Eric Leeper on the Interactions of Fiscal and Monetary Policy

Eric Leeper is a professor of economics at the University of Virginia, an advisor to the Swedish and German central banks and a former Fed economist. Eric has written widely on the links between monetary policy and fiscal policy and joins David on Macro Musings to discuss these links and their implication for the price level. Specifically, Eric and David discuss the relationship between fiscal authorities and monetary authorities as it relates to fiscal dominance and monetary dominance, how the fiscal theory of the price level (FTPL) enhances our understanding of these relationships, how the FTPL can be applied to contemporary economies, what our expectations of fiscal policy should be moving forward, and much more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Eric, welcome to the show.

Eric Leeper: Thank you for having me.

Beckworth: Well, it's a real delight, Eric, to have you on the podcast. I've been following your work for some time. You've written extensively on the links between monetary and fiscal policy. You've written extensively on the fiscal theory of the price level, and these past few years seem very relevant to your work. As you know, we've seen the national debt go up by about $5 trillion. It now sits at about 100% of debt to GDP. Primary deficits are forecasted as far as the eye can see and inflation is rip-roaring hot. The last reading came in at 7.9%. So your work on this is very important and very relevant right now. So I'm looking forward to our conversation. But before we do that, maybe tell us a little bit about your past. How did you get into economics and ultimately into this research area that looks at the link between monetary policy and fiscal policy?

Leeper: Well, I was an undergraduate at George Mason University and the professor who really got me interested in economics was Howard Bloch, who was a micro economist and partly it was because he was both provocative and rigorous. And he provoked me to need to learn more economics so I didn't have to buy into his political views. And I think I also appreciated the logical rigor of his teaching. Now, how I got into macro, it's embarrassingly naive. We were learning IS–LM not from Howard, but from someone else. And I remember shifting those curves and just feeling incredibly powerful and I thought, "Wow, I could really do something good for the world by learning macro."

Leeper: And IS-LM is inherently about monetary and fiscal policy. And I think that's what triggered my original interest, but then I went to University of Minnesota and I had teachers like Tom Sargent and Neil Wallace and Chris Sims. Also had Ed Prescott, but he wasn't so much oriented toward the policy stuff. And that stuff also was just incredibly provocative with all of these neutrality results and things that made me feel impotent, exactly the opposite of IS-LM. So again, I was provoked into being forced to think about ways that I could do things in an equally rigorous way, but not be impotent. And so that was really the genesis.

Beckworth: So you had Chris Sims who has also written on the fiscal theory of the price level. So did you get that inspiration from him or was it a collaborative effort?

Leeper: Well, he had an old paper that I'm sure nobody has read because it was in the appendix to an annex of a door stop book published by Brookings Institution edited by Ralph Bryant for whom I was a research assistant before I went to grad school. And that really got me thinking about the stuff in a serious way. So it's not that we collaborated except to the extent that we had lots of conversations. But when I wrote my dissertation, which really was a more elaborate version of what ultimately got published, I just did that in isolation. It was a weird experience. And then I delivered my finished dissertation to my committee.

Beckworth: Very interesting. Let's jump into your work and discuss what is some of the key ideas in this literature? And I want to do baby steps first, Eric. So let's start with fiscal dominance, a lot of talk about fiscal dominance now given that context I laid out earlier, large budget deficits, expected primary deficits going forward. And Sargent and Wallace in 1981 had a paper, “Some Unpleasant Monetarist Arithmetic,” where they laid out some of the key ideas. So what is fiscal dominance and why does it matter to us today?

Fiscal Dominance vs Monetary Dominance

Leeper: I think a fiscal dominance as a special case of monetary and fiscal interactions where the government issues nominal liabilities, that's a difference between the fiscal theory and unpleasant arithmetic. In unpleasant arithmetic, government debt is real and therefore has to be backed fully by real taxation. And what unpleasant arithmetic exploits is that that real taxation comes from seigniorage revenue rather than from taxes, say. Once you make that debt nominal, then on the margin debt doesn't have to be fully backed by taxes.

