If Your Model Keeps Failing, You Need To Change Your Model

From Matt Zeitlin’s article about the possibility of a new downgrade on American debt:

Steve Bell, a former Senate Budget Committee staffer and investment banker who is now at the Bipartisan Policy Center, says that “we’ve warned people a lot about what will happen if we don’t get spending and tax balanced.” But every time, interest rates on U.S. debt continue to fall. He said that when he goes to the Hill, the threats no longer mean much: interest rates are low despite S&P’s downgrade in August 2011, and there are no signs of inflation.

The fascinating thing about this is that if you read on in the piece it’s clear that Bell has learned a political lesson from this rather than an economic one. Now he says “only a deep and prolonged equity slump, along with higher interest rates on U.S. debt, will move people to demand a big, long-term fix for the deficit.”

But when your predictions about the world fail to come to pass, you ought to alter your model of how the world works and shift your policy recommendations accordingly. If you look at the contemporary United States, and put it in context with the situation in places like Japan and the United Kingdon, it should become clear that long-term fiscal policy projections simply aren’t relevant to interest rate dynamics. Not at all. Not even a little bit. What matters is the overall state of aggregate demand, the attitude of the central bank, the potential growth rate of the economy, and other big picture macroeconomic items.