Thomas Sargent Recounts History of U.S. Debt Limits

The interview below is from the IMF Survey. Also, see my interviews with Thomas Sargent in 2002, 2012, and a recap in 2015 after Sargent winning the Nobel-Prize.

In a recent visit to the IMF, Nobel Laureate Thomas Sargent brought to life the economic and financial history of the United States, with stories of how debt limits have evolved over the years before and since the creation of the Bretton Woods Institutions.

On December 2, Thomas Sargent, 2011 Nobel Laureate in Economics, delivered the inaugural Richard Goode Lecture at the IMF. Convened by the IMF’s Fiscal Affairs Department (FAD), the Richard Goode Lecture, named after FAD’s first director, who served from 1965–1981, is designed to bring together annually academia and policymakers to discuss important topics of fiscal policy.

As noted by David Lipton, First Deputy Managing Director of the IMF, the forum “will offer an opportunity to reflect on the evolution of fiscal policy and think about fiscal challenges that lie ahead.”

In his address, Sargent, the William R. Berkley Professor of Economics and Business at New York University, the Donald L. Lucas Professor in Economics, Emeritus, at Stanford University, and Senior Fellow at the Hoover Institution, discussed the role debt limits have played throughout the economic and financial history of the United States. IMF Survey sat with Sargent to discuss his work on the debt limits.

IMF Survey: Professor Sargent, could you please explain the role debt limits have played in the economic history of the U.S.?

Sargent: Based on the evidence that my friend George Hall and I have assembled, the answer is different before 1917 and after 1939.

Before 1917, there was not an aggregate debt limit. Instead, interestingly, there was a debt limit bond by bond. Congress designed every bond and put a limit on the amount that could be issued. And those limits were taken seriously. They seem to have provided information about what upper bound on what future debt would be, except during wars.

After 1939, an aggregate debt limit was created for the first time. It restricts the par value of the total amount of debt. If you adjust for inflation, in real value, the government debt limit was constant until a little after 1980. It actually went down after 1945. In real terms, the value of debt relative to GDP went down even more. After 1983, nominal debt limits rose and more than inflation except in the Clinton administration. So, as I said, the answer seems to differ substantially after 1939 and before 1917.

IMF Survey: And what was the reason for moving from this bond-by-bond approach to the aggregate limit?

Sargent: Good question. The U.S. Secretary of the Treasury, Andrew Mellon, gave his reasons. After World War I, the federal government had big debts. These debts were in discrete issues of bond of particular maturities. They were issued in big lumps with “echo effects”: lumpy debt service events; potential liquidity and roll-over risks. In the 1920s, the U.S. ran a primary surplus, but not big enough to service all the debt that would come due. So when those big bonds matured, Mellon knew that he was going to have to ask Congress for authority to issue new bonds. He foresaw those “echo effects”. So he asked Congress for authority and flexibility to smooth those things over time. Congress assented. Mellon wanted to manage the debt in ways that would increase the liquidity and allow him freedom basically to be a good portfolio manager.

It is interesting why Congress assented to Mellon’s request while it had denied such requests from earlier Secretaries of the Treasury. You have to know more about the politics of the times than I do to answer that question. The Republicans had big majorities in Congress in the 1920s and they mostly trusted Mellon. Congress evidently thought Mellon’s was a reasonable request and at that time he was respected a lot.

IMF Survey: When would debt limits work effectively in restricting spending?

Sargent: I don’t know. I began this talk [Richard Goode lecture] with a quote from a smart Assistant Treasury Secretary who said debt limits are totally a sideshow, meaning that they are totally irrelevant. Just entertainment. But if you go back to 19th century, they seem to have been taken seriously. In various episodes, they constrained what the President and the Secretary of the Treasury could do, or thought that they could do. Something must have changed between then and now. We are trying to learn more about those changes or at least to frame the question.

IMF Survey: What lessons can policymakers in other countries learn from the U.S.?

Sargent: This is speculative, but the way I look at it is that any decision maker, whether he or she admits it, has two things: (1) a model about the way the world is put together, and (2) some interests they want to advance or protect, that is their constituents’ interests. To me, they try to do the best they can in terms of their constituents’ interests, given their understanding of the way the world is put together. They have theories of economics, including theories about government fiscal policy, whether it matters or not, how it matters.

I think if you go back in the 19th century and try to read and listen, people talk about their theories. Congressmen and journalists discussed and debated them. Presidential elections were fought about intricate technical matters of monetary policy: the silver standard, the greenback, the gold standard, bimetallism. It looks to me as though people on both sides had a common theory.

I believe that the economic doctrines that are in policymakers’ heads are very important. It is very corny to say it, but it is still true.

IMF Survey: How about the IMF? What can we learn from this history?

Sargent: The IMF was set up for good reasons. Keynes and Harry Dexter White and many other good people wanted to solve problems that had devastated the world economy after World War I: adjusting international monetary policies and international debts. The founders of the IMF had theories about how the international monetary system could be set up to handle adverse events in ways that would attenuate adverse consequences.

I see a pretty straight line: the IMF has embodied that theory in a set of practices. I view it as an important institution that seeks to keep alive the thoughts and concerns of its founders. For better or worse, in some countries, they say we don’t want to do it the IMF way. Well, the IMF way is that you have to respect the government budget constraint, mostly from your own domestic taxpayers’ resources, not from abroad. If you want some good outcome, this is what you have to do. A lot of this is just arithmetic and sensible economics. (Some of the arithmetic is unpleasant—that is one reason they call ours “the dismal science”.) The package of IMF policies is coherent and makes sense.

IMF Survey: What is the most interesting thing you have learned from your work?