Leeper: And so, the idea is let's say that hypothetically, the government puts out $5 trillion in transfers over a course of a year. It finances those by selling nominal bonds. If those bonds are fully taxed, fully backed by taxes, then individuals at least to a first approximation are going to be thinking, "Well, gee, I got more transfers today, but I'm going to have to pay more taxes tomorrow. And therefore I'm going to save some of this." Or in the extreme you save all of it that would deliver Ricardian equivalence. But suppose that what happens is this spending is regarded as emergency spending.

Leeper: And there's no discussion at all about how it's going to get paid for. Well, then people see these transfers as an increase in their wealth and like any increase in wealth, they're going to save some of it, spend some of it, which is exactly what we've seen. And as they spend, you are going to generate higher aggregate demand and therefore higher prices. And that would be considered fiscal dominance. The opposite case where it's fully backed by taxes is the standard view of how fiscal policy operates. And that's what's embedded in most of the literature.

Beckworth: Okay, so let me provide maybe a dumbed down version of that. So you tell me if it's right or wrong, but you have fiscal dominance on one hand, and then there's another term monetary dominance. And this will tie into some of your work later we'll talk about active and passive monetary and fiscal policies. But monetary dominance, is that the case where the central bank targets inflation and does whatever it needs to do to get there. And then fiscal policy's in the background supporting those objectives. So fiscal policy is passively working to support monetary dominance. With fiscal dominance, that's flipped.

Beckworth: With fiscal dominance, now the Fed has to support whatever Treasury's doing because Treasury needs to stay solvent, has to generate revenue somehow and relies upon seigniorage revenue. So, and that's I guess, the connotation you hear fiscal dominance, you're going to tie the Fed's hands. You're going to force them to do things they don't want to do and therefore they will lose control over inflation because some other overriding goal will be more important for Treasury. Is that a reasonable explanation or did I miss some nuance there?

Leeper: Yeah, I think I would add one thing. Obviously monitoring fiscal policy, you have great many objectives, but necessary to achieving any of those grander objectives is first of all, that inflation gets determined somehow. And secondly, that debt is stable. If debt gets off on an unstable trajectory and everyone believes that it's just going to grow without bound as a share of the economy, grow fast, too fast, quote unquote, then you can't achieve any of the other objectives.

Leeper: So I think that at its most basic level, what policy has to deliver is a unique inflation rate and stable debt. And so, monetary dominance is one where inflation is really under the control of the central bank and debt stabilization is the job of the fiscal authority. And fiscal dominance just flips that. So, the point is that what the Fed is required to do under fiscal dominance is ensure that the debt doesn't blow up. And one way it can do that is by just pegging the nominal interest rate so that debt service doesn't accumulate too quickly. And that actually is what we've seen the Fed do over a much longer time than I’d like to think. So we may well be in that kind of a world.

I think that at its most basic level, what policy has to deliver is a unique inflation rate and stable debt. And so, monetary dominance is one where inflation is really under the control of the central bank and debt stabilization is the job of the fiscal authority. And fiscal dominance just flips that. So, the point is that what the Fed is required to do under fiscal dominance is ensure that the debt doesn't blow up.

Beckworth: Okay. Now you had some work in 1991, a well-known paper with the Journal of Monetary Economics titled, “Equilibria under 'Active' and 'Passive' Monetary and Fiscal Policies.” So how was this related and built upon Sargent and Wallace's idea as a fiscal dominance and monetary dominance?

Leeper: Well, I chose the language active and passive because I thought that the way I was describing monitory and fiscal behavior was consistent with the way that the economics profession had used that terminology in the past. And I think of an active policy as one that is just blindly pursuing its objective. It doesn't have to pay any attention to what the other authority is doing. And so, for example, if you tell a central bank, "Your primary task is to target inflation." Then it's going to do that and it's going to pay no attention to what the fiscal authority is doing.

Leeper: But then the other authority has to be passive. And in the context of this monetary dominance world, passive means that you are stabilizing debt. And so the passive authority has to take the behavior of the active authority as given and what Sargent and Wallace did was they basically assumed you had a constant primary deficit that makes fiscal policy active in my terminology. And then monetary policy in their setting has to just generate whatever seigniorage revenue is required to stabilize debt.

