Rational Expectations and Inflation

"This is a lecture that was very inspiring to me. Sargent had just won the Nobel Prize and I was in the middle of my graduate studies. It was 2011 and Europe was dealing with the consequences of a sovereign debt crisis. Some countries in Europe were facing problems refinancing their debt, and there was a quirk in the institutional arrangement of Europe, whereby these countries with fiscal policy problems—notably Greece, but also Ireland, Spain, and Italy—were in what is known as a ‘monetary union.’ They were in the Euro area . So, unlike most countries in the world, they did not have their own currency. Lots of questions were being raised about how debt should have been managed in this setup. What was the ideal way to design an institutional arrangement for countries that traded together, shared political decisions and monetary policy but had independent fiscal policy? What role should the Union have? Where should powers lie? What should the Union do? What should the individual countries do? There were all these questions floating around. Sargent had just won the Nobel Prize, and he gave his Nobel lecture on economic history . It was very interesting because Sargent said something along the lines of ‘I’m an American, I don’t know very much about Europe, but I’m going to tell you a story.’ And the story was a very American story, about the design of the institutional setup of the United States in the 18th century, after the War of Independence . It seemed like this was not directly relevant to the issues that were being debated at the time, but it was actually extremely relevant, which is the reason Sargent brought up this episode. He made the point that there was a distinct change in the institutions of the United States at the time. There was an initial constitution, the Articles of Confederation (1777), where the federal government had very limited powers to raise tax revenues. As a consequence, it was very hard for the federal government to pay the debt that had accrued to pay for the war. The debt was very expensive to refinance because nobody wanted to buy it. Lenders to the government knew that it was going to be hard for the federal government to service it. On the other hand, the states—subnational authorities—had all the powers to tax, including international trade, each in their own way. This setup was not working very well. A few years later, starting in 1787, the Founding Fathers came together and redrew that initial constitution and wrote what is now the US Constitution . In doing so, they changed the location of power. They gave the federal government much greater powers to tax and to manage international trade as a unitary country. So trade of the American states with the Brits was now managed at the central level, not by the individual states. This was an important source of fiscal revenue. The states gave something to the federal government, and in return the federal government phased out all the debt of the individual states. The federal government took it on as federal debt. It was a bailout from the central authority to the states, which is something that was being advocated for in the European context: ‘We shouldn’t let Greece face this problem on its own, everybody else should help.’ But there was a bargain, because in return for this bailout the federal government allocated to itself powers to tax. “Fiscal policy is a very rich area” This changed the institutional setup in the United States drastically. It changed the return on their debt, reducing it dramatically, because lenders understood that that the debt was going to be repaid. The debt could have been defaulted upon, but the Founding Fathers said, ‘No, we’re going to repay this debt. In this way, we’re going to sustain a reputation for being borrowers that can be trusted. It is going to be beneficial for us in the future.’ Also, they changed the fiscal policy setup, moving away from an initial setup where there was lots of decentralisation, to another one where there was much more centralisation of international trade and of important parts of fiscal policy. So, the issues facing Europe were being talked about in a very indirect way, because Sargent was talking about the United States. The reasons these topics were so interesting—so much so that they were being dealt with in such an important setting as the Nobel lecture—was because the events of the time were making these issues very topical. Many other points are clarified in the lecture, so I suggest watching it or reading the text . Reading it now, more than ten years later, it’s interesting to notice that the institutional setup of the Euro area, or the European Union , has changed in important ways since Sargent gave that lecture. There’s the issue of Brexit , but that’s not central here. What has happened is that the Euro crisis has been resolved with some intervention from the central government, indeed resembling, in some ways, what happened in the United States 300 years ago. Also, there has been not a complete fiscal union, but some change in the degree of centralisation of fiscal policy in the Euro area, with more powers going to the central authority. I think the European Union resembles the United States a bit more now than it did ten years ago, when Sargent gave the lecture. The comparison is very relevant. The lecture is delivered in a very sharp way. It’s very clear, very insightful, and touches on many topics of great breadth, which I think is inspiring for a student of macroeconomics or for anybody interested in macroeconomic issues in general. Yes. Big reforms came during the crisis of 2011-2013, with new institutions being created, like the European Stability Mechanism, and greater powers being attributed to already existing institutions, such as the European Central Bank. Then there was a second crisis, which had great relevance for these, which was the pandemic. During the COVID crisis, given that different countries were being hit by it to different degrees—Italy was hit particularly severely in the initial phase—the European Union, as a whole, launched new policies that were unthinkable before, such as borrowing in a centralised way. Europe issued debt of the European Union, which is something that would have been inconceivable just ten years ago. In the United States, the federal government issues United States government debt—one of the most widely traded securities in the world—while many states are banned from issuing debt. In the European Union, it’s typically the countries that issue the debt, but the distinction has become less sharp in the last three years. The EU issued debt with the specific purpose of supporting national governments to deal with the health crisis. That’s the major change."