Sargent: To me, one of the most fascinating things is how the U.S. Congress and Treasury recognized and managed rollover risks and interest rate risks; and how they thought about the sources of the fundamentals that drove interest rate risk, some under the government’s control, some not. Many of their discussions and decision seem very wise and modern. The government did various things about rescheduling and issuing callable debt and exercising call options. It was quite a sophisticated operation, done 150 years ago. We are trying to understand: (1) were those good things to do; and (2) what motivated those decisions.

IMF Survey: What’s next for your research?

Sargent: Debt limits are just a part of what we are doing. We are digging deeper and trying to find interesting stories behind individual episodes. Then, we hope to tell some convincing stories—and supplement them with sensible analysis.

Dialogue with Angus Deaton

Congratulations to Angus Deaton for winning the Nobel Prize in Economics. Below is my IMF Survey interview with Deaton (July 2002) on When numbers don’t tell the full story about poverty in India and the world

Before the world can answer questions about how poverty is reduced, it needs to know how progress can be measured. But estimates of the number of the world’s poor and questions about whether it has been decreasing or increasing have given rise to one of the hottest controversies in the development community. Angus Deaton, Professor of Economics and International Affairs at Princeton University’s Woodrow Wilson School, who has looked in detail at India’s poverty numbers, has been at the center of this debate. He speaks here with Prakash Loungani of the IMF’s External Relations Department about the dimensions of the problem and what can be done to provide more transparent and more reliable data on the world’s poor.

LOUNGANI: The World Bank’s estimate that 1.2 billion people live on less than $1 a day is cited everywhere. How reliable is this estimate?

DEATON: There’s surely a very large margin of error in that estimate. Even small changes in the design of the survey used to measure poverty can often have dramatic impacts on the poverty estimates. For instance, you could lower the estimate of the number of poor in India by 175 million just by shortening the recall period from one month to one week.

LOUNGANI: It’s a dramatic example, but you’ll have to explain what a recall period is.

DEATON: To measure poverty, you have to survey people and ask them to recall their expenditures— how much they spent on food, clothing, and so forth. You have to choose whether to ask them to recall how much they spent over the past week or how much they spent over the past month. That’s the recall period. Choosing a one-week recall period generally yields higher expenditures, and therefore lower rates of poverty, than choosing a one-month recall period. (The latter is measured on a weekly basis, of course, so that you’re comparing like and like.) India has long used a 30-day recall period. In recent years, the statistical authorities in India did an experiment to see what difference the recall period makes to the estimate of the number of poor. They found, as I mentioned, that shifting to a one-week recall period would essentially halve the number of poor in India. That must be the most successful poverty-reduction program in the world!

LOUNGANI: But haven’t you been working to resolve such data problems and come up with a good estimate of the number of poor in India?

DEATON: Yes, I have been trying to use the parts of the survey that are consistent over time to adjust the poverty numbers and put them on a consistent track. What that has shown in the end is that there has been fairly steady poverty reduction in India. The number of people living in poverty has declined at a steady rate over the past 20–30 years; there is no evidence of a pickup in the rate of decline since the reforms of the 1990s. I end up with an estimate of a poverty rate for India of 28 percent in 2000. Scholars at the Delhi School of Economics, working independently and using methods quite different from mine, have reached similar conclusions

LOUNGANI: Your findings won’t give much comfort to either side of the debate in India.

DEATON: I think that is broadly right. But the reformers have more to cheer about than their opponents. The findings don’t give the reformers everything they would have liked—notably, a pickup in the rate of poverty reduction in the postreform era. But it certainly shows that the claims of their opponents that poverty reduction stalled as a result of the reforms or that poverty actually increased are quite incorrect.

LOUNGANI: Is the problem just with India’s poverty statistics or is it broader?

DEATON: It is a broader problem, but I should remark that, even with all the problems of measurement, we do know that India accounts for about one-third of the world’s poor. So coming up with a more reliable estimate of India’s poor goes a long way toward getting a better estimate of the world’s poverty rate. But the problems that we face with the poverty data in India are quite likely to be present elsewhere.

LOUNGANI: What are some of the problems with the poverty estimates, setting aside the issues of survey design that we’ve already to some extent discussed?

DEATON: Let me try to get the first problem across in a simple way. Suppose that I had tried to see if income growth in China had any impact on the poverty rate in India. Right away you’d say: “That’s crazy. You need the income and poverty numbers to be from the same country.” Well, in most countries the data on income and the data on poverty come from two different sources. And, exaggerating a bit now to make the point, sometimes these two sources are so far apart in the stories they tell that they may as well be from different countries.

LOUNGANI: For example?

DEATON: The problem is endemic, but again the most dramatic case is India’s. According to its national income accounts, India has had robust economic growth over the last decade, and this certainly accords with what most people think has happened. But, at least until the latest figures came out, the national survey statistics, which are the source of the poverty estimates, showed that average consumption has essentially been flat over the last decade. These two stories about what’s happened in India cannot both be right. How can you have strong growth in consumption in the national income accounts and no growth in average consumption in the household survey? Either consumption hasn’t grown as much as the national accounts say it has or consumption has grown more—and perhaps poverty has been reduced more—than the national surveys say it has. So this, in simple terms, is the first problem—the lack of reconciliation between the household survey and the national income accounts.

LOUNGANI: The lack of price indices is also a big problem, I guess?

DEATON: Absolutely. There are two separate issues here. One is that to compare poverty rates across countries, to make the kind of $1 a day numbers that you mentioned are cited everywhere, you have to use purchasing power parity (PPP) exchange rates. Well, revisions to these exchange rates can play havoc with the poverty estimates. The World Bank itself was caught in this trap: in the 1997 World Development Report, before the crisis, Thailand is shown as having a poverty rate of only 1 /10 of 1 percent of the population. This figure was attributed by then chief economist Joe Stiglitz to the Asian economic miracle. But this was less a demonstration of the miracle than of the dangers of inappropriate PPP conversion. It’s a bit disconcerting when the World Bank’s dream of a world free of poverty can be realized simply by misusing exchange rate data.

