Friday, February 3, 2012

Sargent on debt and defaults

Tom Sargent's Wall Street Journal oped is well worth reading closely. It's a very short summary of his Nobel prize speech

As readers of this blog will probably know, I think Europe should stop bailing out bondholders of Greek and other debt. (See the Euro collection and Euro tags to the right.)

"What about Alexander Hamilton?" has always been a nagging doubt.

Hamilton famously brokered the deal by which the Federal Government assumed state debts. By doing so, he created a group of citizens with a strong interest in the success of the Federal Government. But it was a bailout of the states; it was a bailout of their creditors, many who had bought up debts cheaply. It was explicitly a case of greater "fiscal union."  Perhaps this is Europe's Hamilton moment?

As Tom points out, there are some important differences. The states had borrowed money to fight the revolutionary war, not to import Porsches or build cozy crony economies and fat welfare states. U.S. Taxation was low everywhere. Even the new Federal taxes were only tariffs, amounting to 2% of GDP, not 50% and up taxation in the Eurozone.  The Federal debt ("Eurobonds") was backed by directly levied Federal taxes, not by voluntary contributions or even by remittances from member states. And those direct taxes were to be legislated by a directly-elected legislature, not Brussels technocrats.

Tom points to a second episode: the state defaults of the 1830s and 1840s. Here, many states had borrowed a lot to finance infrastructure projects ("canals to nowhere?") that were not generating enough revenue to pay back the debt. 

Reputation, pre-commitment and moral hazard are big in Tom's thinking and his account of the sophisticated thinking of our ancestors. The US chose to pay off its revolutionary war debt, according to Tom, to enhance its reputation and credibility as a serious nation and future borrower. But this decision led to moral hazard: states and their creditors believed the US would always bail them out. The US chose not to bail out the states (really, their creditors) the second time around. It suffered a financial crisis as a result, but put state overborrowing and default off the table for a hundred and fifty years.  (When Tom talks about reputation and pre-commitment, he's not blowing smoke; he understands the equations.)

This second episode strikes Tom as a better antecedent to the Eurozone. Let Greece and the others default precisely to save the euro and European union.  Now is the time to clarify that the no-bailout clause is real, and that the euro will not be inflated. A crisis is the price of not having been clear about that moral hazard up front. But the union project is too important to abandon.

There are lots more  little gems in Tom's paper. The interaction of monetary and fiscal policy is one; the fact that framers spent all their time on fiscal policy, and money was, as in the constitution, considered just part of the definition of weights and units.

This post is a bit interpretive, and I'm sure I put some words in Tom's mouth here and there. He's always scholarly, informative and precise. If so, well, there's no substitute for the original. 

Important Note: The comments section is running off the rails. Please be polite and stay on topic. You're welcome to disagree, or point out flaws in my arguments or facts -- actually I like that, as I learn something. But if you want to spew venom, go back to Krugman and DeLong's blogs. I'm going to turn off comments if this doesn't end asap.