How can policy changes affect an economy?

Tom Sargent was, alongside Nobel Laureate Robert Lucas, a leading figure of the rational expectations revolution in the 1970s, testing rational expectations against real-world data and pointing out how expansionary policies of fiscal and monetary institutions will not, in the long run, influence output or unemployment. Today, he remains not only one of the most cited economists, but ranks among the most popular professors with students. Though he has a successful academic career to look back on, he is still eager to learn new things – computer languages, for example.

Thomas J. Sargent

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (shared), 2011

At a glance

Born: 1943, Pasadena, USA

Field: Macroeconomics

Prize-winning work: Empirical research on cause and effect in the macroeconomy

Late bloomer: Was behind in math in graduate school (but eventually caught up)

On turning grey: Says he’s in denial but seems fitter than most people over 70

Motto: “We’re lucky we’re given a day. I say take it one day at a time.”

A quiet place to think

In the snowy mountains of Montana, 320 miles from Salt Lake City, lies the little town of West Yellowstone with a population of just over 1,000 people. During summer months, it’s full of tourists visiting the national park of the same name. At this time of year, with all the wooden houses covered in snow, it feels like the quietest place in the whole world.

Thomas Sargent wears snow boots with a suit and red tie for the occasion. Next to an unlit fireplace he explains how much he enjoys his condo outside of town, the nature and especially fly fishing, a popular sport in the area (and the reason why fellow Nobel Laureate Angus Deaton often visits too).

It’s an unlikely location to interview a Nobel economist, quite different from dusty offices, but it is the perfect place to tell a good story. Which is exactly what Sargent is about to do.

What do astrophysics and economics have in common?

The Nobel Laureate of 2011 likes to use examples from the past to illustrate his point. When asked about his Nobel work, he mentions the great physicist Richard Feynman and explains why economics is like a game of chess before taking us back to the 16th century. “It’s a beautiful analogy,” Sargent begins, referring to Nicolaus Copernicus and later Johannes Kepler who were working on the laws of planetary motion at a time when people still believed that the earth was the center of the universe. Sargent explains how Kepler put his many observations into mathematical equations. “It was pattern recognition,” he says. It’s similar to the work of an economist today who work with huge amounts of data in order to select patterns. “You’re very agnostic and don’t try to have a prejudice at that point. Much of one.”

But the most challenging task is to turn a non-causal model into a causal one. For astrophysics, it took 60 years before Isaac Newton used Kepler’s work as a basis and established a causal model. “That’s the gold standard,” Sargent says. “You can teach a machine to do what Kepler did. But you need something else to do what Newton did.”

The friends and foes of fiscal authorities 

It’s quite similar to what Sargent and his co-workers did when they developed a method for interpreting patterns. Their work was not concerned with planetary motion but with fiscal and monetary authorities and their influence on economic variables such as GDP, inflation, employment and investment. Sargent established methods to analyze causal relationships concentrating not on the effect of unexpected events, as his fellow Laureate Christopher Sims was, but on temporary and long-term policy changes.

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What’s the real impact of monetary and fiscal policy?

Sargent emphasizes the legitimate power the government has in certain areas including taxation and social security systems. How much money does the government take in and from whom? How does it spend money and for what? “If you’re like the United States now, we spend more than we tax. And it’s going to get worse,” says Sargent, alluding to controversies around the US tax reform of 2018.

“Fiscal policy has a huge ability to affect an economy but the central bank is a sideshow,” Sargent says smiling. “This is not what you hear in the news, but to a first approximation, it’s a place to start. In the long run, it can affect the price level under certain circumstances but it can only have temporary effects on interest rates.”

Citing the famous Milton Friedman, Sargent argues that expansionary policies of monetary authorities can’t affect unemployment. “This is largely decided elsewhere,” he explains and mentions the work of his colleagues Peter Diamond and Christopher Pissarides, both Nobel Laureates awarded for their theories on matchmaking in labor markets. “If you ask what determines whether you have a job or not, the central bank would be way down the list. All it can do is open market operations. Its assets are government bonds and its liabilities are money.”