LOUNGANI: You said there was a second issue with respect to price indices?

DEATON: Yes, you also need good price indices to compare poverty rates within the country, particularly between urban and rural areas. Countries often have good data for urban centers but not for the countryside, which is often where most of the poor live. This can be a big problem. For instance, I think the unavailability of good price indices for rural areas is in part responsible for the very conflicting views of what impact the Asian crisis had on the poor in Indonesia.

LOUNGANI: If the poverty data are so error-ridden, why don’t we rely on other socioeconomic indicators?

DEATON: That is done. Statistics on life expectancy, infant mortality, and literacy are all things that people look at to supplement the poverty numbers. Amartya Sen has been the intellectual force behind this broader look at deprivation. The United Nations Development Program has come up with a Human Development Index that aggregates all this information in a certain way. I don’t think the way they aggregate it is quite right, but at least it’s wrong in a very transparent fashion. But it is important to realize that income or consumption poverty is an important dimension of poverty in its own right and we should not be using other indicators as a proxy for it, any more than we should be using income poverty as a proxy for health or illiteracy. They are different things.

LOUNGANI: Should we just ignore the poverty numbers altogether?

DEATON: No, that’s clearly going too far. I don’t have objections to the concept of poverty. We do have a notion of poverty, like we have a notion of being cold or being hot; people can generally identify who in their community is poor. But it’s one thing to have a rough notion of poverty in your community, quite another to come up with an estimate of the number of poor in the whole developing world. That, as we’ve discussed, requires a lot of decisions. So what I’m objecting to is the pretense that at the end of this series of decisions we can draw a very sharp cutoff, a poverty line. It encourages a rather Micawberish view of things where the result is taken to be happiness on one side of the line and misery on the other. (“Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”) We should admit that the poverty numbers have large margins of error but keep working to improve them.

LOUNGANI: That’s a nice segue to my final set of questions. What institutional changes are needed to get some quality control on the poverty numbers?

DEATON: The often rather informal arrangements under which numbers are produced need to be looked at. I think the poverty numbers were first thought up for the Bank’s 1990 World Development Report. There was a lot of heroic work by Bank economists to put these numbers together. But they weren’t regarded then as frontline numbers. When folks first started doing GDP numbers, a few academics put some numbers together, and they were thought of as interesting and neat rather than solid numbers you could hang your hat on. Now the poverty numbers have become big important numbers on which many things, including the evaluation of the Bank’s own performance, hinge. At the moment, pretty much no one other than Bank economists can tell you how these numbers were put together and how they can be reproduced. So when someone comes along and accuses the Bank of biasing the numbers one way or the other, it’s difficult for an outside agency or independent scholars to leap to its defense and help resolve the controversy. So we need greater transparency at the Bank on how the poverty numbers are going to be put together in the future. You could imagine setting up other institutions to do this, but greater transparency would get us going in the right direction. And helping countries resolve statistical issues is something that the Bank and the IMF should do a lot more of.

LOUNGANI: It’s difficult for the IMF to take a deep interest in poverty measurement when some still call for us to leave the “poverty business” altogether.

DEATON: I’m in favor of the IMF’s staying in the poverty business, within limits. I was persuaded by [former IMF First Deputy Managing Director] Stan Fischer’s remarks at the conference last year [on macroeconomic policies and poverty reduction] as to why poverty is central to the IMF’s mission. He said that the IMF cannot use the “Von Braun defense”— “I just put the rockets up, and it’s someone else’s business where they fall”—to keep out of poverty. I don’t see how the IMF can cleanly mark out its core mission and say that poverty reduction is someone else’s business. The question is, how far do you go? Certainly, you don’t want to turn yourself into the Bank and hire all the specialists it has and replicate all the detailed poverty analysis it does. But showing greater awareness of poverty measurement issues is essential.

LOUNGANI: What are some areas we could focus on?

DEATON: Several of the problem areas that we discussed are areas where IMF economists are very highly skilled. In countries where there are discrepancies between the national income accounts and the national surveys, IMF staff may have some clues about the extent to which fudges in the national income accounts are responsible. The IMF also has had a long-standing interest in accurate price indices because of the need to get accurate measures of real monetary aggregates, real exchange rates, and the like. And I believe the IMF these days actually issues guidelines on how to provide macroeconomic data and assess their quality. That should be extended to poverty data. This is not the IMF changing its line of business, but simply recognizing that to do your business well you have to be well informed about the measurement of poverty.

The Frenchman Who Reshaped the IMF

From the Globalist:

Reflections on the work of Olivier, the IMF’s now retired chief economist. 

The IMF is often caricatured as an institution that wants to nail every problem with the hammer of austerity and structural reforms.

An article in TIME claimed that the IMF tends to “dish out roughly similar advice to all countries, no matter what their circumstances,” noting that a cursory look at the IMF’s website would show that “prudent fiscal policy and reforms” had been recommended to Lesotho, France and Russia.

Whatever the merits of the caricature, Olivier Blanchard, the French-born, former MIT economist who served as the IMF’s chief economist from September 2008 to September 2015, achieved a rare feat.

He not only changed perceptions of the institution both on the inside and the outside but also, even more crucially, managed to reshape IMF policies.

Under Blanchard’s watch, the IMF:

• lent its support to a global fiscal stimulus during the Great Recession
• urged a very cautious removal of this stimulus during the Not-So-Great Recovery, and
• staunchly advocated easy monetary policies—including quantitative easing.