Beckworth: So what they wrote is basically a special case of the possibilities that you've set out in your papers. One combination.

Leeper: Yeah.

Beckworth: Yeah. Okay. So one of the things that I like about your work is you really stress this link. Central banks don't operate on the islands, magically independent of what's happening to the rest of public finance. And you had a 2010 paper at the Jackson Hole Symposium held by the Kansas City Fed and the paper's title was “Monetary Science, Fiscal Alchemy.” And you had a line in there that was really, I think, important and tied to what we're discussing here. And in it, you talk about this dirty little secret. And here you are talking to central bankers around the world, probably one of the most prominent central bank gatherings.

Beckworth: And you mentioned this dirty little secret that exists, and I'm quoting you here. And you say, "For monetary policy to successfully control inflation, fiscal policy must behave in a particular circumscribed manner." So central banks don't operate in isolation's what you're saying. There's an assumption that there is some fiscal backstop that's in place. So even the most ardent monetarist, at least implicitly has to acknowledge. Look, if you've got a bankrupt Federal government, it's going to put pressure on you. How was that point received by central bankers when you made that at a conference in front of them? I'm just curious. Were they willing to accept your point?

Leeper: Going back much further than that than when I was in the Fed, I started at the Fed in 1987 and fiscal policy was just taboo and I get that central bankers should not be speaking publicly about the details of fiscal policy. But we have seen more and more that central bankers are willing to talk about the aggregate features of fiscal policy and whether they are appropriate for what the central bank is trying to achieve. So I think there's been an evolution. If we go back to Volker, and this is where the dirty little secret is really laid bare.

Leeper: We attribute to Volcker the success of disinflation. And what people seem to forget is that after the 1981 tax cut which was very large, there were then before the end of the decade, five tax increases. Well, that is exactly the fiscal support that you need for that disinflation to be successful. And another way to think about this is that tight monetary policy has to be followed by tight fiscal policy if we want to really put it in simple terms. And I think that by and large, in the post-war period in the United States, we have seen exactly that pattern of behavior.

Leeper: Not so much in the '70s, but then we weren't really seeing tight monetary policy in the '70s either. And we saw what the consequence was. But now my concern is that the situation is really very different. When Volker was doing this debt as a shared GDP was about 25%, now it's 100%. If the Fed has to, as Larry Summers is now saying, has to raise interest rates to about 5% to fight off the current inflation, that's going to raise debt service by about a trillion dollars.

If the Fed has to...raise interest rates to about 5% to fight off the current inflation, that's going to raise debt service by about a trillion dollars.

Leeper: Now these days, a trillion doesn't seem like real money, but it's still going to require some sort of a tax increase, otherwise it becomes unstable. And what will happen is bond holders will be getting more interest payments if they don't anticipate that those interest payments are eventually going to get taxed away, then that becomes a positive wealth effect at precisely the time that the Fed is trying to tighten. That positive wealth effect could undermine the Fed's ability to bring inflation down. And that's my worry now that we may be breaking from that norm of that deficits beget surpluses.

Beckworth: So I bring up this question that you've answered very nicely about central bankers and you noted that the evolution has changed. And it's definitely the case we saw Chair Powell talked a lot about fiscal policy during the pandemic, for example. But it's interesting if you go read the FOMC, the Federal Reserve's committees statement on longer run goals and monetary policy strategy. This is their constitution if we can call it that, but every year they re-affirm it or they tweak it. But what it says in there is, "The inflation rate over the longer run is primarily determined by monetary policy." So they're taking ownership of it. They're saying, "It's all about us."

Beckworth: And I'll mention also a speech by Governor Chris Waller, who himself has written on the fiscal theory of the price level will come back to that later. But last year in March 2021, he had a speech titled, “Treasury–Federal Reserve Cooperation and the Importance of Central Bank Independence.” And here's what he said. This is a paragraph I'm just reading from the speech he goes, "Because of the large fiscal deficits and rising Federal debt, a narrative has emerged that the Federal Reserve will succumb to pressures to keep interest rates low to help service the debt and to maintain asset purchases to help finance the Federal government. My goal today is to definitively put that narrative to rest. It is simply wrong. Monetary policy has not and will not be conducted for those purposes." And I guess you would say not so fast, it depends on the pressures that are coming from the debt burden and sustainability. Is that right?

