Rewarding those who are culpable

I didn’t comment earlier this week on the recent decision to award the (not)Nobel Prize in Economics to Thomas Sargent. My thoughts were otherwise occupied but it is worth recording that Sargent has been at the centre of the mainstream macroeconomics literature which has been used to justify the claims that government fiscal interventions are ultimately futile and only generate accelerating inflation. His ideas helped my profession to claim authority in its campaign to pressure governments in deregulation, privatisation, inflation targetting and abandoning full employment as a primary policy target. The upshot has been three decades of policy development which really laid the foundations of the current crisis. If Sargent and his cohort had not been so influential the world economy might not have been in the mess that it finds itself in. And … millions might still have their life savings and be gainfully employed. The so-called Nobel Prize in Economics continues to reward those who are culpable.

I covered the event last year – Nobel prize – hardly noble – and noted that the award had nothing to do with Alfred Nobel’s will which wanted prestige to be bestowed on “shall have conferred the greatest benefit on mankind”. Instead, the economic prize was established in 1968 by the ultra-conservative Swedish central bank and the prize is awarded by the Royal Swedish Academy of Sciences.

There is a good critique of Sargent’s selection by John Cassidy in his New Yorker article (October 12, 2011) – A Nobel for Freshwater Economics. He said:

This week’s announcement of the Nobel Prize in Economics got me thinking about the state of the subject, and my thoughts weren’t very positive. Three years after the great financial crisis of 2008 discredited the ruling orthodoxy in macroeconomics and finance, the Royal Swedish Academy of Sciences has chosen to honor one of the leading creators of that orthodoxy: Tom Sargent, of New York University. And judging from the reactions to the Nobel announcement, most academic economists heartily approved of it.

The “prize” is just an insider’s club where they share the plaudits between themselves (them = mainstream economists) without regard to how the person’s work has contributed to humanity (“mankind” in Nobel’s terms).

As John Cassidy points out, Sargent has certainly been “influential” – in that he was among the group of economists in the 1970s who really pushed the neo-liberal thinking along via his work on “rational expectations”.

Please read my blog – The myth of rational expectations – for more discussion on this point.

In brief, rational expectations (or “ratex”) evolved in the late 1970s and claimed that government policy attempts to stimulate aggregate demand would be ineffective in real terms but highly inflationary. People are alleged to anticipate everything the central bank or the fiscal authority is going to do and render it neutral in real terms (that is, policy changes do not have any real effects). But expansionary attempts will lead to accelerating inflation because agents predict this as an outcome of the policy and build it into their own contracts.

In other words, they cannot increase real output with monetary stimulus but always cause inflation. Please read my blog – Central bank independence – another faux agenda – for more discussion on this point.

The idea is that everyone understands the Quantity Theory of Money (QTM) which in symbols is written as MV = PQ. This means that the money stock (M) times the turnover per period (V) is equal to the price level (P) times real output (Q). The mainstream assume that V is fixed (despite empirically it moving all over the place) and claim that Q is always at full employment as a result of free market adjustments.

So this theory denies the existence of involuntary unemployment. The more reasonable mainstream economists admit that short-run deviations in the predictions of the Quantity Theory of Money can occur but in the long-run all the frictions causing unemployment will disappear and the theory will apply.

Keynes demonstrated that Quantity Theory of Money could not be correct given that he observed price level changes independent of monetary supply movements (and vice versa) which changed his own perception of the way the monetary system operated.

Further, with high rates of capacity and labour underutilisation at various times (including now) one can hardly seriously maintain the view that Q is fixed. There is always scope for real adjustments (that is, increasing output) to match nominal growth in aggregate demand. So if increased credit became available and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will respond by increasing real output to maintain market share.

John Cassidy says that RATEX – the idea “that people form expectations about the future on the basis of an accurate model of the economy that they have in their head … isn’t very plausible” even though it became standard doctrine among the mainstream neo-liberals.

It went well beyond the plausible view that we attempt to take into account our feelings about the future. That was standard ground for Keynes, for example – that is what animal spirits is all about.

RATAX essentially added expectations to the QTM so that once there is an inflation, people are alleged to form the view (expect) that the inflation will continue and so they act on that presumption. But RATEX makes much stronger claims than that.

RATEX theory argued that it was only reasonable to assume that people act rationally and use all the information available to them. What information do they possess? Well RATEX theory claims that individuals essentially know the true economic model that is driving economic outcomes and make accurate predictions of these outcomes with white noise (random) errors only. The expected value of the errors is zero so on average the prediction is accurate.

