Mistakes and How To Deal With Them, by Paul Krugman, in NY Times: So Alex Tabarrok thinks he has a great gotcha in my warnings about deficits and interest rates from 2003. Except, I’ve already acknowledged that mistake:
The second [big mistake] was circa 2003, over the Bush administration’s use of the illusion of victory in Iraq to push through more tax cuts, even though the optimistic budget projections used to justify the first round had proved completely wrong. It’s worth pointing out that the situation was not at all like the present, where I support temporary deficit spending to deal with a depressed economy; the Bushies were pushing permanent tax cuts that had nothing to do with economic stimulus, and did so at a time of war with no offsetting spending cuts (and then pushed through an unfunded expansion of Medicare too). This struck me at the time as banana-republic behavior, and still does.
However, I wrongly believed that markets would look at it the same way, and that they would lose faith in American governance, driving up interest rates on our debt. Instead, bond investors discounted the politics, and acted as if they believed that America would eventually pull itself together and start behaving responsibly. The jury’s still out on that, but clearly my short-run prediction proved wrong.
Now, the problem with Heritage this time is that they didn’t make the prediction of rising rates conditional on loss of confidence in US solvency (whether that makes sense is another issue); they presented it as a pure crowding out argument. Here’s Brian Riedl:
The government is going to have to raise interest rates in order to convince people to lend them the full amount they need. We’re already facing a deficit of $1.2 trillion this year, and 700 billion next year. We borrowed $700 billion for TARP, and now we’re going to borrow $800 billion for this stimulus package. Compare those numbers to the entire public debt, which was 5.8 trillion up until a few months ago. It’s going to be very difficult for a global economy, which is already in a recession, to supply the U.S. government with [$3 trillion] in new borrowing. Right now, a lot of banks are happy to buy Treasury bonds because they are safe investments . . . but overall, that may not be enough. The government may have to raise interest rates higher and higher and higher in order to persuade people to lend their diminishing savings to the government. And that’s going to hurt the economy for a long time.
That was just wrong; it represented a completely wrong model of how the economy works. So where’s the rethink?