Even a famous critic of the institution agreed: “A recovery in aggregate demand is the single best cure … what a relief to hear the Fund say that,” Paul Krugman cooed about the thrust of IMF policy prescriptions during the Great Recession.

Olivier Blanchard also threw out some controversial ideas for discussion, such as: Should inflation targets be raised?

That idea ran into some predictable criticism (“if you flirt with inflation, you end up marrying it,” said a former German Bundesbank president).

But it also drew fire from friendly sources—Blanchard’s mentor and long-time collaborator Stan Fischer, currently the U.S. Fed Vice Chairman, thinks that a higher target would be a “mistake.”

Blanchard also nudged the IMF towards less doctrinaire positions on several other issues, notably on the use of capital controls during crises.

He thereby gave an impetus to a rethinking that had started after the Asian crisis of 1997-98—see my article for The Globalist entitled “The Vindication of Joe Stiglitz.”

The fiscal triptych

The biggest change that Blanchard brought about was in the IMF’s advice on fiscal policies. This came in three steps:

1. In early 2008, Larry Summers advocated a U.S. fiscal stimulus that was “timely, targeted and temporary.” Avoiding alliteration’s allure, Blanchard and co-authors advocated a global fiscal stimulus that was “timely, large, lasting, diversified, contingent, collective, and sustainable.”
2. Next came a chapter in the October 2010 edition of the IMF’s flagship publication (World Economic Outlook), which Blanchard played an active role in shaping. To the question “Will austerity hurt?” the chapter gave a clear answer: “Yes.
3. And then came three pages that Gavyn Davies in a FT blog said could have “a greater effect on global economic policy than all of the interminable” sessions held in Tokyo that year at the Bank-Fund annual meetings.

This was in the October 2012 World Economic Outlook—and subsequent paper — where Blanchard and his colleague Daniel Leigh showed that “in advanced economies, stronger planned fiscal consolidation has been associated with lower growth than expected.”

Translation: the adverse impact of austerity on output was perhaps larger than had been expected.

The upshot of this work was not that fiscal consolidation should never be undertaken. Rather, it was that one should expect austerity to lower output.

Moreover, this effect could be greater in some circumstances (e.g., when monetary policy was constrained because policy interest rates could not be pushed below zero).

It wasn’t just fiscal

Here are three other areas where Blanchard left his imprint through his own writing, by guiding the work of others or by creating an open atmosphere where his staff could explore new pastures:

Who’s afraid of capital controls?

Blanchard presided over a series of papers by IMF staff that nudged the Fund towards a more flexible position on capital controls.

A December 2012 blog by Blanchard and Ostry “explains the logic and research that underpins the shift” in the Fund’s position.

The “4% solution”

In a paper with Giovanni Dell’Ariccia and Paolo Mauro, Olivier posed the question: “Should policymakers therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks?”

Though the paper never explicitly advocated a new 4% target (that was done later by Larry Ball in an IMF working paper), and certainly not one to be adopted right away, this quickly became known as the “4 percent solution.”

Inequality

The IMF has received a lot of credit for its work on inequality. The finding that captured attention — by Jonathan Ostry and Andy Berg — was that inequality was detrimental to sustained growth.

Blanchard initially regarded this finding as an interesting cross-section correlation and then as a correlation that had cleverly tapped into the zeitgeist.

It is only more recently, in his foreword to the April 2014 WEO, that Blanchard has come to the view that the implications of inequality for macroeconomic developments are a “central issue.”

Johan Norberg: India Awakes

Since 1991, 250 million people have been lifted out of poverty in India. Johan Norberg’s documentary India Awakes discusses how this happened.

It used to be said that Indians succeeded everywhere except in India. Now Indians are starting to succeed in India.

At an event at Cato, Norberg said that "India is waking up because the government is starting to take a nap every now and then (imposing fewer regulations)".

"What you can do and at what price matters more than who you are or what caste," said Norberg.

"It's morning in India but that is when the work day begins."

India has set the goal of being in the top 50 countries in the World Bank's Doing Business Index. Today it is at number 142 out of 189 countries.

A lesser known fact about Norberg is that he helped me inaugurate the IMF’s Book Forum: the topic was “Capitalism and its Critics”. The transcript makes for very interesting and prescient reading today – all the speakers (Jerry Muller, Ann Florini and Norberg) brought their ‘A’ game. For a short summary of the event click here.

Tom Sargent on U.S. and Europe: A Blast from the Past

Nobel-Prize winner Tom Sargent has an op-ed in the WSJ. Some of it was in an interview he did with me a couple of years ago.

Loungani: Europe’s fiscal challenges are foremost on minds here. This is something you have worked on in the past—the interplay of monetary and fiscal policy. 

Sargent: Yes. I think Europe can learn from the U.S history. In the 1780s, the U.S. consisted of 13 sovereign states and a weak center. The states could levy taxes, the federal government could not. Government debt, federal plus state, was 40 percent of GDP, very high for a poor country. It was a crisis. Creditors worried that they could not be repaid. 

Loungani: How was it resolved? There wasn’t an IMF … 

Sargent: Well, in the end the outcome was that the U.S. founding fathers rewrote the constitution so that it gave better protection to creditors. The constitution reflected a grand bargain: the central government bailed out the states, and the states gave up the power to levy tariffs. Knowing that the federal government had the power to raise tax revenues gave creditors reassurance that their debts would be repaid. 

A fiscal union 

Loungani: You’re saying the present U.S. constitution was adopted to give better protection to creditors? 

