It must be a twist of fate that the mentioned method of finance “we” never want to face with again is cited as the savior of Europe.

This year’s Nobel Prize in Economics was shared by Christopher Sims and Thomas Sargent. The Award Committee explained the justification for this decision with a forty-page report that discussed the contributions of Sims and Sargent. I think that it will be useful for graduate economics students and undergraduate students that take advance macroeconomics courses to access and read the report online. Page eight of this report addresses the significance of Sargent’s studies in terms of economic policy. One of the studies addressed was cited at this column several times: "Some Unpleasant Monetarist Arithmetic”, coauthored with Wallace. The study quoted several times at this column, the reason for which will become clearer at the end of this commentary, was published in the academic journal of the Federal Reserve Bank of Minneapolis in 1981. The title refers to a scenario like this:

In a country which implements a loose fiscal policy, the central bank cannot say, “I will take my way. No one can turn me away from tight monetary policy.” The study can be summarized as follows: Assume that a government has been implementing a loose fiscal policy for a considerable period and thus the level of public debt is noticeably high. Therefore, investors will demand an increasingly higher interest rate for purchasing the newly-issued state bonds. In that case, the real interest rate (interest rate minus inflation rate) the state pays for its debt will be significantly above the rate of economic growth. Under these circumstances, the real debt of the state will rise continuously unless the loose fiscal policy is reversed. At some point, the state will have only two options: it will either say “I declare default” or call the central bank, “Enough with your independence and tight monetary policy. I am going default. You should issue money so that I can pay my debt”. If it goes with the second option appears the “unpleasant monetarist arithmetic”. The central bank trying to fight with inflation in the face of loose fiscal policy and the absence of any signal for reversal is forced to issue money after some point, eventually causing the inflation rate to reach higher than the initial level it aimed to lower.

That’s not the whole story: If the residents of that country notice that things are not on track, demand for state bonds halts earlier than expected; so does the issuance of money and the hike of inflation rate. Don’t you think this partially resembles the recent developments in Europe? After all, everyone will eventually expect the European Central Bank (ECB) to bail banks out. The ECB, however, does not seem that it wants to join the game. What arouses curiosity is when exactly the ECB will fully join the game. I said that the study “partially” resembles the European case; because no one thinks that the ECB’s issuing money at large amounts will inflame inflation, at least for now. On the other hand, it is evident that the recent developments are about to downgrade Europe into a typical emerging market economy of the 1990s. What were we used discuss in Turkey and in the Latin American countries in the 1990s? High public debt, resultant finance requirement fulfilled via central banks and harmful circumstances of such practices. It must be a twist of fate that the mentioned method of finance “we” never want to face again is cited as the savior of Europe. Let’s wait and see what else the planet will face!

This commentary was published in Radikal daily on 22.10.2011