The economist acknowledges that the strict separation between fiscal and monetary policy is a theoretical one, and he remembers times in history when it broke down like the German hyperinflation of the early 1920s or the current crisis in Venezuela. “They’re taxing people who are trusting the government holding its currency,” Sargent says.

How should we structure welfare programs?

Sargent has also been studying unemployment outcomes in both the United States and Europe. He focused on the design of welfare systems and the duration of unemployment compensation programs. Within this area, he examined the depreciation of human capital as a consequence of long-term unemployment.

“Welfare programs can trap you into having it in your own best interest to stay on government benefits,” he points out. It’s similar to what he said when addressing the audience at the Nobel banquet in Stockholm in 2011. “People respond to incentives, including the people you want to help.” Replacement rates and duration of payments are the crucial factors of compensation programs. Sargent illustrates how many European countries, after World War II, would gradually decide to set up systems in which a huge percentage of the last wage was paid, for an infinite amount of time.

Those systems were doomed to break down with the rise of globalization and increasing competition from abroad. It’s similar to any new major technological change, Sargent argues. “Your skills are wiped out. But if your unemployment compensation is linked to your last wage and now you have skills that are much less valuable, you get offers for wages less than your compensation.” Why would you agree to that? “You’re in a trap,” Sargent concludes. “And your skills will deteriorate further.”

The importance of retraining

He points out that there are various ways governments could use their money more wisely when it comes to compensation systems. For example, instead of giving a flat rate and then cutting people off, they could set an amount that depends on how long someone has been unemployed for. “It turns out that gives you the incentive to look hard early.” There are several countries working on a different approach to their welfare systems – to help people, not lead them into a trap.

Since there remain a lot of people who were once high skilled but have become “wards of the state” due to technological developments, Sargent also emphasizes the importance of retraining programs. Whether it’s outside or inside the job, “You need to think about this stuff.”

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How to stay flexible in a changing world

Especially when it’s hard to predict which ways technologies will go, Sargent feels that it’s extremely important to stay flexible and keep learning, even as you age. To him, the key ingredient is to be interested and enthusiastic. “That’s what counts,” he says. He explains that he was very good at using what is now an old obsolete computer, and that he was a specialist on economic models no one is referring to anymore. But it doesn’t bother him. Despite his age, he has learned some new computer languages fairly recently to keep himself feeling agile.

Today, he’s spending some of his time in Shenzhen and Beijing, figuring out new ways to use statistics to learn more about the Chinese economy. It’s fun for him to be in China. “They’re very eager to exploit technological developments. They train a lot of engineers and scientists and they’re very ambitious.” His continued motivation makes him living proof of the value behind his argument.

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Obstacles young people face when entering the job market

Though Sargent clearly believes that everyone has his or her own part in having a chance to succeed, he also explains that policy reforms are highly important. In the past, he has used computer models to tackle labor market problems. In his mind, there are two harmful features, especially to young people: job protection and minimum wages.

“A minimum wage really hurts young people who are just getting in the market,” argues Sargent. To him, it’s evident that you learn various skills when being new on a job. Therefore, accepting a low wage can be an entry to something bigger and better in the long run. Though they may help some people, “High minimum wages cut that off,” he says. The Nobel Laureate believes that it decreases the flexibility needed for a modern, vibrant economy. “You’ve got to let entry and exit go on.”

The magic in math

When talking to Sargent, you get the impression that he must be a wonderful teacher. He is good at explaining without overcomplicating things, he makes a joke from time to time, and he has a calm and comforting way of talking. At one point, he remembers how he dreamed of starting his own high school that was very different from other institutions. “I taught at a university in Korea. They make students work way too much. If I were in their shoes, it would destroy my interest in anything. You’re supposed to be having fun. I’m not talking about having fun doing drugs or drinking,” he laughs. “I’m talking about having fun looking at the beauty of physics.” He pauses for a moment and adds, “Or having fun realizing that some stupid little mathematical equation, which you are able to understand, can actually explain how the planets are going around the sun. That’s magic.”

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