Sargent: Yeah, makes me sound like a Marxist, doesn’t it? But it’s all there in our history. Alexander Hamilton was basically creating a fiscal union—bailing out the states in return for a transfer of tax-levying authority to the center. And the point of a fiscal union was to change the expectations of creditors about the chances of being repaid now and in the future. Note, by the way, that the U.S. had a fiscal union before it had a monetary union. 

Loungani: So what are the lessons for Europe today? 

Sargent: Don’t some aspects of the EU today remind you of the historical experience I’ve described? The member states have the power to tax, not the center. Many EU-wide fiscal actions require unanimous consent by member states. But reforms that could lead to a fiscal union are being proposed, as they were in the U.S. in the 1780s. I think at the very least the historical episode—not just the one I described but several others that I could—shows that many configurations of fiscal and monetary arrangements are possible, and some of these work to provide assurance to creditors that there will be enough tax revenues to service the debt. I offer this as hope, but I must say that I am not an expert on day-to-day European economics or on their politics. 

Curing U.S. unemployment 

Loungani: You are an expert on the U.S., and particularly on unemployment, which you’ve also worked on over the years. What would you do about the high U.S. unemployment rate? 

Sargent: I would deal with the fundamental causes of financial crisis—the housing market particularly, where there are debts that haven’t been settled and people can’t yet see how they will be settled. And then to the extent that uncertainty about the course of government regulations is holding things back, I’d tackle that. 

Loungani: That could take time. How would you ease the pain of the unemployed in the meantime? 

Sargent: Some of the European countries, Germany and the U.K., have the right idea. They seem to do better on what’s called welfare-to-work programs—ways of helping the unemployed get into new jobs. We could have done more of that here in the U.S. 

Loungani: We extended unemployment benefits many times. Were you in favor of that? 

Sargent: I worry that can be a trap—we could end up with persistently high unemployment. 

Loungani: Why? 

Sargent: You have to go back to the basic ideas in the work that I’ve done with colleagues over the years. Our work builds on the finding that after about 1980 something changed. The [adverse] hits that people suffered to their incomes became more permanent in nature. In the jargon of our profession, the volatility in the permanent component of earnings increased; workers were more likely to suffer permanent shocks to their human capital. Tom Friedman’s The World is Flat has many examples of all this and the reasons why it happened. So we talk about the Great Moderation at the macro level but for individual workers it was just the opposite. 

An unemployment trap 

Loungani: How does this lead to the trap? 

Sargent: Well, think about what can happen when workers suffer a permanent hit to their incomes, and you offer then the alternative of generous and long-lasting unemployment benefits. For older workers, particularly, the benefits become an attractive option relative to looking hard for another job, which is not going to pay as much because your human capital just took a hit. And getting retrained is hard. I mean I was just 30 when my human capital was hit. You know I went to Harvard, right? I actually got pretty good at playing around with the IS/LM model, which is what I learnt there. And then a new thing—rational expectations—came along and I had to learn all this math and it was hard. Well, if you’re in your 50s you’re not going to be eager to try out the hard things. You’ll try to get by with the unemployment benefits. You end up with lots of workers who are detached from the labor force. I think that’s what happened in Europe in the 1980s. They’d always had more a generous welfare system but the impact of that wasn’t felt until the nature of the shocks to incomes changed in the manner that I described. 

Loungani: Yes, the interaction of shocks and institutions. Olivier Blanchard once said when the shocks changed Europe became like someone wearing a winter jacket in the summertime—the labor market institutions curbed flexibility when it was needed. 

Sargent: Exactly. So I think the people who want to keep extending U.S. unemployment benefits have the right motives but we can end up in the wrong place—a world of persistent high unemployment. So, while in the case of fiscal institutions Europe could look to early U.S. history, in the case of labor market institutions, the U.S. should keep in mind the European experience of not so long ago. 

Robert Barro doesn't look 70

My profile of one of my thesis advisors, Robert Barro, for whom the LSE held a major conference last week. Of all the profiles I've written I like this the best -- I think I knew the subject matter well and it shows. 

Nobel Prize winner Robert Shiller on house prices … and Eliot Spitzer

My ‘golden oldie’ interview with Robert Shiller still makes for interesting reading. It is prescient but even Shiller could not have predicted the fate of Eliot Spitzer.

Shiller on US corporate scandals: “On that score I’m actually somewhat sanguine … Eliot Spitzer has been going after corporate crime as aggressively as Eliot Ness, the guy who went after the gangster Al Capone. Combine that with people like … William Donaldson, Chair of the SEC, and it adds up to a lot of people who are really doing their jobs. The budget for the SEC has really been increased; for 2004, it was over $800 million, more than double what it was five years ago. And people can see what a price Martha Stewart paid for acting on a tip. This is the U.S. solution: the United States has generally handled financial scandals aggressively.”

Shiller on housing markets (in 2004): “I’m not exactly sure what’s going on with housing prices. People still report that a major consideration for their buying houses is that they think it is a good investment; that is, they expect house prices to appreciate. But fewer people report buying houses just to make a profit from speculation. I think the thought process a lot of homebuyers are going through right now is more like: I know prices are too high, but that’s what I thought last year and prices still went up. I better buy now before I’m totally priced out.”

Shiller on importance of combining psychology and economics: “We know the role that overconfidence and wishful thinking play in driving financial markets. But psychological theories have still not been completely integrated into economics. Human behavior is very complex, and economists have been in the mood to simplify it, and simplify it heroically. We will have to change our whole approach to problems—our methodology and our tool kits—if we are serious about grappling with the complexity of human behavior.”

