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 maths (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 February 23 at the 2012 Morningstar Ibbotson Conference. Before his speech, we sat down to discuss policy responses to crisis; below are excerpts of our conversation regarding Europe.
Moral Hazard in the Eurozone
Torralba: I want to talk about the eurozone. What is really at the core of the problem? Is it that countries flaunted the fiscal rules or is it the current account imbalances? Or is it both?
Sargent: One reason is accounting, when those rules were imposed. In some countries, there are implicit obligations, where the government is standing ready to bail out various kinds of debts that are incurred by other people, like regions or maybe some banks. So when you’re in good times, the books are not going to show the value of these obligations.
Here’s a rule: Fiscal rules that are announced are just hot air, just so much talk. A real rule, you have to test it. But this was not done.
So you go back to 1995 or so, and Germany says, “Look, you are free to join a monetary union, and it’s a monetary union with Germany. And, by the way, we’ll change the name of the Deutschemark to the euro. And this is going to be a currency issued by Germany. You’re free to denominate in terms of the euro if you want. You can trade in terms of it. And actually if you want to use it, we’ll print some up so you can issue it. But if you issue debts denominated in euros, that’s your problem.”
Germany could have treated the rest of Europe like the United States treats Panama. Panama uses the dollar. But if they want to issue dollar-denominated debt, that’s not the United States’ problem.
So then what would happen is that various countries would join the euro. They might issue some debt, and some of it might go bust. At that point, Germany could say, “Um, sorry. That’s not our problem. That’s not the deal.” So then, Spain could still use the euro, and the debt could go under, be renegotiated. That would be a clear understanding. A few defaults like that, and people would get the message.
Torralba: The funny thing, however, is that when the eurozone was created there was no explicit provision for bailouts. Yet the markets, if you judge the yields in that period, were assuming no defaults or bailouts.
Sargent: In the early 1990s, interest rates on Italian debt were 20%. I told friends from Italy—I was just kidding—that I was thinking of buying some. My friend said, “Are you stupid? Why do you think it’s 20%?” Well, I should have bought it, because they joined the union and those bonds had huge capital gains. Someone made a lot of money on those things.
Why do you think those default premiums or inflation premiums went down? Well, you have two possibilities. The Italian government is going to change its fiscal behaviour. Or, it was, “Oh, boy, now the Germans aren’t going to let them fail.” I think the market thought it was the second, or maybe the market thought it would be some combination—that the Germans would make the Italian fiscal policy different.
Torralba: What about creating some joint liability, like eurobonds? Just create a joint Treasury or some form of guarantee of debt. Then, how would you deal with incentives and the moral hazard problem? Italy could say, “Why am I going to be disciplined if the Germans are going to bail me out?”
Sargent: It’s a good question. There’s a great paper, which everyone should read, by [John] Kareken and [Neil] Wallace [“Deposit Insurance and Bank Regulation,” 1978]. It’s about moral hazard and deposit insurance. Their analysis says that if you have deposit insurance and it’s not priced properly—and it never is—it provides incentives for banks to become as big as possible and as risky as possible. You will have a crisis with probability one. The reason is it’s in banks’ shareholders’ interests for the banks to become big. Kareken and Wallace’s conclusion was, if you’re going to have deposit insurance to fight this moral hazard, you’re going to have to regulate banks’ portfolios to prevent them from becoming too risky.
You can translate that to what you were saying and just change the names of the variables. If Germany is going to foster a facility of lender of last resort, to fight the moral hazard, it is going to have to put in controls.
Torralba: So Italy needs to give up some of the fiscal sovereignty.
Sargent: Absolutely.
Torralba: Which is a political issue.
Sargent: That’s the heart of the issue, right? K
This article first appeared in Morningstar Advisor magazine.
