Morningstar Advisor - April/May 2012 - (Page 50)

Morningstar Conversation inflationary effects of what the Fed is doing. In one of your best-known papers, “Some Unpleasant Monetarist Arithmetic,” with Neil Wallace, you talk about the interplay between monetary and fiscal policy and how inflation is actually determined by both. Thomas Sargent: Yes. There’s a fiction—it may And when you’re in a fiat money system, it’s no longer true that the government budget has to be balanced in the present value sense—just with explicit taxes covering the deficit—because the Federal Reserve can raise revenues by printing money. When it prints too much money, we get inflation, but nevertheless it raises revenues. It’s an additional source. It’s as old as the hills. You print money. And now the control of that is supposedly under the Fed. So is the Fed really independent? The answer is, if you take the government budget constraint out, it can’t be. The reason is because now what you get is government debt backed by, well, not only the present value of explicit taxes, but also the present value of the inflation tax. And it’s gotten worse in the recent years, after the crisis. Additional powers were given to the Federal Reserve, which were basically fiscal powers. It’s an immense power. The Fed now has the ability to pay interest on reserves to banks. You have to ask, how are we going to finance those payments of interest on reserves? Ultimately, it’s going to be tax collections. Torralba: Mechanically, if you look at the equation that describes the inter-temporal change of sovereign debt, there’s essentially four ways that a country can reduce or increase its debt. It can reduce its deficit, it can increase growth, it can have inflation, or it can reduce its debt by defaulting. Sargent: Yes, and there’s one more. You can What that means is, if you actually go look at the promises that have been made— meaning the status quo legislation—Medicare is on a path, Social Security is on a path. Well, those programs are unsustainable. But what that’s telling you is that they’re not credible, because the government budget constraint is going to make them credible. They’re going to balance. Government budgets balance. So what that means is that some of those promises are going to be broken. This is the macroeconomics of broken promises. And everyone knows that. But this is actually creating uncertainty, because to reach the resolution, what is going to give? Are expenditures going to come down? Which ones? Are entitlements going to come down? Entitlements to whom? Are taxes going to go up? If so, which taxes? There’s going to be winners and losers. I’m absolutely sure that either taxes are going to go up or expenditures are going to go down, or some combination. One way taxes can go up is defaults. That’s taxing somebody who’s holding your debt. Torralba: Would you then rule out inflation? Sargent: No, I wouldn’t rule out inflation. Inflation is a thief in the night. And one thing it avoids is the courts. There’s no recourse. But it creates winners and losers—massive winners and losers. It’s a sneaky redistribution. be a useful fiction, but nevertheless economically it’s a fiction—that we have an independent monetary authority, an independent Fed, and that we have an independent fiscal authority, which is the Congress and the president. But the facts are that Congress and the president determine taxes and government expenditures—or they determine the laws that determine those. Some government expenditures and some taxes depend on the state of the economy. But given that taxes and expenditures are set by the Congress and the president and that taxes and expenditures don’t have to be equal, government expenditures can exceed taxes. What happens then is that the government borrows. Say we were on a gold standard, which means that we did not have a monetary authority and we were basically using a foreign currency. The government budget, while it could be unbalanced in a given year, then would have to be balanced in the present value sense. The reason is, when we floated bonds, the bondholders would want some insurance that they were going to be paid. The only way they can be paid is if the government runs surpluses in the future and uses the surplus to pay off the bonds. But we’re not on a gold standard. We’re on a fiat money standard. And when you’re on a fiat money standard, what determines the value of this un-backed piece of paper? It’s the implicit promise of the people who print the paper that they’re not going to print too much. So what’s been done in the United States is management of the stock of money has been handed to an “independent agency”—the Federal Reserve— that, roughly speaking, determines how much un-backed currency is printed up. have an angel like Germany bail you out. Torralba: Yes (laughter). Going forward, then, I think many people are worried about the explosive path on which U.S. debt is. Considering the political constraints that we have, what is the optimal solution, and what solution do you think we’ll actually get? Sargent: I’m going to paraphrase the situation. It’s actually one of my pet peeves. You’ll hear the phrase “U.S. fiscal policy is unsustainable.” You know, we can’t be too insular. There are lots of examples, and we don’t even have to leave our hemisphere. In Latin America, there’s been country after country that has had explosive debt paths, and they have had inflation—Brazil, Argentina. A Force for Inflation Torralba: We are in a situation of slow growth. Short-term interest rates are essentially zero and Congress seems not to be too willing 50 Morningstar Advisor April/May 2012

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2012

Morningstar Advisor - April/May 2012
Contents
Contributors
Letter From the Editor
We’re Too Smart
How Do You Use Alternatives?
Taking the Lead
How to Find Economic Moats
The Beauty of Currencies
No Clarity on Bonds
Four Picks for the Present
Investment Briefs
Performance Chasing, Evaluated
Technology’s Slim Pickings
How Much Is Enough?
The Fear Bubble
Three Traits of a Successful Long-Short Equity Manager
Why Absolute-Return Funds Fail to Deliver
An Economist’s Response to Crises
Undiscovered in Plain Sight
Untangling ETF Tax- Efficiency Myths
Central Banks Driving the Gold Rush
U.S. Industrials Could Add Some Magic to Europe-Weary Portfolios
No-Hesitation Allocation Funds
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Greatest Story Ever Told

Morningstar Advisor - April/May 2012