Shiller on how he got into behavioral finance: “I wasn’t much of a rebel as a graduate student. My dissertation was on rational expectations. But I was always a bit skeptical about conventional economic theory. An early formative influence was George Katona, who wrote the book Psychological Economics in 1975. I never took one of his courses, but I sat in on one of his lectures and was impressed. It seemed fine to me, then, that there were only a few people like Katona who wanted to sit halfway between economics and psychology. It wasn’t as clear to me then as now that psychology should be central to economics. Much later, Stan Fischer invited me to write a review essay critiquing the rational expectations revolution for a conference he’d organized. Writing that essay awakened further doubts about rational expectations, which I always thought of as a construct that had some interest but was a small part of a big picture.”

Read the full interview here and also a very nice profile of Shiller written by Paolo Mauro.

Judging Jeff Sachs

I wrote a profile of economist Jeff Sachs that paints a positive picture of his achievements, particularly of his early work in Poland. A new book seems to be much more critical of Sachs, particularly of his recent work in Africa, according to this book review.

Stan Fischer: A Class Act

In 2012, the magazine Global Finance gave Stanley Fischer, then central bank governor of Israel, an A for his handling of the economy during the financial crisis. It was the fourth year in a row that Fischer had received an A. It’s a grade the former professor—who taught both Federal Reserve Board Chairman Ben Bernanke and European Central Bank (ECB) President Mario Draghi—cherishes: “Those were some tough tests we faced in Israel.”

Fischer stepped down as central bank governor in June this year after eight years in the job, bringing the curtain down on an extraordinary third act of his career. The second act was as the IMF’s second-in-command during the tumultuous period of financial crises in emerging markets from 1994 to 2001. This role as policymaker came after a rousing opening act in the 1970s and 1980s, during which Fischer established himself as a preeminent macroeconomist, one who defined the contours of the field through his scholarly work and textbooks. It speaks to Fischer’s success that stints as the World Bank’s chief economist in the 1980s and as vice chairman at Citigroup in the 2000s—which would be crowning achievements of many a career—come across as interludes between the main acts.­ For the full profile, continue reading here. 

Also, see the Washington Post's article titled: The most qualified candidate for Fed chair isn’t Summers or Yellen. 

A Project in Every Port

 Prakash Loungani profiles Jeffrey Sachs, peripatetic development economist

IT IS HARD to imagine a more accomplished—and more varied—career than that of Jeff Sachs. Harvard University granted him tenure in 1982 when he was only 28. In his early thirties, he helped Bolivia end its hyperinflation and restructure its debt. Only a few years later, he was drafting the Polish government’s blueprint for transition from communism to capitalism. Stints as advisor to the governments of Russia, Estonia, Burkina Faso, and India—among many others—followed. Sachs campaigned for debt relief for poor countries and, as an advisor to UN Secretary General Kofi Annan, developed a plan to achieve the Millennium Development Goals. Since 2002, as director of the Earth Institute at Columbia University, Sachs has set his sights even higher. The Institute, an interdisciplinary group of 850 people, addresses some of the world’s most difficult problems, from eradication of disease to global warming. Read more.

Interview with IMF Fellow Olivier Coibion

Olivier Coibion

Loungani: Congratulations on your selection as an IMF Fellow. Is this your first stint at a policy institution?

Coibion: Thanks, I’m thrilled to be here!  I worked for a year at the CEA [U.S. Council of Economic Advisers] in 2000-01. It gave me an enduring sense of how economic theory and empirical methods can help address policy questions and make a difference in people’s lives. And because I happened to be there during the transition from the Clinton to the Bush administration, it was fascinating to see the change in style and personalities—and in the dress code. The suits got much more sober and I even had to start wearing a tie once the Bush administration was in place.

Loungani: Dress is casual at the IMF over the summer. You see the suits out in full force in the fall. What will you work on during your year here?

Coibion: I’ll continue some of my work on inequality. One project will look at links between inequality and financial crises, which folks at the IMF have also studied. I’ve also been studying the impact of monetary policy on inequality—who gains, who loses when the Fed changes its policy. This gets debated in policy circles a lot but not much in academia. Ron Paul says that expansionary monetary policies, or debasing the currency as he always puts it, raises income inequality; people on the left like Jamie Galbraith say the opposite.

Loungani: What do you find?

Coibion: We find that expansionary monetary policy has typically reduced U.S. inequality in the short run. This suggests that when the central bank can’t cut interest rates any more—when rates hit the so-called ‘zero lower bound’, as is the case at present—inequality will be higher than it would be otherwise. To avoid these additional increases in inequality at a time of crisis, the government should use other tools, such as targeted fiscal policies. I hope to do some more work on this while I’m here. More generally, I’ll be studying how best to sequence fiscal and monetary policies when the multipliers—the impacts of the policies on the economy—associated with each may vary with the state of the economy.

Loungani: Do you think the Fed has done enough to promote recovery?

Coibion: I think the zero lower bound [on interest rates] has certainly limited the size of their response. They would be lowering rates further if they could.  But as the IMF’s latest review of the U.S. economy noted, the Fed still has a few options to further support economic activity, given the weak state of labor markets and given the significant downside risks that still exist.

Loungani: Do you think that to avoid hitting the zero lower bound in the future, central banks should raise the target rate of inflation?

Coibion: No, I don’t. A higher inflation rate also has economic costs. So raising the target inflation rate will confer the benefit that we’ll be less likely to hit the zero lower bound. But such episodes are rare. So the high benefits conferred on rare occasions have to be balanced against the small but frequent costs of having higher inflation. In some work I’ve done, it turns out that the costs consistently outweigh the benefits for inflation rates above 2%. So rather than raise the target rate of inflation to deal with future episodes like the Great Recession, I’d prefer the more aggressive use of temporary policies designed for precisely this kind of episode, such as additional quantitative easing or fiscal policy.