Everyone is assumed to act in this way and have this capacity. So we all understand the QTM and understand that whenever the central bank expands the monetary base or the treasury increases the deficit there will be inflation.

So “pre-announced” policy expansions or contractions will have no effect on the real economy. For example, if the government announces it will be expanding the deficit and adding new high powered money, we will also assume immediately that it will be inflationary and will not alter our real demands or supply (so real outcomes remain fixed). Our response will be to simply increase the value of all nominal contracts and thus generate the inflation we predict via our expectations.

This approach was gathering speed when I was a graduate student in the early 1980s. The mainstream considered it closed the book on government aggregate demand intervention. I remember Sargent’s 1980 book on Macroeconomics being held out as the breakthrough text even though there was scant macroeconomics in it.

As John Cassidy says:

The Lucas, Sargent, and Wallace approach to economics wasn’t just about criticizing government interventionism. It came with its own methodology, which involved trying to build everything up from micro foundations with some snazzy new mathematics. (New to economists, that is.) This abstract approach, which is often referred to as “freshwater economics,” eventually came to dominate the teaching of macroeconomics, first in the United States and then in other countries, too. The students and acolytes of Lucas and Sargent took over many of the top professorships and journals. Eventually, it got to be difficult for young scholars to publish articles that challenged or ignored the Lucas-Sargent methodology.

RATEX became the centrepiece of the neo-liberal religion.

I was at a conference once as a young postgraduate student in the early 1980s at the height of the RATEX cult boom. Robert Lucas and Thomas Sargent were the new cult emperors and the teaching programs were based on the religious doctrine of RATEX. At one point the famous James Tobin made a point along the lines that if everybody is rational and has the same information as the government and understands the true “model” of the economy that the policy makers share then what use is the economics profession.

If we can get our forecasts from the postman or around our kitchen tables what can we learn by studying economics? Extending the logic of RATEX we would conclude that studying economics adds nothing to what we already know. Clearly as an “efficiency” measure (that is, applying their own definitions of wasted resources) we should sack all the mainstream economists in universities and central banks.

Why would we waste trees publishing economic papers if we already know understand the economy at an intricate level – down to the last $ allocated? Why would we pay economic forecasting agencies because RATEX says they are useless because we already know what they are going to produce?

Further, a Sargent’s RATEX co-founder, Robert Lucas himself abandoned the approach sometime later in his career as its logical and empirical shortcomings became obvious.

The first (difficult to understand) point is that there is no aggregate (macroeconomic) validity in the RATEX theory. This deserves another blog but relates to the insights provided by the Sonnenschein-Mantel-Debreu Theorem.

In simple terms, and extending the notion of the fallacy of composition where what happens at the individual level will not hold at the aggregate level, the Sonnenschein-Mantel-Debreu theorem tells us that even if all individuals are rational and make decisions according to RATEX the aggregate household will not exhibit the same rational behaviour. So there is no macroeconomic representation of the theory.

But then the behavioural economics literature has categorically shown that the RATEX conception of human decision making as rational and far-sighted is totally flawed.

It is clearly not sensible to believe that households and firms know very much about what drives economic outcomes. While my blog readership is probably more informed than most can any of you predict with white noise errors only what is going to happen in the next 12 months. Do you seriously believe that people use the myriad of financial and economic data to determine every spending decision they take.

Does anyone believe that households are always rational and perfectly informed about all current and future events? If you understand the RATEX theory then you will realise that to get the predicted results highly unrealistic assumptions like this had to be made. Once they were relaxed the results fail to hold. In other words, they don’t hold in any world we live in as humans.

John Cassidy said:

Unfortunately, in case it needs restating, freshwater economics turned out to be based on two ideas that aren’t true. The first (Fama) is that financial markets are efficient. The second (Lucas/Sargent/Wallace) is that the economy as a whole is a stable and self-correcting mechanism. The rational-expectations theorists didn’t refute Keynesianism: they assumed away the reason for its existence. Their models were based not just on rational expectations but on the additional assertion that markets clear more or less instantaneously. But were that true, there wouldn’t be any such thing as involuntary unemployment, or any need for counter-cyclical monetary policy.

The reality when there are recessions the mainstream belief in the efficacy of the market and the ineffectiveness of government is shown to be nonsensical.

Only theoretical structures that recognise the central role that aggregate demand plays in determining real GDP and employment and the central role of fiscal policy in managing aggregate demand can credibly explain recessions – their incidence, duration and solution.

