“The current inflation episode is just the kind of event that the fiscal theory of the price level can easily describe. It’s simple. The US government printed up about $3 trillion of money and sent people checks. It borrowed an additional $2 trillion of money and sent people more checks.” — John H. Cochrane, Senior Fellow, Hoover Institution, Stanford University
“The fiscal theory, I think, is the right way to approach monetary issues and inflation. I don’t think it’s well accepted. It’s not what central bankers or a lot of academic economists adhere to . . . It’s also a heretical view. It happens to be the right one. But it’s still an uphill battle.” — Thomas S. Coleman, Senior Lecturer, Harris School of Public Policy, University of Chicago
John H. Cochrane submitted his book about the fiscal theory of the price level (FTPL) to the publisher, Princeton University Press, early last year. Up to that point, despite massive fiscal and monetary stimulus in response to the global financial crisis (GFC) and more recently amid the COVID-19 pandemic, inflation had remained at or near historical lows for the better part of a generation.
This all seemed to fly in the face of the conventional understanding of both inflation and monetary policy. Viewed from a classical or monetarist perspective, real interest rates stuck at zero and quantitative easing (QE) stimulus should have had some effect: Whether hyperinflation or a deflationary spiral, theory dictated extreme consequences. Yet there weren’t any — no deflation spiral or a rerun of the epic stagflation of the late 1970s and early 1980s.
Modern monetary theory (MMT) was on the ascent. Inflation hawks perhaps had sounded too many false alarms to be taken seriously. Indeed, in the opening months of 2021, inflation fears had come to be seen as almost anachronistic, the relic of an earlier and increasingly irrelevant era.
“Well, inflation seems stuck at 2%,” Cochrane recalled writing in the initial introduction to his book. “And for 30 years, nobody has really cared about it. Maybe someday somebody will care about this book.”
Of course, several months later, inflation soared to 40-year highs and stayed there. And for those looking to understand the resurgent and unfamiliar phenomenon, the FTPL model became critical.
“I’ll just say I got the opportunity to revise that introduction,” Cochrane remarked.
In May 2022, Cochrane and Thomas S. Coleman, co-author of Puzzles of Inflation, Money, and Debt: Applying the Fiscal Theory of the Price Level from the CFA Institute Research Foundation, spoke with Rhodri Preece, CFA, and Olivier Fines, CFA, who are, respectively, senior head of research and head of advocacy and capital markets policy research for Europe, the Middle East, and Africa (EMEA) at CFA Institute. The lines of inquiry, informed by insights from “Covid-19, One Year Later: Capital Markets Entering Uncharted Waters” and “Money in Covid Times: A Primer on Central Bank Response Measures to COVID-19,” zeroed in on the dynamics and rationale of the FTPL theory as well as the associated implications for the inflation outlook, fiscal and monetary policy, and the markets in general.
In this first excerpt in the multi-part FTPL series, the conversation centers around the nature of inflation and how the FTPL can explain both the current late-pandemic inflationary environment and its non-inflationary post-GFC predecessor as well as other historical episodes.
What follows is an edited and condensed transcript from our discussion.
Olivier Fines, CFA: The Bank of England has indicated that they wouldn’t be surprised if inflation reached 10% before the end of the year. So, inflation is a global phenomenon, or at least a Western one. What are the fundamental aspects of the fiscal theory of the price level and how does it explain the current rate of inflation?
John H. Cochrane: It is a simple and intuitive idea. Inflation breaks out when there is more overall government debt than people think the government will repay by its future excess of taxes over spending. If people see that the debt is not going to get repaid, that means it will either be defaulted on or inflated away in the future. They try to get rid of the government debt now. And the only way to get rid of government debt is to spend it, to try to trade it for goods and services. But it’s a hot potato. There’s so much of it around; we can’t get collectively rid of it. All we can do is drive up prices.
First, we try to buy assets. The asset prices go up. Then, feeling wealthier, we try to buy goods and services. The goods and services prices go up until the real value of the debt — the amount of debt divided by the price level is its real value — is back to equal what people think the government will be able to pay off. That’s the fiscal theory of the price level in a nutshell.
It’s still too much money chasing too few goods. But money includes all nominal government debt, not just money itself.
The current inflation episode is just the kind of event that the fiscal theory of the price level can easily describe. It’s simple. The US government printed up about $3 trillion of money and sent people checks. It borrowed an additional $2 trillion of money and sent people more checks.
That’s a big increase in the amount of government debt. Now, that doesn’t have to be inflationary if everybody understands this is borrowing that will be repaid. We’re going to send people checks, but by the way, there’s going to be either higher taxes or lower spending coming soon to repay that debt. Then people are happy to hold the debt as an investment vehicle. We can talk about government borrowing crowding out investment, and other smaller issues, but borrowing by itself isn’t instantly inflationary.