**

Olivier Coibion--Recent Publications:

    

• The Optimal Inflation Rate in New Keynesian Models: Should Central Banks Raise their Inflation Targets in Light of the ZLB?” (with Yuriy Gorodnichenko and Johannes Wieland), forthcoming in  Review of Economic Studies. 

• “Why are target interest rate changes so persistent?” (with Yuriy Gorodnichenko), forthcoming in American Economic Journal: Macroeconomics. 

•  “What Can Survey Forecasts Tell Us About Informational Rigidities?” (with Yuriy Gorodnichenko), 2012, Journal of Political Economy 120(1), 116-159. 

• “One for Some or One for All? Taylor Rules and Interregional Heterogeneity” (with Daniel Goldstein), 2012, Journal of Money Credit and Banking 44(2:3), 401-432. 

• “Are the Effects of Monetary Policy Shocks Big or Small?” 2012, American Economic Journal: Macroeconomics 4(2), 1-32. 

• “Strategic Complementarity among Heterogeneous Price-Setters in an Estimated DSGE Model” (with Yuriy Gorodnichenko), 2011, The Review of Economics and Statistics 93(3), 920-940. 

• “Monetary Policy, Trend Inflation, and the Great Moderation: An Alternative Interpretation” (with Yuriy Gorodnichenko), 2011, The American Economic Review 101(1), 341-370. 

People in Economics

A compilation of interviews published in F&D magazine of Nobel prize winners, policymakers, and intellectual leaders around the world in the fields of finance and economics.

Fred Bergsten: will the euro survive?

Fred Bergsten is the founder of the world’s most influential think tank on international economics, the Peterson Institute. Fred recently announced that he would be stepping down as the Institute’s director. My interview with him covers Fred’s views on whether the euro will survive, but other topics as well—his proposal for a G-2 (a tacit economic club of the U.S. and China to go alongside the G-20), his early work predicting the rise and success of OPEC, and his Cold War with Henry Kissinger. Not many people would have the courage, as Fred did at the age of 30, to quit working for Kissinger telling him: “Henry, you do not seem to need—or deserve—the quality of the advice I am giving you.”

Photo: Michael Spilotro/IMF

Bergsten on the Euro crisis

The adoption of the euro was a singular event in world monetary history. But most U.S. economists have been skeptical of the euro’s success. Two U.S. economists have bucked the trend: Robert Mundell and Fred Bergsten. Has the euro crisis led Bergsten to change his mind about the euro’s successt?

BERGSTEN: Mundell actually waxed and waned. Sometimes he’s a fixed rate guy. Sometimes he’s a floating rate guy. Anyway, maybe with him as the other exception, I was about the only other American economist that really supported the euro right from the start.

The difference was methodological. The other American economists, including Mundell, based their views on optimal currency areas. They all concluded that Europe was not an optimal currency area and, therefore, the euro was a bad idea.

I came at it with a totally different perspective. This was a political economy perspective. In my jobs in government, but also from outside, I had been actually quite close to the European integration exercise really from the start. And what deeply impressed me was that every time Europe had a crisis, they not only overcame it, they came out stronger. As Monnet said impressively way back at the start, “Europe will be built by crises and it will move forward through crises, but it will always move forward.” And so far he’s been proven right.

And so when you get into this crisis, my mantra is “Watch what they do, not what they say.” And at every stage of this crisis, they have done enough to avoid a collapse -- not enough to sway the market, but mind you that’s because they can’t say to the markets what they are going to do, because then that would take all the pressure off the other countries and it would be a moral hazard.

So they’re playing a risky game, but again, based on this political kind of motive, I say very strongly Germany will pay whatever it has to pay, both because of that continuing geo-strategic imperative, but also now because the euro is so hugely important to Germany’s economy. The ECB will discount to whatever extent it has to to avoid a collapse even though they can’t say that they’ll do it and, therefore, can’t give the markets the assurance they want.

So I’m actually quite confident still, despite all the rumor mills, that the euro will survive. There will be no widespread defaults. The Greeks might have to, but you might say they’ve already defaulted a lot.

And, even more importantly I’m convinced Europe will come out of it stronger When they created the so-called economic and monetary union they were pretty complete with the monetary union, but there was no economic union. So it was a half-way house, it had to be reconciled sometime. Either you had to forget about the euro or you had to create an economic union. And I’m convinced they will never, never, never let the euro just fail.

Therefore, they have to create an economic union, and I’m convinced that all the steps that they’re taking now -- the EFSF, the successor mechanism, the economic governing systems they’re setting up, Merkel’s calls for a political union -- I think all that’s leading toward a full economic union. And five years from now -- I think it will take years and it it’ll take key Constitutional amendments -- they’ll have it. 

Photo: Michael Spilotro/IMF

**

Read the full interview here. The interview was conducted on December 22, 2011 for a profile of Fred that just appeared in the IMF’s magazine Finance & Development.

Tom Sargent on European and U.S. Economic Woes—and History

Thomas Sargent, winner of the 2011 Nobel Prize in Economic Science, has made several visits over the past year to the IMF's Research Department. Last week, he talked to Prakash Loungani about problems ailing Europe and the United States—and what each could learn from the other’s history.

Photo: Stephen Jaffe/IMF

Loungani: Europe’s fiscal challenges are foremost on minds here. This is something you have worked on in the past—the interplay of monetary and fiscal policy.

Sargent: Yes. I think Europe can learn from the U.S history. In the 1780s, the U.S. consisted of 13 sovereign states and a weak center. The states could levy taxes, the federal government could not. Government debt, federal plus state, was 40 percent of GDP, very high for a poor country. It was a crisis. Creditors worried that they could not be repaid.