This point is worth reflecting on. Sargent was interviewed in 2010 by Art Rolnick, a former central bank colleague of his.

The interview is quite interesting for someone well-versed in the macroeconomics literature but will be somewhat opaque for the general reader. It is also a large file so if bandwidth is an issue I wouldn’t recommend reading it.

During that interview the following exchange occurred:

Rolnick: … that the faith in good outcomes always emerging from competitive markets is misplaced; that the assumption of “rational expectations” is wrong headed because it attributes too much knowledge and forecasting ability to people; that the modern macro mainstay “real business cycle model” is deficient because it ignores so many frictions and imperfections and is useless as a guide to policy for dealing with financial crises; that modern macroeconomics has either assumed away or short changed the analysis of unemployment; that the recent financial crisis took modern macro by surprise;

Sargent: OK. The criticism of real business cycle models and their close cousins, the so-called New Keynesian models, is misdirected and reflects a misunderstanding of the purpose for which those models were devised. These models were designed to describe aggregate economic fluctuations during normal times when markets can bring borrowers and lenders together in orderly ways, not during financial crises and market breakdowns.

Which was an extraordinary exchange.

John Cassidy said of Sargent’s perception of his own work:

… it is not as if Sargent has acknowledged its failings. In a 2010 interview with the Federal Reserve Bank of Minneapolis, he staunchly defended it, saying it was designed to explain how the economy works in normal times, not in times of crisis. But this won’t do, surely. The lesson of the 2008 financial crisis and subsequent recession is that in a modern financially driven economy, it is what happens in “normal times” that gives rise to instability.

That is a crucial point. In the 2010 interview, Sargent made a lot of the so-called “Great Moderation” – a period in the 1990s leading up to the crisis where mainstream macroeconomists concluded that the “business cycle was dead” and all governments had to do was focus on more deregulation at the microeconomic level – freeing up labour and financial markets.

Please read my blog – The Great Moderation myth – for more discussion on this point.

But what Sargent would call “normal” times were in fact the period when the groundwork which contributed to the crisis was being laid. The foundations of the crisis are to be found in the way in which governments reacted to the pressure being placed on them by the RATEX crew. Government policy making departments (treasuries, central banks etc) became infested with this way of thinking.

They started deregulating, privatising, distancing themselves from so-called “independent” central banks and allow the same to use unemployment as a policy tool rather than, as previously, a policy target.

They created the conditions where the real wage would lag behind productivity growth and thus allowed for a massive redistribution of real national income to profits.

They allowed the financial sector to grow out of control and appropriate the redistributed real income as gambling chips.

And the rest of it. What the mainstream economists were calling normal times were in fact the path to the devastating crisis the world is now enduring which has destroyed the wealth and aspirations of millions.

Sargent was at the centre of all that and now is being honoured by the “club”.

John Cassidy also provides a reminder of a nice blog by Willem Buiter in 2009 which I have referred to previously – The unfortunate uselessness of most ‘state of the art’ academic monetary economics. It is worth reading. He quotes the classic Buiter conclusion:

… the typical graduate macroeconomics and monetary economics training received at Anglo-American universities during the past 30 years or so, may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding. It was a privately and socially costly waste of time and other resources

While thinking about this, I recalled a speech Sargent gave to the graduation class at Berkeley (his alma mater) in 2007.

He introduced the Speech by stating that “Economics is organized common sense” and then listed 12 “valuable lessons that our beautiful subject teaches”. Some of these “lessons” relate to microeconomic matters and some to macroeconomics. For example, “lesson” 10 is:

When a government spends, its citizens eventually pay, either today or tomorrow, either through explicit taxes or implicit ones like inflation.

Which tells you that he considers a “lesson” to be a statement that misinforms those who are being “taught”. A sovereign government doesn’t tax to spend. It spends to tax.

Sargent’s statement is a direct reflection of his belief in the erroneous government budget constraint framework which misconstrues the way governments operate in the fiat monetary system.

It thinks that if the government net spends it has to either issue bonds or “print money”. The latter is inflationary so they prefer to issue bonds. The said bonds “have to be paid back” so ultimately taxes have to be raised to facilitate the repayment. If the government chooses at that point to “print money” to pay back the debt then inflation occurs and this undermines the nominal wealth of the citizens. So either way, “there is no free lunch”.

The problem with this “lesson” is that:

(a) governments do not “pay” back the debt in this way. They retire debt on maturity but rarely reduce the total volume of public debt. Further, when they pay back debt they just credit bank accounts in the same way as they spend generally.

