Did Confusion Over Supply and Demand Cause the Crash of 2008?

If I knew Mankiw was going to link to my last post, I wouldn’t have made it so meandering and confusing. So here is the mop-up, what I really wanted to say. But first a few clarifications, as I am getting a lot of comments that are challenging whether my question on movies was fair. Here’s what I was trying to get across:

Question: Suppose that people buy more of product X when the price is high, and less of product X when the price is low. Does that violate the laws of supply and demand?

The answer is no. It’s not maybe, or it depends, it is no, non, nein, nyet, bu shi, etc. And it doesn’t depend on what the product is, what the two prices are, what the two quantities are, the answer is always no.

Now let’s consider why this is so confusing. Take two more examples:

1. In 2007 the price of copper soared to an all time high of $4.30 a pound. Consumers increased consumption and bought 26% more copper in 2007 than in 2006, when the price was $2.85.

2. In 2007 the price of copper soared to an all time high of $4.30 a pound. Producers increased production and sold 26% more copper in 2007 than in 2006, when the price was $2.85.

Seeing them together, I think almost everyone can see what I am doing here. But suppose you showed these two statements to students in isolation. You asked 50 students if statement 1 was consistent with S&D, and you asked 50 students if statement 2 was consistent with S&D. I’ll bet that many more students would say that statement 1 is not consistent with S&D, despite the fact that they are exactly the same statement, just worded slightly differently.

One problem is that many people assume a term like ‘consumption’ is synonymous with ‘quantity demanded,’ whereas it is equally equivalent to ‘quantity supplied.’

The other mistake is to make inferences from a price change. Often the inference is that supply shifted, not demand. When people jump to this conclusion, they make the erroneous inference that the laws of S&D predict that when the price is high, consumption will be low. Of course that is not a prediction of S&D.

OK, how did this confusion cause the crash of 2008? The exact same mistake we make fun of students for making is made by journalists and professional economists every time they assert that money was “easy” because nominal interest rates were low. Actually this mistake is even worse, because it is doubly wrong.

1. It ignores the identification problem. Thus it may be the case that low interest rates are caused by easy money (more supply) or they may be caused by less demand, perhaps due to a weak economy.

2. In the case of interest rates, however, it is even worse, because even if money was easy, it wouldn’t necessarily cause low interest rates. Money is easy when there is hyperinflation, but interest rates are usually high. That’s because monetary policy (the supply of money) also affects the broader economy, and hence the demand for money.

Thus when economists like Anna Schwartz and Joan Robinson equate easy money and low interest rates, they are actually making a much worse mistake that our students make when they make inferences from a change in price. Just so you don’t think I am picking on these two fine economists; most of us, including me, occasionally slip into this bad habit. In some cases it is sort of justified, if the two people speaking both understand that it is obvious that either supply or demand is shifting.

Most people did make this mistake last year. Monetary policy was roughly as tight last year as in 1981, when Volcker raised rates 20% in order to break the back of inflation. Both monetary policies were tight enough to drive NGDP growth rates down very sharply. If the business community and the public and journalists and economists had been aware of what was going on, there would have been riots in the streets. Some of my commenters point to a hard money bias at the Fed. Who knows if that’s true, but in a way it doesn’t matter because the Fed bends to public pressure, so they never would have been allowed to adopt such a deflationary policy in the midst of a debt crisis if it had been recognized as such. And the main reason economists didn’t think money was tight was because rates were cut to low levels, just like in 1930. This is drawing inferences from a price. It is the same error that our students make in economics 101.

And as one of my commenters pointed out, it’s not just S&D that economists get confused about, it’s also opportunity cost, as this link shows. So while I appreciate those who said S&D is easy once you understand the difference between demand and quantity demand, I beg to differ. It is easy to teach supply and demand, just as it is easy to teach opportunity cost. It is not easy to apply either concept to the real world. Even for economists.

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