Leeper: Well, I can't obviously speak for the Fed and what it will do. I think a central banker has to say those things. That's fair. I don't think it's a problem with central bankers. I think it's a problem with Congress. If Congress is going to give the Fed the job to control inflation, then it's got to do what it needs to do to support that. But there's a deeper issue here, which goes back to how the economics profession has talked about inflation. And the famous Friedman line about, "inflation is always in every way a monetary phenomenon.”

Leeper: I would agree with that if what you mean by monetary includes government debt, that isn't what he meant. And then you have this whole generation of New Keynesian models that also makes monetary policy seem to be all powerful. And this is all part of the dirty little secret that swept under the rug in those models is fiscal policy doing a lot of heavy lifting. And if you read Woodford, which is the classic new Keynesian source these days, there will be an occasional footnote because Woodford, he's a brilliant guy and he knows the economics. In fact, he's even written about the fiscal thing.

Beckworth: Right. Exactly.

Leeper: He may now be in denial about that, but there are little footnotes that say, "Oh, we're assuming this about fiscal policy." Well, that's a lot to assume especially in the current political environment. And so it's hard to separate these issues from the politics that's going on. But I do think that the economics profession shares some of the blame here. If you believe that really it's only monetary policy that matters for inflation, then the Federal Reserve Act makes perfectly good sense without any adjustment to fiscal behavior. But that isn't how the world works. It just isn't.

Expectations for Fiscal Policy

Beckworth: Right. Well, the challenge is not just the profession, I think, but the body politic at large, Congress, who does Congress go after if inflation's going high like right now? Jay Powell, they'll go after the Fed, the Fed didn't do enough. And yeah, maybe the Fed should have tightened sooner maybe late last year, but they should actually be also looking at themselves. They should be thinking about the decisions they've made but it's easy to point the finger at the Fed because the Fed has been the center of attention as you noted.

Beckworth: I remember when Alan Greenspan was retiring, I believe there was a Jackson Hole conference that praised him, all the wonderful things that he did and read to respect. You dig underneath the system a little bit, you see all those implicit assumptions that you just outlined. Tied to this, so in that 2010 paper, the alchemy part was tied to fiscal policy and in it, you highlight how monetary policy has kept up with advances in monetary theory where fiscal policy and our use of it hasn't kept pace with the literature and also what we know about it. So where does that stand today? What are your thoughts on that issue now?

Leeper: I would say there's been no progress whatsoever. So at the conference, the head of the CBO was there and he took great offense, arguing that we actually do more science than Eric says, but you alluded to the projections of deficits that presumably comes from something like the CBO. And the problem is that the CBO by law has to make the assumption of unchanged policy. So the CBO can't do economics. Congress has made sure that the CBO cannot do economics. And so you see these projections of government debt going off to five, 600% of GDP. So I can tell you that the main impact that Jackson Hole paper had was that instead of doing 50-year projections, the CBO started doing 20-year projections. And then it doesn't reach 500%. It's still growing exponentially, but they truncate it.

Beckworth: Nice.

Leeper: So to me, that's alchemy, and I don't fault the CBO here, I think it all comes back to Congress wanting to have the Fed as a whipping boy and the CBO as a rationalization for what they want to do.

Beckworth: Well, do we set our hopes to high for fiscal policy? In this sense, we created an independent central bank to be more rigorous, to be technocratic independent of politics, but fiscal policy is always going to be subject to political change, the whims, we can build in maybe better automatic stabilizers. In theory, we could add maybe a constitutional rule, but it just seems like fiscal policy will always be subject to whatever the latest thinking or fad is. So maybe we shouldn't have high expectations or should we?