Loungani: How was it resolved? There wasn’t an IMF …

Sargent: Well, in the end the outcome was that the U.S. founding fathers rewrote the constitution so that it gave better protection to creditors. The constitution reflected a grand bargain: the central government bailed out the states, and the states gave up the power to levy tariffs. Knowing that the federal government had the power to raise tax revenues gave creditors reassurance that their debts would be repaid.

A fiscal union

Loungani: You’re saying the present U.S. constitution was adopted to give better protection to creditors?

Sargent: Yeah, makes me sound like a Marxist, doesn’t it? But it’s all there in our history. Alexander Hamilton was basically creating a fiscal union—bailing out the states in return for a transfer of tax-levying authority to the center. And the point of a fiscal union was to change the expectations of creditors about the chances of being repaid now and in the future. Note, by the way, that the U.S. had a fiscal union before it had a monetary union.

Loungani: So what are the lessons for Europe today?

Sargent: Don’t some aspects of the EU today remind you of the historical experience I’ve described? The member states have the power to tax, not the center. Many EU-wide fiscal actions require unanimous consent by member states. But reforms that could lead to a fiscal union are being proposed, as they were in the U.S. in the 1780s. I think at the very least the historical episode—not just the one I described but several others that I could—shows that many configurations of fiscal and monetary arrangements are possible, and some of these work to provide assurance to creditors that there will be enough tax revenues to service the debt. I offer this as hope, but I must say that I am not an expert on day-to-day European economics or on their politics.

Curing U.S. unemployment

Loungani: You are an expert on the U.S., and particularly on unemployment, which you’ve also worked on over the years. What would you do about the high U.S. unemployment rate?

Sargent: I would deal with the fundamental causes of financial crisis—the housing market particularly, where there are debts that haven’t been settled and people can’t yet see how they will be settled. And then to the extent that uncertainty about the course of government regulations is holding things back, I’d tackle that.

Loungani: That could take time. How would you ease the pain of the unemployed in the meantime?

Sargent: Some of the European countries, Germany and the U.K., have the right idea. They seem to do better on what’s called welfare-to-work programs—ways of helping the unemployed get into new jobs. We could have done more of that here in the U.S.

Loungani: We extended unemployment benefits many times. Were you in favor of that?

Sargent: I worry that can be a trap—we could end up with persistently high unemployment.

Loungani: Why?

Sargent: You have to go back to the basic ideas in the work that I’ve done with colleagues over the years. Our work builds on the finding that after about 1980 something changed. The [adverse] hits that people suffered to their incomes became more permanent in nature. In the jargon of our profession, the volatility in the permanent component of earnings increased; workers were more likely to suffer permanent shocks to their human capital. Tom Friedman’s The World is Flat has many examples of all this and the reasons why it happened. So we talk about the Great Moderation at the macro level but for individual workers it was just the opposite.

An unemployment trap

Loungani: How does this lead to the trap?

Sargent: Well, think about what can happen when workers suffer a permanent hit to their incomes, and you offer then the alternative of generous and long-lasting unemployment benefits. For older workers, particularly, the benefits become an attractive option relative to looking hard for another job, which is not going to pay as much because your human capital just took a hit. And getting retrained is hard. I mean I was just 30 when my human capital was hit. You know I went to Harvard, right? I actually got pretty good at playing around with the IS/LM model, which is what I learnt there. And then a new thing—rational expectations—came along and I had to learn all this math and it was hard. Well, if you’re in your 50s you’re not going to be eager to try out the hard things. You’ll try to get by with the unemployment benefits. You end up with lots of workers who are detached from the labor force. I think that’s what happened in Europe in the 1980s. They’d always had more a generous welfare system but the impact of that wasn’t felt until the nature of the shocks to incomes changed in the manner that I described.

Loungani: Yes, the interaction of shocks and institutions. Olivier Blanchard once said when the shocks changed Europe became like someone wearing a winter jacket in the summertime—the labor market institutions curbed flexibility when it was needed.

Sargent: Exactly. So I think the people who want to keep extending U.S. unemployment benefits have the right motives but we can end up in the wrong place—a world of persistent high unemployment. So, while in the case of fiscal institutions Europe could look to early U.S. history, in the case of labor market institutions, the U.S. should keep in mind the European experience of not so long ago. 

Photo: Stephen Jaffe/IMF

Photo: Stephen Jaffe/IMF

In Memoriam: All Economists Great and Small

A brief remembrance of four economists who passed away in 2011: Anand Chandavarkar, Alan Stockman, David Aschauer and Ioannis Tokatlidis

• Anand Chandarvarkar was an illustrious Indian economist, known for his books on Keynes and on central banking in developing economies. My review of Anand’s book on Keynes gives you a flavor of Anand’s scholarship, but an excellent look back at his work and career can be found in a piece in the Economic & Political Weekly by his friend and noted economist Deena Khatkhate.

• Alan Stockman, one of my professors at Rochester, was a noted international economist and a wonderful teacher of introductory economics. I was one of the army of RAs for Alan’s principles of econ course. An obit and a nice tribute from Maury Obstfeld.

• David Aschauer was a classmate at Rochester. He and I went through the bonding experience of failing our macro qualifying exam together on our first try. He later got me into the Chicago Fed when I got tired of a being in a long-distance marriage and wanted to move from Florida to Chicago to be closer to my wife. The Boston Globe had a nice obit piece on David.

• Ioannis Tokatlidis (“Yannis”) was a colleague in the IMF’s Research Department. He served -- with great distinction -- several IMF chief economists, including Raghu Rajan (with whom he had co-authored some papers such as this one), Simon Johnson and Olivier Blanchard. Though a fine economist in his own right, Yannis devoted his life to making other people’s research better.