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An Economist’s Response to Crises

Nobel-winner Thomas Sargent discusses the economic effects of policy responses to crises in Europe and the United States.

Francisco Torralba, Ph.D., 04/06/2012

This article originally appeared in the April/May issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000.  

Macroeconomists have a really tough job. They do not have the luxury of empirically testing theories as many times as needed, under controlled conditions, the way physicists or biologists do. Instead, most of the time they rely on noisy data, gathered over decades, and from which cause and effect are not inferred easily, if at all.

Thomas Sargent, a professor at New York University, earned the 2011 Nobel prize in economic sciences—with Christopher Sims—doing something really hard. He developed models of the macroeconomy based on deep, microeconomic factors that do not change with economic policy. Using those models, Sargent was able to show that expected monetary growth will not do much for output because it does not fool people.

Most of Sargent’s work involves serious math (which I know firsthand after taking his class when he was visiting the University of Chicago). But he has also produced very readable work on economic history, such as “The Ends of Four Big Inflations” (1981) and The Big Problem of Small Change (Princeton University Press, 2002). Sargent gave the keynote address on Feb. 23 at the 2012 Morningstar Ibbotson Conference. Before his speech, we sat down to discuss inflation, unemployment, and the European crisis. Our discussion has been edited for clarity and length.

The Fiction of an Independent Fed
Francisco Torralba:
People are worried in the United States about the possible inflationary effects of what the Fed is doing. In one of your best-known papers, “Some Unpleasant Monetarist Arithmetic,” with Neil Wallace, you talk about the interplay between monetary and fiscal policy and how inflation is actually determined by both.

Thomas Sargent: Yes. There’s a fiction—it may be a useful fiction, but nevertheless economically it’s a fiction—that we have an independent monetary authority, an independent Fed, and that we have an independent fiscal authority, which is the Congress and the president. But the facts are that Congress and the president determine taxes and government expenditures—or they determine the laws that determine those. Some government expenditures and some taxes depend on the state of the economy. But given that taxes and expenditures are set by the Congress and the president and that taxes and expenditures don’t have to be equal, government expenditures can exceed taxes. What happens then is that the government borrows.

Say we were on a gold standard, which means that we did not have a monetary authority and we were basically using a foreign currency. The government budget, while it could be unbalanced in a given year, then would have to be balanced in the present value sense. The reason is, when we floated bonds, the bondholders would want some insurance that they were going to be paid. The only way they can be paid is if the government runs surpluses in the future and uses the surplus to pay off the bonds.

But we’re not on a gold standard. We’re on a fiat money standard. And when you’re on a fiat money standard, what determines the value of this un-backed piece of paper? It’s the implicit promise of the people who print the paper that they’re not going to print too much. So what’s been done in the United States is management of the stock of money has been handed to an “independent agency”—the Federal Reserve— that, roughly speaking, determines how much un-backed currency is printed up.

Francisco Torralba is an Economist for Morningstar Investment Management.

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