Brad DeLong reposts something he wrote two years ago about interest rates; it was, I think, at least in part a followup to my slightly earlier post on liquidity preference and loanable funds. Brad and I both believe that the story of interest rates in this crisis is both remarkable and under-appreciated.

Here’s how it went down. In early 2009 we were faced with the prospect of (a) huge borrowing by the United States and other advanced-nation governments, because the recession had savaged revenues and increased the costs of safety-net program (b) a protracted period of high unemployment, with monetary policy likely to be up against the zero lower bound for years to come.

Many private investors – plus economists and economic commentators who never understood Keynes – looked at (a) and confidently predicted soaring interest rates. Economists who did get Keynes looked at (b) and said that rates would stay low unless government borrowing was large enough to return the economy to something like full employment, which was unlikely.

The economic argument for rates staying low, by the way, wasn’t complicated: it amounted to saying that the IS curve looked like this:

and that there was no reason for the interest rate to rise, even with large government borrowing, unless that borrowing shifted the IS curve enough to the right to bring the economy above the zero lower bound. The subtlety arose from understanding that at each point on that IS curve the supply and demand for loanable funds are in fact equal, that liquidity preference and loanable funds are both true.

And here we are, two-plus years later, and the interest rate on 10-year U.S. Treasuries is only 2.94 percent. This should count as a triumph of economic analysis: the model was pitted against the intuitions of practical men, making a prediction many people considered ridiculous – and the model was right.

And nobody noticed; economic discourse – and even a lot of investment strategy — continues to rely on the supply-and-demand-for-bonds view, even though it has been thoroughly discredited by experience.

How is this possible?

One answer is that the Greeks muddied the waters. The solvency problems of the Greek government actually have nothing to do with the notion that we’ll face crowding out because the government is selling too many bonds, even with the economy depressed; but many of the original crowding-out prophets nonetheless seized on Greece and claimed that it vindicated their views.

More broadly, I guess it turns out that Hicks/Keynes analysis is harder than it looks, and that even smart people – many of them with economics PhDs – just can’t wrap their minds around the notion that sometimes just doing supply and demand isn’t enough.

The result – that one theory has been proved wrong, another proved right, yet the world continues to believe in Theory #1 – is frustrating. It’s also tragic, because that intellectual obstinacy is contributing to the “new normal” of permanently high unemployment.