Clear thinking about economic policy

By Thomas Cooley, Paganelli-Bull Professor of Economics & David Backus, Heinz Riehl Professor of Finance and Economics and Chair of the Department of Economics

Thomas Sargent and Christopher Sims gave us a coherent framework with which to think about and discuss these critical policy issues. And they fully anticipated the difficult dilemmas we now face as a consequence of recent fiscal policy.

November 9, 2011

For some, the fiscal problems in the US and Europe are a case of bad politics getting in the way of good economics. This column argues that there was plenty of bad economics as well. It looks at the work of the two recent Nobel Laureates in offering some clear thinking.

The US and the EU, the most powerful economic areas in the world, are bedevilled by seemingly intractable fiscal problems. Their problems stem from a variety of sources; inconsistent promises of low taxes and high benefits, creative accounting, and financial bailouts have all contributed to mounting government debts, with no end in sight. Although politicians on both sides of the Atlantic prefer delay to action, the logic of the situation is inescapable – over some horizon, government spending and government revenue must match.

This year’s Nobel Prize in economics went to two economists who years ago laid out the bracing logic of government finance. Thomas Sargent is famous among economists for many things, but among them is “Some Unpleasant Monetarist Arithmetic,” a paper he wrote with Neil Wallace in 1981. His distinguished Nobel partner Christopher Sims is known partly for a 1994 paper “A Fiscal Theory of The Price Level” that connected the price level to fiscal policy. Both papers focus on the government budget constraint – the unavoidable connection between deficits, debt, and inflation.

Read full article as published on VoxEU.org.