Correlation and Causality

correlation |ˌkôrəˈlā sh ən| noun – a mutual relationship or connection between two or more things

causality |kôˈzalətē| noun – the relationship between cause and effect

Perhaps the most important thing that an economist, and any individual for that matter, can learn is the difference between correlation and causality. The famous saying is that the rooster does not make the sun rise, but unfortunately that is not always the perception.

The most recent example of the confusion between correlation and causality was the inversion of the yield curve. Doom-sayers from miles around began shouting that there was sure to be a recession. There argument was based on their claim that every recession was preceded by an inverted yield curve. However, the inverted yield curve has also occurred without being followed by a recession, so perhaps this is an example of correlation rather than causality. After all, roosters do not only crow at sunrise.

Additionally, the recollections of the Great Depression are filled with misinterpretations of its causes. The convential wisdom of the man on the street is that the stock market crash of October 1929 caused the Great Depression when, in fact, it did not. The depression was caused by protectionist tariffs and deflation due to the contractionary monetary policy. Deflation pushed prices down and real wages up and companies were reluctant to lower nominal wages. The Smoot-Hawley tariff made the situation worse by preventing foreign competition.

Some of the people hardest hit by the depression were not stock market investors, but farmers. For example, suppose a farmer was paying a mortgage on his property. When prices go down the cost of his mortgage does not. Therefore when he sells his harvest he receives lower prices than he anticipated and this makes it harder for him to afford his mortgage payments.

During the depression many people began to blame falling prices for their hardship. Many believed that by reducing supply and thus raising prices the country would be lifted out of the depression. However, the falling prices were a result of a major contraction of the money supply rather than supply and demand. These changes proved to be failures because not only did they further dampen output, but also made goods harder to afford for individuals who were being forced out of their jobs due to the rising real wages.

Correlation and causality are often confused. Just remember to ask yourself whether it is the cause or just the rooster.