I have to admit that when I first heard about and read John Cochrane’s book, about the fiscal theory of the price level, I didn’t exactly get it, and wasn’t ready to accept it. For years as I have covered the Fed’s monetary policy’s twists and turns, and prior to the pandemic-driven inflation surge I don’t think I ever heard a Fed chair mention it in a post-meeting presser, for example. The narrative has been that the Fed controls inflation by interest rates an wards off recession with rate cuts.
The discussion of fiscal forces only seemed to come into focus when inflation started surging in 2021 and massive fiscal stimulus finally made people wonder if maybe it was more than supply shocks at play. The $5T of government money that poured into the economy seemed to also be at work.
Enter John Cochrane and his book, which he says has ”the simplification that hindsight brings.”
Here are highlights of this educational, interesting, thought-provoking interview.
John's gambit in describing fistula theory in a nut shell is this:
"Just like a stock is worthwhile because people think they'll get dividends. When people lose that faith that the debt will get paid back. They all try to get rid of the government debt. The only way we can do that is to buy stuff with it, and so we get inflation. The same way, if you learn that a stock won't make profits, won't be paying dividends, you try to get rid of it."
Where inflation comes from...
"everybody agrees inflation comes from too much money chasing not enough goods, but too much money relative to what? Okay. And fiscal theory emphasizes that if there's too much money out there, the easiest way what the government can do is soak the money up with taxes greater than spending. Spending puts money out, taxes bring money in, or they can soak it up by selling bonds. But for the bonds to be worth anything, people have to expect taxes in the future to pay the bonds back. Okay, so it's too much money relative to what people think the government can soak up with taxes is the central feature of money now."
and Monetary policy matters!
"Fiscal theory...does not say that there's no Federal Reserve and interest rates don't matter and none of that state or all that matters is fiscal policy. Absolutely not. The Fed is very important as part of the fiscal theory and the Fed setting interest rates is a very important determinant of inflation."
and debt really matters
"it's pretty obvious that dumping that much money on the economy is going to cause inflation. That much money financing a deficit. Mm hmm. Because we had just tried that much money in quantitative easing, it didn't make any difference at all. But that much money financing a deficit...."
Leveraged spending causes inflation
" I think a lot of what caused the inflation to be so severe was not the money given out during the pandemic, but the fact that after the pandemic was over, starting in early 2021, we had the Inflation Reduction Act, hilariously named...I mean, money was just being poured on the fire, even though the you know, the case for we're in an emergency was over and I think that was the act so that that did not need to happen. But a lot of official Washington was stuck in this mindset that debt doesn't matter..."
The Rodney Dangerfield Trap_ debt don't get no respect...
Modern monetary theory, secular stagnation, blah, blah, blah. And so this - the attitude that debt matters - was, just still isn't, in Washington. It certainly wasn't there at the time."
Cochrane on debt and deficits...
What matters is not debt and deficit, but whether people think that money will be paid back
. If you have a plan, government debt is a great and wonderful thing
why if a country is in a war or a crisis or a severe recession, the government can borrow, you know, fight the war and then pay it back afterwards.
And if people understand that, pay it back is coming there, they'll hold the debt, they'll hold the money. There won't be a big inflation
How to tell how much debt will be repaid...dream on
"...everyone keeps saying, Oh, I get it now, if there's more debt than people expect, will be repaid. We'll get inflation. Tell me how much people expect will be repaid. And I say, look at the inflation rate. Now, how does that mean the theory is empty? Well, let me at least plead to the theory we've had for 60 years of how stock prices work, prices, the present value of dividends.It's about general faith in American institutions. Do we trust that sooner or later, after they've done everything else, Congress will get around to paying back the debt? Or do we think they're never going to do it?
Cochrane on supply shocks
Here's what happens. A supply shock happens and our central banks flood the economy with money. They don't want wages to go down. They think, well, this is not as dangerous to the economy. Is that so? We'll flood it with money to make sure that the price of everything goes up rather than any price having to go down....The supply shock induces the monetary and fiscal policy which causes the inflation, but it's not supply shock that caused the inflation. It's a monetary and fiscal policy that caused the inflation. In fact, you could call this a pandemic shock because of the pandemic, because the supply shocks that caused the monetary and fiscal policy.
Why the pandemic was not mainly a supply shock- it wa a fiscal theory event
"...every theory, every conventional theory says if inflation is above the interest rate, inflation will keep spiraling up until the Fed gets the interest rate above, the inflation pushes back down again. That never happened. Inflation started going away and the interest rate rose and then they kind of met each other. But there was never interest rates getting above inflation to push it back down again. Barely. But fiscal theory. I gave you one shot of $5 trillion. Yep, you spent it. The level of prices went up and then that force for more inflation is gone."So fiscal theory is perfect. Yeah. Yeah. The inflation goes up, the inflation goes away all on its own."
"Yeah, in COVID we gave people money. We got inflation. Yeah, during quantitative easing, we gave them money to pay back the Treasury bills and there was no inflation at all.It didn't budge a basis point. So you can't ask. And these were trillions of dollars. Yeah. So you can't ask for a better experiment."
These are the rudiments of the Fiscal Theory of the price level. The interview goes on. John's theory is interesting; it is controversial and in the Covid pandemic it has found some surprising and amazing support for some of tis predictions- predictions and analysis of real world events that do not fall out of other models. Enjoy the interview!
John H. Cochrane is a senior fellow at the Hoover Institution. He is also a research associate of the National Bureau of Economic Research and an adjunct scholar of the CATO Institute.
Before joining Hoover, Cochrane was a Professor of Finance at the University of Chicago’s Booth School of Business, and earlier at its Economics Department. Cochrane earned a bachelor’s degree in physics at MIT and his PhD in economics at the University of California at Berkeley. He was a junior staff economist on the Council of Economic Advisers (1982–83).
Cochrane’s recent publications include the book Asset Pricing and articles on dynamics in stock and bond markets, the volatility of exchange rates, the term structure of interest rates, the returns to venture capital, liquidity premiums in stock prices, the relation between stock prices and business cycles, and option pricing when investors can’t perfectly hedge. His monetary economics publications include articles on the relationship between deficits and inflation, the effects of monetary policy, and the fiscal theory of the price level. He has also written articles on macroeconomics, health insurance, time-series econometrics, financial regulation, and other topics. He was a coauthor of The Squam Lake Report. His Asset Pricing PhD class is available online via Coursera.
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