Christine Benz: Hi, I am Christine Benz for Morningstar. I am here at the Morningstar Ibbotson Conference, and I had the opportunity to sit down with Thomas Sargent. He is the winner of the 2011 Nobel Prize in Economics. And we talked about some recent research of his that compares the current debt crisis in Europe to the United States in the 1800s.
Benz: Your recent work has focused on the similarities between Europe's crisis today and the U.S. in the 1800s. I am wondering if you can outline what you think are the key similarities.
Thomas Sargent: So, Before the United States constitution, in the 1780s, we had another constitution called the Articles of Confederation. It looked a lot like Europe today. It had a very weak center, the Continental Congress. It had 13 sovereign states. The fiscal policies of the 13 sovereign states were independent. The 13 sovereign states had the ability to levy the most important tax, the tariff.
The center was dependent basically on the peripheral governments for taxes; it couldn't raise taxes itself. The central government couldn't impose a tariff, couldn't regulate trade. Basically, at that time, this central government had a bunch of debt that was going at a big discount, and these 13 states had a bunch of debt that was going at big discounts.
... Was there a fiscal crisis then? Well, this was a whole constitution that was set to prevent the central government from taxing, borrowing, and spending, and it worked. So those debts that were going at deep discount would never, politically, they were never going to be funded at adequate levels by those institutions.
So, what happened was, what we call the framers or founding fathers, they pulled off a political revolution. That's what it was: A second revolution. They rewrote … they wrote a new constitution, our Constitution, which took fiscal sovereignty massively away from the 13 states, centralized the tariff in the federal government, that's the main revenue raiser, this central government under Alexander Hamilton and George Washington. And they were explicit that this was what they wanted to do. They took that tariff and there was a "grand bargain" made.
At the very beginning of a republic, the federal government bailed out all the states--completely--13 states. So the United States began with a big bailout in exchange for a massive reconstruction of fiscal authority. And Alexander Hamilton, in his report on public credit, he's was 32-year-old guy, who learned his economics on the side, while he is fighting a war. It's amazing. He says, the reason he wants to bail out the state debts is he wants to transfer the allegiance of the creditors of the state governments, and make them interested parties in the success of the federal government, and they want them to support the federal government levying that tariff at a rate that's sufficient to pay off their debt.
So, this was state-building, in my little story, it's driven by these fiscal considerations, and it's not just economic arithmetic; it's political arithmetic. It's rearranging interests so that once you have the new constitution up and running--and a constitution is a set of rules, who decides, what, when, who votes on what. Under these new rules, that government debt that had been at a deep discount goes back to par--huge capital gains on it. So, that was when the United States became a fiscal union.
Actually, the monetary union was an afterthought. In many ways, we were already on a monetary union because we were using the silver standard. So, this was an ambitious project. Alexander Hamilton and George Washington are explicit about it. They want to create it; they are nationalists, and everything's above-board.
Benz: So, a logical follow-up question given what do seem to be quite striking similarities with Europe's situation today: Is a logical outcome the United States of Europe, where you have a united fiscal as well as monetary union.
Sargent: So, this is political dynamite. This is the kind of thing you have to be careful about saying in public, but it's clearly on people's minds. If you read comments coming out of Greece, they are, I would say, thinly veiled, but they are no longer veiled, the project to create a united Europe is not a new one. Other people had it. Napoleon had it. In some ways, Kaiser Wilhelm had it, and Adolf Hitler certainly had it. And … all three of those people, especially the first and the last, they were going to rearrange sovereignty, nicely put.
There are two ways you can put together a monetary union … one of them does involve creating a fiscal union, and if you create a fiscal union you have to take control of individual [states]. So, that's a project which used to be the project, I would say, of the bad guys in Europe, and now I would actually say, it's a long story, but I think it's project of the good guys, and I think it's a project of the good guys in Germany as part of the origin of this project to create a bigger Europe, beyond just Germany or beyond just France.
You can read about this in this book by Tony Judt, called Postwar, part of the project is elements of Germany that want to bind Germany to the rest of Europe, because they don't trust German history. They want to have a peaceful union. So, even though it's a project to create a united Europe, its motivation is different, but that's lurking in the background, and the rule of thumb is, if somebody bails you out, they are not going to do it out of their goodness of the heart, even on the best of motives, because if they bail you out once, they don't want to have to bail you out again. And to prevent that … moral hazard, they are going to take control. And you can see, what's underlying every day in the newspaper. You can see efforts to take more control and the people who are bailed out, they take the stance they want to be bailed out, but they don't want [to lose] any control.
I read things about it in The Financial Times, deputy finance ministers and other people … talking about German boots. So these are hard political issues, which someone like myself, an American, who really doesn't get a vote and doesn't understand European politics and European history all that well, you kind of observe the choices that are open, which ones will be made, who knows?
Benz: Well, while this works itself out, I wonder if you could discuss the implications for the U.S. economy, because it does seem like a cloud hanging over out economy, what's next for Europe. What's your take on that question?
Sargent: So, the honest answer is, I don't know, and I'll kind of tell you, some of the things I am uncertain about. And lots of people are uncertain. So, lots of things depend on politics. There are 23 countries in the euro if you count the Vatican, by my last count. A lot depends on the politics in those countries. And in any resolution of what's called the euro crisis, there are going to be winners and losers, within countries and across countries. So, the politics are formidable.
The other thing you don't know is, there can be shocks--economic shocks of various kinds: Acts of God, political things in the Middle East, they could be big.
So, there are scenarios that you can imagine in Europe--a disorderly, I'll call it, default--I guess they're all disorderly--that could lead to contagion of various kinds, not just Greece. The reason people are worried about Greece, they don't care about Greece--they care about Italy. And you could imagine the contagion that had affected Italy. … Even if American institutions are not invested there, that's going to have repercussions, some of which are hard to see.
Benz: Well, thank you for sharing your insights. Obviously, a lot to ponder and certainly, a lot of unknowns, but we very much appreciate you being here.
Sargent: Thank you.