The Unassuming Economist

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

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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.

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

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.

In a seminar at the IMF, Tom Sargent said that when he was in graduate school at Harvard in the 1960s, low European unemployment rates “were viewed as a great success and envied” by Americans. John Kennedy’s May 1961 speech to the U.S. Congress, famous today for its rhetoric about the space race (“this nation should commit itself to . . . launching a man on the moon and returning him safely to earth”), was in fact concerned largely with matters much closer to home. First and foremost on the U.S. president’s mind was his country’s high unemployment: “Large-scale unemployment during a recession is bad enough, but large-scale unemployment during a period of prosperity would be intolerable.” The 1970’s and 1980’s, however, saw a reversal in fortunes as European unemployment rates shot up dramatically. Sargent’s seminar examined why this reversal in fortunes came about. Today, as fears are being expressed about America’s labor market becoming Euro-scelerotic, Sargent’s work on unemployment remains highly relevant. 

The 40% prediction was made in a talk at the IMF in September 2010. Below is what he said a few days ago for the current scenario and few years back: