Thursday, April 25, 2013

Papers We Read: United States Then, Europe Now (cps)

This week, we read

Sargent, Thomas J. (2012): "Nobel Lecture: United States Then, Europe Now", Journal of Political Economy, 120 (1), 1-40.

In short, it's a historical case study---set in the 18th- and 19th-century to-be-United States of America---wrapped around the intertemporal government budget constraint. Sargent presents some of his core messages right at the beginning. Here are some examples (quotes in italics taken from pp. 3-4):
  1. The ability to borrow today depends on expectations about future revenues. Under the United States' first constitution, the federal government incurred very much debt but didn't have the power to tax accordingly. The consequence was that the respective debt titles traded at high discounts (I don't remember any passage explaining how this was even possible for the federal government---could it really have been ignorance of creditors?). This all changed under the second constitution which traded single states' taxing powers for a bail-out by the federal government.
  2. Free-rider problems exist for subordinate governemnts vis-à-vis a central government, which amounts to the classic problem of how to make several parties pay for a public good (for example such a "Glorious Cause" as national independence). This problem was closely connected to the low 'bargaining power' of every single state in trade relations with Great Britain: No state could afford to increase tariffs and the like (the main source of tax revenues at the time) because it would have only benefited the neighboring states. In effect, tax competition made paying war debts on a state level almost impossible.
  3. Good reputations can be costly to acquire. While the federal bail-out of the American states at the end of the 18th century created a strong reputation for some decades, a different kind of reputation was generated in the mid-19th century: When another federal bailout was discussed, opponents prevailed, exchanging the USAs standing on capital markets (which was now demolished) for a strong reputation of the federal government vis-à-vis state governments (that introduced balanced-budget rules soon after).
There is more in the article: Two additional lessons (It can help to sustain distinct reputations with different parties and Confused monetary-fiscal coordination creates costly uncertainties). Some math, 80% of which seems a little out of place, but I guess it wouldn't be considered a 'real Sargent' if the paper didn't contain at least a few formulae. And finally, some very nice quotes:
  • On economic theory (p. 8, italics added): "For the purpose of (...) buyers and sellers, it is enough to have a good-fitting statistical model (...) But for other purposes, a statistical model alone is inadequate. (...) Economic theory goes deeper by analyzing contending economic and political forces that actually produce a statistical regime."
  • Directly following, but worth a separate mention: "In economic theory, an agent is a constrained optimization problem. A model consists of a collection of constrained optimization problems. Theories of general equilibrium, games, and macroeconomics acquire power by deploying an equilibrium concept whose role is to organize disparate choice problems by casting them within a coherent environment."
  • A joke at the expense of Milton Friedman (footnote 18).
  • "Prejucides help because data are limited." (footnote 20)
What it didn't do was go into much (i.e. only some) detail about "Europe now", which is what you'd clearly expect from the title. Just strike that out, enjoy the rest, and possibly have a look at another historical article by Sargent (co-authored by Francois Velde (1995): "Macroeconomic Features of the French Revolution", Journal of Political Economy, 103 (3), 474-518) if you're interested.