Sending people checks is a particularly powerful way of getting them to spend the new debt rather than hold it as savings. Milton Friedman told a great story that if you want to cause inflation, you just drop money from helicopters. That’s pretty much what our government did. But dropping money from helicopters is a fiscal intervention; it’s a transfer payment, spending not paid by taxes. It’s not a monetary intervention. It’s not about giving you money and taking back bonds.
We couldn’t have asked for a cleaner exercise for chapter one of fiscal theory of the price level in how to create inflation.
So, that’s at least the spur of inflation. We’ll come back to where it’s going.
Fines: What about the post-2008, pre-COVID-19 era? I was among those totally baffled by the lack of connection between money supply stimulus and the lack of inflation. How does the fiscal theory of the price level explain that weird trend?
Cochrane: That’s actually a little more troublesome because there was a big deficit. And that one did not send inflation up. Everything’s hard to read in real time, but we can at least point to a couple of things. First, that was an economy with depressed demand. Whether extra aggregate demand spills into inflation depends on how the economy is doing. So, in 2008, there was arguably room to stoke aggregate demand to increase output.
Second, the fiscal stimulus was relatively small. That one was in the $1 trillion range. This one is in the $5 trillion range. But this time, when they spent the $5 trillion, a pandemic is not a lack of demand. Restaurants are not closed because people don’t have enough money to go out. Restaurants are closed because of the pandemic. Likewise as we saw, the economy bounces back very, very quickly on its own. The COVID crisis was a supply shock if there ever was one.
From the economic point of view, the pandemic is like a big snowstorm. In a big snowstorm, businesses shut down, people stay home. But the problem is not that nobody has enough money to buy things. The problem is there’s a snowstorm. Then, when the snowstorm ends, the economy bounces back quickly. We effectively had a half-year snowstorm and did not need lots of stimulus.
Third, after 2008, real interest rates hit zero and went negative throughout the world. And so the interest costs on the debt proved to be tiny. Well, that’s a windfall for the government. Being able to roll over your debt with negative interest rates is like discovering a treasure trove of money in your pocket that helps you to repay the debt. That’s not likely to happen again. Interest rates can’t go even more negative for 10 years.
The 2008 to 2020 period was a decisive experiment, in my view, proving the fiscal theory of the price level over its competitors. Recall, everybody in 2008 was saying that when interest rates hit zero and get stuck there, we will be in a “liquidity trap,” leading to a big deflation spiral.
Fiscal theory says there does not have to be deflation when interest rates get stuck at zero. As long as there isn’t additional, really bad fiscal news, inflation can be very stable and just kind of bat around, while interest rates stay at zero, and that’s exactly what happened. Until, of course, we just got bad fiscal news.
Check off the classic theories of inflation: When interest rates hit zero, classic interest rate theories said there’s going to be a deflation spiral. It didn’t happen. The monetarist theory said that $3 trillion in quantitative easing will lead to Zimbabwe-like hyperinflation. That didn’t happen. The fiscal theory is the only one consistent with steady interest rates and inflation not going anywhere. It’s a dog that didn’t bark.
Failing to see something that did happen, the way the Fed failed to see this inflation, the way standard economic models failed to see the inflation of the 1970s or its decline in the 1980s, that gets in the newspapers. But saying something big would happen and then nothing happens is just as bad. So, I view both the 2008 to 2020 period and the current one as events that are uniquely and easily explainable by a fiscal theory perspective, and not so much by classical theory.
Fines: In the current context of COVID-19, we’ve surveyed our members about inflation, monetary stimulus, the growing role of central banks and governments, how the underlying relationships play out, and how the dynamic between the world of policy and the world of markets has changed. We were particularly fascinated with Tom’s Puzzles of Inflation, Money, and Debt. We saw a convergence of our survey findings and the explanations provided by the FTPL.
Thomas S. Coleman: I started talking with John about the fiscal theory back in 2013 or 2014 during the post-2008 era, and it really was something of a puzzle: Low and stable inflation in the presence of a zero nominal interest rate, substantial quantitative easing — a puzzle for everybody. And I remember — I don’t think you were there, John — standing around with some awfully smart economists at a cocktail party and hearing the remark, “Central banks are working as hard as they can to create inflation, and it is low. Isn’t this a puzzle?”
I think the genesis of my involvement and interest in the fiscal theory came from 2008, recognizing it as an explanation for why we might be living through substantial increases in reserves and yet low and stable inflation. Another thing: If you think about government spending in 2008, 2009, there was a substantial purpose to that, to bail out the economy. And bailing out sounds bad, but the financial system was broken. So, that money was in one sense an investment in repairing the economy. And I think that government spending during the pandemic was a very different form of government spending. It was transfers to individuals and businesses that were shuttered. It wasn’t for a productive purpose in the way that 2008, 2009 spending was an effort to repair the broken economy.