Leeper: Well, I think we should, because I think fiscal policy is absolutely central to everything that goes on in the macro economy. I think that we have... Well, first let me back up for a second. The main point that a lot of people make is, "Hey, fiscal policy has first order distributional consequences and those should be in the hands of elected officials." I agree with that. But you know what? Monetary policy has distributional consequences too. But somehow we've decided that's okay. We're not going to put that in the hands of elected officials.

Leeper: Alexander Hamilton actually saw the dangers of putting money in the hands of elected officials which was what was underlying his proposal for the first central bank of the United States. But I think that one thing that we could do is think about which components of fiscal policy are really macroeconomic rather than microeconomic. For example, this isn't a formal proposal, but you could think about, "Okay, we should be running a deficit or a surplus of a certain size. It's left to the elected officials to decide how to get there, but they've got to get there. We shouldn't have debt growing more rapidly than K%. How they do that, that's up to them." And so, you're putting some limits on what they can do. It's like having a Fed for fiscal policy. You have some technocrats that come up with those aggregates and then Congress has to really be subject to those constraints. I don't think that's going to happen, but I think it's not a crazy idea. And I don't think it is undemocratic to think about that.

I think fiscal policy is absolutely central to everything that goes on in the macro economy...But I think that one thing that we could do is think about which components of fiscal policy are really macroeconomic rather than microeconomic...And so, you're putting some limits on what they can do. It's like having a Fed for fiscal policy. You have some technocrats that come up with those aggregates and then Congress has to really be subject to those constraints.

Beckworth: Certainly.

Leeper: But there are also smaller ways that I think we could make improvements. There's always this argument that, "Well, elected officials change every two years and so they can never commit to anything in the future." I think that's oversold. There's a lot of commitment in fiscal policy. You create social security in the '30s and here we still have it. If that's not commitment, I don't know what that is. The tax code has a lot of commitment embedded in it. We never see them just do a whole wholesale change of the tax structure. Even the 1986 reform, which was a big deal by historical standards still retained a lot of features that were there for decades. So I think that we could do more to communicate the COVID spending, for example, was it intentional that this was going to be unbacked by taxes? Was anybody about that even?

Leeper: It's interesting that the press secretary at the White House, I think just yesterday or the day before, when talking about the latest request for COVID funding said, "Hey, Congress, this is an emergency. You can't apply all your standard rules for budgeting to this proposal." Well, okay. That's a policy. That's a statement that is going to affect individual's expectations. Do they want to affect them that way? And so I think there's more that we could do. And I think there's a role here even for the press to play, but we don't see any of that.

Beckworth: Right. It would be great to have some way to get the press, everybody out there myself included excited about fiscal policy budget, the deliberations as much as we do every FOMC meeting. What's the announcement exactly? What's the press conference going to say? I had a former colleague when I was back in the university, he called it hyper monetarism. We're so worried about what the Feds wanted to do every little minutia detail. How did Powell breathe on that last sentence as opposed to what are some of the deliberations going on in Congress?

Leeper: Yeah. And in fact, pick up any newspaper that's talking about the Fed and they know the minutia. What they don't know is a theory of inflation. And there's a narrative that has grown up around the Fed and there was a beautiful example of that in the New York Times yesterday. I assigned it to my graduate students and said, "Critique this." But the narrative is, "Okay, we've got this nice story about the punch bowl. And it's all Phillips Curve-driven.” Everything is about tight labor markets and on and on and on. And there's no discussion there about what's happening to government liabilities. And what's happening about the backing of those liabilities. And so, I think that the level of discourse is just extraordinarily low with monetary policy as well as fiscal policy.

Fiscal Theory of the Price Level

Beckworth: Well, let's move on then to the fiscal theory of the price level, we've been really talking about the ideas that really underlay it and form its foundation. So walk us through, what is the fiscal theory of the price level? What are the basic ideas behind it and how do we apply it to our current setting?

