Posted by: Dirk | November 11, 2013

Thomas Sargent on sovereign debt

I have been at Humboldt Universität Berlin recently, attending a talk by André Orléan. The talk did strike me as quite circuitist, which is no surprise. Orléan has been quite a heterodox economist, among other things attacking the efficient market hypothesis, as theotherschoolofeconomics shows:

To put it straight, when price goes up, demand increases, rather than slowing down like in the real world. (Have you ever noticed how punters rush to buy stocks that go up?) When prices go down, demand decreases, rather than increasing like in the real world (Have you ever notice how nobody want to buy stocks that crash?).
This is due to the substantial fact that agents in a financial market are not buying assets for their use, but purchase equity to make a profit later on. This profit will come as a benefit after sale. Unlike on the good old farmer’s markets, the actual intrinsic quality of what is traded on financial markets is not relevant to buyers, only the price forecast is. This price will end up being settled according to the will of agents, whether they buy it or not. Therefore, rational agents buy when prices go up, because it’s the most obvious signal that the value will be higher the day after! Whatever the quality of the traded item, if prices go up you should buy and buy again tomorrow.

How could such behaviour reach an equilibrium? How could such mechanism set the right price for the ‘traded stuff’ (read: equity or asset)?

Nevertheless, one of HU’s professor attacked Orléan by saying that it was all in Sargent. This is a strange thing to say. The Nobel website offers the following insight on Sargent’s thinking, even thought he never was rewarded a Nobel prize (there is none – what has been awarded to him is The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2011):

Sargent and Wallace (1981) explored the connections between fiscal policy and monetary policy. They argued that monetary and fiscal policy were inexorably linked, thereby demonstrating how Friedman’s assertion that inflation is always and everywhere a monetary phenomenon can be quite misleading. As the paper shows, fiscal policy may force monetary policy to become highly inflationary. The basic argument is that monetary policy generates seigniorage, i.e., real revenue that contributes to government financing, and that this seigniorage may become necessary in the wake of large budget deficits. Thus, current fiscal deficits may require higher future inflation in order for the intertemporal budget to balance.1
So, current deficits may require higher future inflation for the intertemporal budget to balance? Apart from the eurozone, all developed modern economies have sovereign currencies where the government can create as much reserves as it wishes and the central bank accommodates. There is no intertemporal budget constraint, period. Japan has 250%+ of sovereign debt, and deflationary problems since 1991. Everywhere sovereign debt increases, the interest is low but inflation no problem: US, UK, Sweden, Japan, Canada, etc. And if there is a budget constraint for government, like in the eurozone, deflation and default seem to be required to solve intertemporal problems. Apart from this, I have never ever seen a government that pays back its debts. There is not one case in history, while there a thousands of cases of default and inflation. So, the whole idea of intertemporal budget constraints for public debt is ridiculous. If governments spend more today, they will not have to spend less tomorrow. What is true is that high government debt more often than not comes together with low interest rates, and that inflation is not a monetary phenomenon. However, the reasons are not those given by Sargent and his collaborators. Very shortly: inflation is driven by wages and therefore redistribution, and expansionary fiscal and monetary policy normally go together, which is why in times of weak growth you have both low interest rates and high government debts. Everything else would be nonsensical: government spends to increase demand, but high interest rates block more private investment, or low interest rates spur private investment while the government spends less. Either you put your policy instruments at “expansionary” or not, but putting one lever on “go” and the other on “stop” doesn’t make any sense.
On a side note, if Sargent is correct with “current fiscal deficits may require higher future inflation in order for the intertemporal budget to balance”, then the ECB should take note and tell eurozone governments to spend more in order to fight the deflationary trend. Higher future inflation is just what the eurozone needs, after all. However, I haven’t heard this argument from any of the followers of Sargent in Germany. Conveniently, it is overlooked in the current policy debate.
The schism is economics is a very large one, since mainstream economics professors seem to get neither reality nor alternative economic schools. A bleak prospect for the economics discipline in Germany, I am afraid.

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