.

But if real interest rates are negative, why isn't demand for credit going up? After all, if real interest rates are negative, aren't creditors effectively paying debtors to borrow?

Scott Sumner writes:

Mark, You said:

"But if real interest rates are negative, why isn't demand for credit going up?"

This is common mistake in economics. Many people think prices impact demand. They do not, they impact quantity demanded. Draw a supply and demand curve, and then shift the demand curve to the left. Interest rate fall. See what happens to equilibrium quantity.

Kevin Erdmann writes:

This is especially ironic, given that housing is clearly, far and away, the sector that has seen investment demand dry up - for nearly a decade now. And Shiller is all over the media telling everyone what a terrible investment housing is. And when there is a hint of recovery, he's out popping supposed bubbles.

Mark Bahner writes:

Hi Scott,

You wrote, "This is common mistake in economics. Many people think prices impact demand. They do not, they impact quantity demanded. Draw a supply and demand curve, and then shift the demand curve to the left. Interest rate fall. See what happens to equilibrium quantity."

Let me start by saying that my entire economic education (or "book-learning", as we called it) consists of...I think a quarter or two of Intro to Econ, and one Money and Banking course.

So it would be better (and I certainly would not be offended) if you told me what would happen, rather than recommending that I puzzle it out for myself. :-)

But OK, here's a wild-and-crazy generic set of demand and supply curves:

Generic supply and demand curves

I assume you're basically saying we're going from D2 to D1 (rather than D1 to D2).

But what I don't understand is, this is not just *free money,* but **paying people to accept money**!(!!!!) That's what negative real interest rates represent. How in the world can that possibly not lead to more money demanded?

Suppose you went outside and handed people packages of $500,000 in Monopoly money bills, and told them, "For every $100 in Monopoly money you return to me in a year, I'll give you $2 in real money", don't you think people would return their packages of Monopoly money in one year to collect the $10,000 in real money?

Scott Sumner writes:

Mark, It's not quite like your example, as you still have to pay a positive interest rate on money you borrow. The interest rate is low, but it's not negative.

If it were easy to profit from these low interest loans, people would be doing it. It's not as easy as you might assume.

Dikran writes:

It's hard to know what Shiller was thinking from such a short article. But there was a time when economists "proved" that real interest rates must always be positive. See, for example, "Stationary Ordinal Utility and Impatience", T. Koopmans, 1960. (There are other examples, I'm sure.)

Shiller is old enough to have read some of this stuff, and may have acquired thereby the intuition that negative real interest rates are a puzzle. This intuition is common; one can find it expressed in Peter Thiel's recent bestseller "Zero To One".

By "proved", I don't mean to suggest that the proofs were wrong--the theorems follow from the stated hypotheses. It's just that the hypotheses need not be satisfied by the world we live in.


Gizzard writes:

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mico writes:

""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.""

I'd probably agree with his "someone" but then he transitions to "the government". I would guess that the average government investment has a negative return in the double digits, so it's prudent that they don't borrow even at low but negative rates.

Scott Sumner writes:

Dikran, As you may know, I don't consider inflation to be a useful concept. It's not even clearly defined. That means that I don't view real interest rates as a useful concept. But perhaps you are right.

Brian Donohue writes:

Scott,

Of course real interest rates are a useful concept- they're THE useful concept for anyone contemplating consumption now versus later.

People argue that CPI under- or overstates inflation (I think it overstates, but...), but 5% CPI increase is 3% more than 2% CPI increase regardless.

So, real interest rates are nebulous. I don't see why this makes the concept, like the concept of 'purchasing power', useless.

Martin writes:

It's quite amazing how uneven is the macro coverage in The Economist - I've stumbled across a recent article on currency volatility and it's hard to know where to start. Apparently Euro is falling because ECB is finally buying bonds and falling commodity prices cause Russia to cut interest rates from 14% to 19%.

"The Swiss, by contrast, abandoned their policy of capping the franc against the euro, which required them to buy increasing amounts of euro-denominated assets."

This gem has so much subtext, I'm not even going to start commenting.

It all almost beggars belief that this type of thinking is still alive and well in 2015.

Why currency volatility has got worse

Scott Sumner writes:

Dikran, I should have given you a link, here it is:

http://econlog.econlib.org/archives/2014/12/why_debates_ove.html

Brian, Perhaps it has some small value, but once you know the nominal interest rate minus the expected growth in NGDP per capita, inflation adds little of interest.

Jeff writes:

Pardon my ignorance (I'm new here), but while it's certainly true that demand has shifted in, is it not also true that supply shifted out, quite considerably?

If both are true, I understand that one effect will likely dominate the other, but I wonder how much the central bank would have to do to force the outward supply shift to overcome the inward demand shift? What's the procedure that economists use to discuss completing changes in curves?

Ricardo Cruz writes:

Pardon my ignorance but the article talks about negative interest rates. What does that mean? Banks in America are lending people $2 and asking them to pay $1 the next year?

Scott Sumner writes:

Jeff, You asked:

"What's the procedure that economists use to discuss completing changes in curves?"

They look at the change in quantity. In this case quantity fell, which suggests that demand shifted left by more than supply shifted to the right.

Ricardo, Good question. No, most borrowers still have to pay positive rates, indeed even positive real interest rates. It's risk free short term government bonds that now pay negative real interest rates. Longer term government bonds have positive real and nominal interest rates.

Mark Bahner writes:
Mark, It's not quite like your example, as you still have to pay a positive interest rate on money you borrow. The interest rate is low, but it's not negative.

If it were easy to profit from these low interest loans, people would be doing it. It's not as easy as you might assume.

Hi Scott,

You're right that my analogy was not a good one. But people should be borrowing more than they are, if real interest rates are indeed negative. Robert Schiller said:

Even the corporate sector, you might think, would be investing at a very high pitch. They're not, so something is amiss.

I don't think you've addressed that puzzling situation by simply referring to a supply curve and a demand curve and pointing to the "equilibrium" quantity of money demanded.

A potential reason I can think of for the "amiss" situation is that corporate borrowers are thinking that inflation might be even lower than the measured values, or that inflation might *become* dramatically lower (even including the possibility of significant deflation) during the periods of their loans.

Steve Roth writes:

"the primary factor was less demand for credit"

I just don't understand how you can make that blanket statement.

There are all sorts of measures showing that supply has tightened, at least in some important lending markets. U.S. mortgage standards and requirements, for instance, have been ramped way up. That constitutes a supply constraint, no?

Dmitry writes:

Professor Sumner,

Could you please clarify one point I've been struggling with. I think I understand well your logic, but only in the context of quantities that are purely determined in the market. Like the price of apples. So, when the price of apples changes, it could be important whether this is due to demand or supply.

But interest rates, unlike most other markets, are controlled by the Fed. So, the observed interest rate is not necessarily the one that equilibrates the market for savings/borrowings, but can be "anything" Fed wants it to be.

Is this somehow relevant? Does it somehow affects your reasoning in this post?

Thank you.

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