Leeper: I think the first thing I want to say is I hate the name fiscal theory of the price level. I think there's only one theory of the price level and that is that it's determined by the interaction of monetary and fiscal policy. But that was a battle I’ve lost. So, I will go ahead and use the term with that caveat. Essentially, I think of the fiscal theory as an outgrowth of Tobin, Sargent, and Wallace, where what we learned from those people was that the backing of government liabilities is central to determining their value. So if you think about government debt, we really want to think of that as being like any other asset where its value is going to get determined by expected future cash flows. Those cash flows are primary deficits. Those are the goods that the government is going to extract from the private sector to use, to pay off those liabilities.

Leeper: And it's not just about government bonds either, especially now that in that reserves pay interest. They're just another form of government debt. And so the amount of actually unbacked currency in the U.S. economy is tiny. It's literally just bills and coins and that's just supplied perfectly elastically. So I don't see that's the unbacked stuff is having very much to do with how the price level, what gets determined. So, the fiscal theory basically says that if the expected backing of real resources for government debt increases, then that debt's going to become worth more.

Leeper: That's going to show up as a combination of higher bond prices and a lower price level, because then the real market value of that debt increases. So I think you can boil it down to supply and demand and where the demand for government bonds depends on the price of bonds and on what the real backing is, which is primary surpluses. And there's nothing here that's uniquely the fiscal theory. The statement I just made, holds whether you think you live in a monetary dominant world or a fiscal dominant world and so forth.

The fiscal theory basically says that if the expected backing of real resources for government debt increases, then that debt's going to become worth more. That's going to show up as a combination of higher bond prices and a lower price level, because then the real market value of that debt increases.

Leeper: And that's why I say there's really only one theory. But the key difference I think here, and this is what fiscal policy has really emphasized is fiscal authority has taxing capacity. The central bank, yeah, it can generate seigniorage revenue, but if everyone decides they're not going to hold dollars, then it can't get any real resources from the private sector. So long as the government can always raise taxes, it can extract real resources. And therefore at some fundamental level, what gives government liabilities their value is the taxing capacity of the government.

Beckworth: So one way to think about the fiscal theory of the price level as an asset pricing equation for government liabilities. So you have this future stream of primary surpluses, you discount to the present, and that affects the real value today of government securities. So let me walk through a scenario and help me see the steps from the future to the present. So let's say for whatever reason we now expect larger primary surpluses for a sustained time. So maybe tax laws are changed. Spending is cut. What are the concrete steps that lead to a lower inflation rate we observe in the economy? What has to happen? What do bond traders do? What do households do? Walk me through that.

Leeper: Well, I think the first thing that happens is households get this news that their taxes are going to go up in the future. And because what they want to do is smooth their consumption path, they're going to increase their saving today. So that already cuts aggregate demand. And part of their savings is going to be held in the form of government bonds. So the demand for bonds would increase and that's the whole story in terms of the economics. It's driven by the desire to smooth consumption. And so if you think your after tax income is going to be lower in the future, then you want to save in anticipation of that. And bonds are one form of saving.

Beckworth: Well, there you go. Straight forward. Pretty simple.

Leeper: It ain't rocket science.

Beckworth: Right. Well, let me throw out the other version of this. Think you alluded to fiscal theory of the price level you said is supply and demand. Let me generalize. It's a quantity theory but for all government liabilities, government bonds, as well as Federal Reserve liabilities. Is that a reasonable interpretation? Supply of them versus the demand for them?

Leeper: Yeah, but isn't all of economics that? I don't want to say all of economics is the quantity theory.

Beckworth: But all supply and demand.

Leeper: Quantity theory has a lot of baggage attached to it in my mind. And it has very strong implications, people start to think only about… and so I'd prefer not to say, "Yeah, this is a quantity theory applied to debt."

Beckworth: Well, let me frame it this way. The fiscal theory of the price level. One way I like to think about it is you're looking at the expected path of government liabilities in the future which is a quantity. And that's going to determine the trend path for inflation. What terms trend inflation is the supply and demand for these government securities over the infinite horizon. How do we factor into that equation? I guess it could be in the model somewhere, but supply shocks. So let's look at the past few years. We can clearly talk about a fiscal side of the story, but we can arguably we talk about some supply shocks as well. So the two aren't necessarily exclusive. You could still say the trend is being set by government securities in this expected path where we might have some temporary deviations due to supply shocks. Is that fair?