Cochrane: There’s a separate issue. In 2020, there was a threat of another financial crisis, and the Fed bailed everyone out again. In a financial sense, the Fed prevented that crisis from breaking out. We could have seen a wave of business bankruptcies. But why the Fed had to embark on another huge bailout is a scandal that nobody’s talking about. All of the promises of 2008 were broken. Dodd–Frank will fix the financial system; we won’t have any more bailouts. And the time comes, and they bailed out Treasury markets, money market funds, and issued a “Whatever It Takes” pledge to support corporate bond prices. There it is, an explicit Fed put! I’m astonished that nobody is talking about this.
There is a reason for government spending in the pandemic. It is a form of ex post insurance for people. The sense in which I think both Tom and I think it was overdone was we went beyond people who needed the insurance, even beyond the bailouts. They simply wrote checks to lots of people who weren’t especially hurt. Hundreds of billions also got stolen.
Rhodri Preece, CFA: So, the 1970s-era inflation is commonly understood as having an oil price shock as the initial trigger. Is it true that whichever inflationary episode you analyze that an unanticipated fiscal shock is a primary factor in driving the phenomenon?
Coleman: It’s the combination of the fiscal, the coordination between fiscal and monetary policy.
Cochrane: Historically, all significant inflations have come from fiscal problems. Countries that are running steady primary surpluses and growing happily never seem to have inflation no matter how dimwitted their central bankers. I can’t think of a single case of a healthy growing country that had inflation just because central bankers made some mistake.
The standard story for the 1970s and 1980s is entirely monetary. But there were very important fiscal parts of it. Even in the standard view, inflation in the US started with the combination of the Great Society and Vietnam War under President Lyndon Johnson. That fiscal stress was exacerbated by living the Bretton Woods system. There was still a gold price target and closed international markets, so we couldn’t just borrow internationally to finance our deficits. The end of Bretton Woods was a classic, fiscally induced currency collapse. The 1970s had a productivity slowdown, and then 1975 had the biggest deficits since World War II. The economic and fiscal malaise was there. Evidently.
In the UK, things were worse. There were several currency crises, strikes, slow growth. Prime Minister Margaret Thatcher really picked up the pieces of a fiscal disaster as well as a monetary one. 1980 was kicked off by a monetary contraction. But that was swiftly followed in the US and in the UK by profound fiscal and microeconomic growth-oriented reforms.
In the US, the top federal marginal tax rate was cut from 70% to 28%, along with broadening the base and microeconomic deregulation. The UK also went through a big privatization. GDP boomed in both countries, and the governments started raking in money, not from higher tax rates or austerity policies but just from growth. This is a classic counter example to post-2008 austerity in Europe, which focused on higher tax rates that produced even less growth. That’s like walking up a sand dune.
Both monetary and fiscal policies were key in 1980. The Fed needed that fiscal backing. When interest rates went up in the early 1980s, and inflation went down, interest costs on the debt skyrocketed. That was paid by taxpayers. Furthermore, people who bought bonds at 15% yield in 1980 got a wonderful deal as those were paid off with 3% to 5% inflation. That came courtesy of taxpayers. All successful disinflations — for example, the inflation targeting regimes that were put in place in New Zealand, Sweden, and other countries in the early 1990s — were fiscal, monetary, and microeconomic. Hyperinflations end when the fiscal problem gets solved. Those are the most classic examples. You solve the fiscal problem, and inflation goes away. The government can even print more money and interest rates go down, not up.
Coleman: And if you look at other historical episodes, with Germany in 1923, hyperinflation ended within a period of what looks like a few weeks, literally going from 100% inflation per month down to 2% or 3% per year. And really the best explanation is the fiscal reforms that were taking place in the summer and fall of 1923, substantial reforms in terms of laying off government workers, reforming the tax revenue system, and so on.
Cochrane: Latin America is full of contrary examples. Argentina and Brazil have had several episodes where monetary tightening didn’t work because it didn’t have fiscal backing. They had inflation because they were printing up too much money to finance deficits. There’s a monetary tightening, or they try to raise interest rates. But they don’t solve the fiscal problem. It works for a couple months to a year or so. And then inflation comes back worse than ever.
Why don’t we move to the next big issue: What will it take to get rid of our current inflation?
John H. Cochrane and Thomas S. Coleman will tackle that question and more in future installments of the FTPL series. In the meantime, check out Puzzles of Inflation, Money, and Debt and “Inflation: Past, Present, and Future,” among other research from JohnHCochrane.com.
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