(b) government spending is not revenue-constrained. The private sector cannot pay taxes unless the government spends unless they run down previous savings which are just an accumulation of past deficits anyway. There is no systematic correlation between past deficits and future taxation in any dataset I am familiar with.

(c) inflation does not arise if the central bank credits private bank accounts. It arises when nominal spending growth outstrips the capacity of the economy to produce real output. So governments could spend forever without creating inflation as long as the economy could keep responding in real terms. The underlying bias in Sargent’s claim is that the economy is at full employment more or less continuously and so any demand expansion triggers inflation. There is no systematic correlation between past deficits and future inflation in any dataset I am familiar with.

(d) government spending – if well targetted – increases the human capital endowment and public infrastructure which allow the future citizens to enjoy increased prosperity.

Sargent was rewarded for this sort of misinformation by his peers. Presumably by keeping the “prize” in the club they prevent comparisons with economists who are actually insightful and have advanced our understanding of the monetary system – comparisons which would contrast the intellectual poverty of the existing club members.


It was a week when the Wall Street Journal (Murdoch-owned) has brought credit to itself by creating an elaborate network where it buys its own newspaper to boost circulation so it can increase advertising revenue – Guardian story.

It was also a week when another one of the culpable was rewarded for his culpability. At least the WSJ scandal claimed the job of one of Murdoch’s senior European managers.

Saturday Quiz

The Saturday Quiz will be back sometime tomorrow – even harder than last week!

That is enough for today!

This Post Has 9 Comments

  1. Rationality (‘utility-maximising rationality with respect to your own best interests’) is also computationally impossible.

    It requires you to solve precisely a combinatoric equation will millions and millions of combinations always choosing the right one for just a choice amongst 100 goods. There are at least 10,000 in the average supermarket.

    What people really do is make a satisfactory decision in a finite time. Once again neo-classical economists forget to take into account the most valuable and finite thing each of us have – time.

  2. Thank you, thank you, thank you… I read the New Yorker article, but your insights are deeply appreciated. I enjoy going back through the (referenced) older material written prior to my subscribing to your site. Cheers.

  3. I understand that they are different prizes, but if Obumer can get the Nobel Peace Price why shouldn’t Sargent get a Nobel prize in economics?
    Now, I have another question. I understand that in the long run the government should have a budget deficit because public spending is the inverse of private savings, but over the past thirty years capital has benefited over labor in almost every way including taxes. My question is if those actions were reversed (taxes moved back to fictitious capital,etc.) causing money to move away from the top where most of it is roaming the world looking for better returns and back to labor where it would be spend, couldn’t there be a period of balanced budgets and the economy still grow? In other words, aren’t you saying in your article that the real problem with the economy is that the policies of the past few decades are caused by the budget deficits going to the wrong class? For example, I understand that Bush II’s tax cuts to the rich didn’t grow the economy and the only way the economy grew during his term, and maybe most of Clinton’s, is because of the fraud perpetrated by the banks.

  4. harder than last week? I only got one right. On the upside though I was offered a job in the UK treasury on the strength of that result!

  5. I read “The Prize in Economic Sciences is not a Nobel Prize. In 1968, Sveriges Riksbank (Sweden’s central bank) instituted “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel”, and it has since been awarded by the Royal Swedish Academy of Sciences, Stockholm” at

  6. Bill,

    Thanks for pointing us to Cassidy’s piece.

    Here is the view from the local horse’s…mouth, gloating in today’s local paper.

    The paragragh (in which Chari notes the …”serene confidence” these “founders of modern macroeconomics”… had in their “intrepid” selves) unwittingly and exactly captures the prevailing tone throughout the ascension of the RatEx paradigm. When you and Randy Wray win your richly deserved Nobel, this can serve as a reminder for you to take your anti-arrogance pills.

  7. Keynes demonstrated that Quantity Theory of Money could not be correct given that he observed price level changes independent of monetary supply movements (and vice versa) which changed his own perception of the way the monetary system operated.

    Is the QTM not correct or just useless because the velocity is unknown?

    There is no systematic correlation between past deficits and future inflation in any dataset I am familiar with.

    The lack of correlation could be attributed to the borrowing matching the deficits, so this would be consistent with the quasi-monetarist view for instance.

    The RatEx theory might be a fantasy, but that does not mean expectations don’t play an important role wrt inflation, exchange rates, etc. MMT seems to ignore any effects expectations might have. Is there any blog where this issue is addressed?

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