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Modern Classical Economics Flunks Its Reality Tests

Interest Rates Varieties of Error  NYTimes com

Paul Krugman:

Interest Rates: Varieties of Error: I wrote recently about how the failure of inflation to soar was one of the three key tests that classical economics, in all its forms, failed in this depression, while Keynesian economics succeeded.

A second was the effect of austerity; Jared Bernstein points us to one of the many charts, this time from Jay Shambaugh, showing that euro experience looks awfully Keynesian.

The last point is interest rates. But I constantly encounter people claiming that high bond prices and hence low interest rates are just a bubble. I don’t think so, but even aside from that, this claim misses a key point about the original nature of the argument. Originally, claims that deficits would drive up rates weren’t based on arguments about solvency; they were based on the “crowding out” claim that the government would be competing with the private sector for a limited supply of savings. Then, when the promised rate spike failed to materialize, this was attributed to Fed purchases, with the claim that rates would spike when those came to an end. Wrong, and wrong again. As I wrote at the time, all this represented a basic misunderstanding of how the economy works.

Now, maybe there’s a solvency issue, and bond vigilantes will turn on America over that — although of course this keeps not happening either to us or to anyone else with their own currency. But you do need to know that many of the people making the solvency argument originally made a completely different argument — one that was completely wrong.