Thomas Sargent and Cutting the deficit

Alexander Hamilton, George Washington and the Euro Zone

Dec 13, 2011 • Economic Debates, Economic History, Economic Thinkers, Financial Markets, Government, Macroeconomic Measurement, Money and Monetary Policy, Thinking Economically • 204 Views    No Comments

How to decide euro zone policy today? Just look at the U.S. between 1780 and 1840.

Saturday, in his Nobel Prize lecture, economist Thomas J. Sargent compared the past U.S. to the current euro zone. He based his talk on 4 questions:

  1. Should governments default on their debt?
  2. Should a central government bail out a subordinate state?
  3. Should monetary union precede fiscal union?
  4. Should fiscal union precede monetary union?

First setting the scene, Dr. Sargent reminded us that after winning the War of Independence, U.S. debt was massive, the Congress was weak, and we had 13 different trade and fiscal policies. What to do? Write a new Constitution. The results? A bailout of state war debt, fiscal union, and national trade policy.

But, during the 1840s when states needed another bailout for excessive borrowing, the federal government refused. The results? Lenders avoided federal and state debt but states added balanced budget provisions to their constitutions.

A 1790s bailout and an 1840s refusal took Dr. Sargent back to his initial questions:

  1. Default: The cost of a default is reputation and elevated lending expense. But it also means higher current consumption because taxes can be lower.
  2. Bailout: The cost of a bailout is moral hazard and perhaps, excessive federal control but creditors benefit and are likely to lend again.
  3. Monetary Union: Should monetary union come before fiscal union? Saying, “No,” Dr. Sargent concluded his talk.

The Economic Lesson

U.S. fiscal authority–the power to spend, tax, and borrow–was established when the U.S. Constitution was ratified. By contrast, the U.S. had no central monetary policy and therefore no control over the nation’s supply of money and credit until after the Civil War.  (More from econlife here on Alexander Hamilton’s economic policy.)

Using the U.S. as his prototype, Dr. Sargent conveyed the importance of a central fiscal authority and implied that euro zone success will depend on it.

His 33 minute talk was excellent. You might want to look separately at his slides.

An Economic Question: How do monetary and fiscal policy interrelate?

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