The eurozone’s ‘ambiguous’ architecture

“That’s not something you’re supposed to say in public, right?” In his humble way, Thomas Sargent, Nobel Prize winner in Economics, tries to avoid the question posed to him by Kathimerini regarding his surprise that the Greek bank run has not gone further. “My guess is that people still think that Europe will continue to lend its support.”

As he explains, the institutional architecture of the eurozone was characterized from the start by a “high degree of ambiguity,” so much so that it is unclear if it is a currency union where each member is exclusively responsible for its debts or whether there is some degree of debt mutualization.

“The bond markets until 2009 thought that the second version was the case. Since then, they have been going back and forth between the two versions,” says Sargent, adding that things are further complicated by high-stakes bluffs, like Mario Draghi’s claim in 2012 that we would do “whatever it takes” to save the euro.

Everything, in other words, boils down to expectations – a subject into which Sargent has delved perhaps deeper than anyone else.

This is the man who built the empirical groundwork for the spread of the rational expectations revolution. He did this in the 1970s, when stagflation was undermining the reputation for practical effectiveness that Keynesian economics had previously enjoyed. In those years, Sargent was among the key economists chipping away at the theoretical foundations of Keynesianism, by promoting the controversial policy ineffectiveness theorem: the idea that the rational expectations of economic agents about the consequences of economic policy neutralize the government’s ability to manage the level of economic activity.

Test of time

Today, 40 years and many trials and tribulations later, how well does the rational expectations theory stand up?

“It has stood up extremely well,” he replies. “It is used throughout finance, throughout policy analysis, in models that explain bubbles and the causality of financial crises, in the explanation of how deposit insurance works. It is basically a theory about how the beliefs of economic agents adjust to the system – it assumes they understand it – and it has proven to be a very powerful method to understand reality.”

How does he respond to criticism that rational expectations presuppose too much rationality and overly sophisticated forecasting abilities in the economic behavior of ordinary people? “We do use some math. So does physics. It doesn’t mean that the molecules understand that math.” He mentions, however that, along with some colleagues, he is currently developing a new model – again using advanced mathematics – which attempts to incorporate the spirit of the criticisms relating to the inability to predict the future.

Speaking of predictions, we ask him how satisfied he is with the sense of urgency with which economists warned of the 2007-8 crisis.

“The charge that we failed to predict the crisis is based on ignorance,” he says bluntly. “There were many analyses in the literature of the condition that would lead to an outbreak of a financial crisis. And after 2008, there was a lot more work in that direction.”

In the years of euphoria, however, were these models that warned of what was coming reaching top policymakers? In his response, he refers to “Fragile by Design,” the “very fine” book by Charles Calomiris and Stephen Haber: “They explain that there were interests that were benefitting from some of these practices that exposed society to dangers.”

A core theme of the book, the New York University professor tells Kathimerini, is “the idea that the combination of deposit insurance and government bailouts have given incentives to banks to become as big and as risky as possible. This is because the money they are risking, ultimately, belongs to the taxpayers.” As he points out, unfortunately “not enough has been done to change the institutional framework” that created these warped incentives.

One subject that fascinates Sargent is the search for the right model for spotting bubbles in the economy. He refers to the theory of Jose Scheinkman of Princeton University, according to which extensive short-selling can lead to a market correction before a bubble gets out of hand. In this way, he says, the “pessimists check the optimists.”


Among the many issues that the 71-year-old economist has grappled with is the comparison of unemployment rates in the United States and Europe. Unemployment in Europe was consistently lower than in the US until about 1970 and has been consistently higher since 1980. Sargent, along with Lars Ljungqvist, is one of the primary exponents of the theory that attributes the divergence since 1980 to the more generous safety net that exists in Europe, which dampens the incentive to look for a new job. Yet as he tells Kathimerini, Paul Krugman had observed that the welfare state was stronger in Europe even before 1970 – so that cannot be the explanation.

Sargent’s answer is based on a factor he calls “turbulence,” which is tied with the spread of globalization. As he explains, since 1980, as the outsourcing of manufacturing to developing economies gathered pace, the cost of losing a job increased significantly in the West. “The result was that in Europe, where unemployment benefits are long-term and generally high, many workers – especially those close to retirement age – chose to move permanently from the world of work to the structures of the welfare state. This is something [former German Chancellor] Gerhard Schroeder understood. His reforms were geared toward tackling this problem.”

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