Leeper: Yeah. So what's in that equation that we're dwelling on here. It's not just future surpluses which of course will be affected by supply shocks. Surplus is very strongly endogenous, but also discount rates. So just loosely let's think of that as short term real interest rates. And so anything that drives short term real interest rates down is going to cause the value of a given stream of surpluses to go up. And so you can think about a whole host of different shocks that are hitting the economy in a general equilibrium setting, you would trace through what are their impacts on the path of surpluses? What are their impacts on the path of real interest rates? And then you can compute that present value.

Beckworth: Okay, well, let me move on with the fiscal theory of the price level to some work that I just became familiar with but apparently others have thought about this a lot in the past. And I became aware of this with Markus Brunnermeier's work with some co-authors and he has a paper called “The Fiscal Theory of the Price Level with a Bubble” and then in my subsequent search, I found a paper by Aleksander Berenstein and Chris Waller, which we mentioned earlier 2018, where they have a paper, “Liquidity Premiums on Government Debt and the Fiscal Theory at the Price Level.” And the basic idea in this argument is that you've, you've got to, you've got to expand that asset pricing view of government debt. So it's still an asset pricing equation and depending on how you look at this, I guess.

Beckworth: But there's also a demand for government securities related to the liquidity premium or service they provide. So like Waller in his paper, he says, "If you just look at discounted present values of primary surpluses, it's not going to equal the market value and the difference is due to the liquidity services treasury securities provide." So we need to account for that term and what Brunnermeier does, and Waller doesn't do this in his paper the same way, but Brunnermeier does, he actually adds a second term on the right hand side of that equation. So left hand side, you got nominal government liabilities divided by the price level equal to the discounted present value of primary surpluses plus the discount on present value of these liquidity services that treasurers are expected to provide. So what is your thought on that extension of the fiscal theory of the price level?

Leeper: Oh, I think that's really important. And actually, it goes back to Wallace again, because what Wallace, his Modigliani-Miller Theorem says is that if you have identical rates of return and you hold fiscal policy fixed in a certain sense, then things like open market operations may have no effects at all. Now we know that the returns on reserves and on treasuries are different and a big reason for that is that they serve different purposes in the economy. And there are some legal restrictions, you can't use treasuries for clearing balances and things like that, and you can't use reserves as collateral in the repo market. So I think the question is how big are those effects quantitatively? And I suspect they're pretty important. And there's a revealed preference argument if you look at how active the Fed has been in the treasury market with their standing facilities and repos and reverse repos. That tells you that they think that the stability of the treasury market is absolutely critical. And so I think by extension, we need to be thinking about, "Well, why do people hold these things and what is their value?"

Leeper: And you might even find... I made this argument in a discussion in the Jackson Hole Symposium last year, that if you're in an environment where reserves are really plentiful, let's say, hypothetically, you have flooded the economy with reserves, and then the Fed goes out and buys treasuries and pays for them with even more reserves. The question is, is that expansionary or contractionary? Does that disturb the repo market by making safe assets more scarce? And then what are the consequences of that? So an action that you might think of as being expansionary may not be expansionary if those treasuries are really playing a critical role in the financial system. And I think modeling that is incredibly important. And I'd like to try to get a better quantitative handle on that. But that's hard.

Beckworth: Yeah, very hard for sure. We had Peter Stella on the show and he with Manmohan Singh, they've had several papers a few years back where they say, "Look, the Fed is at effectively draining the financial system of these incredibly liquid securities because not everyone can trade bank reserves. Reserves are limited to the banking system proper. So of course, what we are seeing though is that the Feds opening up its balance sheet more and more to non-bank. So money market funds now go into overnight reverse repo facilities so that's another solution. One that I'm not excited about.

Beckworth: I don't want the Fed to open its balance sheet to everybody but the alternative then is we need to think about the liquidity services provided by treasury security. So I'm glad to see your interest in that. And I had also Hanno Lustig on the show and he along with Arvind Krishnamurthy, they did a lot of work on trying to estimate those convenience yields on treasury securities, an empirical approach at this question. And he made this point that this is going to be a great research question moving forward, how to estimate the size of that service, how important is it? So it's interesting to see you're excited about it as well.

