An excerpt from a piece Tom Cooley and I wrote connecting the work of Sargent and Sims to government budget problems in the US and Europe:
These classic academic papers [by Sargent and Sims] address, in different ways, the underlying logic of the [government budget] problems we face right now [in the US and Europe]. Governments finance their deficits by collecting taxes and borrowing. Their borrowing works because there’s an implicit promise to pay back principal and interest. If the magnitude of the debt calls this promise into question, something must give. Basic accounting tells us we will see some combination of lower spending, higher revenue, or – somehow – lower debt. In some cases, thankfully rare, governments reduce their debt through default, as Argentina did in 2002 and as Greece is contemplating today. In other cases, inflation reduces the real value of the debt. In still others, the government runs primary surpluses and the economy grows, making the debt more manageable. The budget constraint doesn’t tell us which of these things will happen, only that one of them must. Pension and healthcare obligations may not be honoured, taxes may be raised or inflation may increase, taxing consumers and debt holders indirectly. None of them are politically popular, but if governments don’t take action, history tells us that action will be imposed on them. Sargent’s study of hyperinflation in interwar Europe offers compelling reading on the consequences of government indecision.
Posted by David Backus