Leeper: But this is really an old question. If you go back to Brainard and Tobin, their whole idea was to think about you have this whole range of assets out there. And what we wanted to try to do is estimate a system of demand functions for those assets. The problem that they had, because that work just died. And I asked Brainard, why did it die? Because this seems like it should have been the right way to think about things. And he said, "It all came down to, we couldn't identify what the cross elasticities are among these assets." So what I think we need is more theory that is getting to kind of the micro foundations of what these assets are really doing.

Leeper: And then maybe that will deliver some restrictions that will allow us to estimate the things that Brainard and Tobin wanted to estimate. It's the same point with the yield curve. Theoretical models of the yield curve are terrible and there are some empirical things, but there's no theory there. And why is a 10-year bond different from a one-year bond? We got to get a handle on that, especially when the Fed is doing a lot out of yield curve manipulation through balance sheet operations. And this is the old... It's not that old, but this is what Bernanke said that these asset purchases work great in practice, but not in theory.

Beckworth: Well, this goes back to the Wallace neutrality critique too in normal of time.

Leeper: Exactly.

Beckworth: It's hard to see what effect, I've made that point on this show multiple times. I had a guest on recently who argued that as well, that outside of panics and crisis, what exactly does large scale asset purchases accomplish? And there's a signaling channel I think that's a reasonable interpretation, but I'm largely of a view that it doesn't make that much difference, other than signaling in normal market operating times, that QE doesn't make that big of a difference. However, I had another guest. He gave me pause on that, on that view, Bill Nelson, he was just on the show.

Beckworth: He used to work at the Fed and he makes this point and this gets into the plumpness so going back to your point about micro understanding, the plumbing of the financial system is so important here too. He notes that as the Fed has increased the amount of reserves, what has happened is with this ample reserve system or the floor operating system, they want to have a buffer setup so they'll stay on that part of the bank reserve demand curve. And so they always want to pack in a little buffer, but what happens is they extend the supply of reserves that buffer becomes seen as normal. And so structural demand increases.

Beckworth: What happens is you get the cycle where the balance sheet gets larger and larger just to stay stable. So reversing QE doing QT shrinking the balance sheet may not be as easy a task as maybe Wallace neutrality makes it out to be because of some of the plumbing issues involved. But let's move on from that to the application and back to fiscal theory of the price level. And I want to apply this to some countries because this is a critique you'll often hear. So let's go through a list of countries. Let's start with probably the most obvious one, Japan. How do we make sense of Japan with the fiscal theory of the price level?

Applying the FTPL to Contemporary Economies

Leeper: I think there are three important considerations about Japan. First of all, remember that what we are really interested in is the government's net position. So you can't just look at total bonds that have been issued which is the headline number you always hear for Japan. So you've got to net out their foreign reserves, which are substantial. Then on top of that, a lot of the bonds are held by these quasi governmental institutions and they're not held by the public. And so how do you count those? And then on top of it, the bank of Japan has bought a huge amount. If you adjust their data for those three things, the debt to GDP ratio in Japan's about 50%.

Leeper: So that's one consideration. The second consideration is Japan has sent very mixed signals. This goes back to the role that expectations play, where they say, basically, "Hey, we're going to stimulate but don't worry we're going to contract." A little like what Obama did after the 2009 stimulus package. Well, make up your mind, what are you going to do? You're going to stimulate. You're going to contract. And Japan has also been under a lot of pressure from the IMF to commit to a path for consumption taxes. So when Abe was there, he postponed the tax increase but he didn't eliminate it. Well, okay. So what are you really doing here? Does it matter that much to me, whether my consumption tax is higher next year or two years from now?

Leeper: In the grand scheme of things, probably not. So it's not obvious that they have been living in a world with active fiscal policy. I think that the expectations in Japan have been pretty anchored on eventually something will happen. And then the third consideration is what we've already alluded to. They've had negative, real interest rates for a long time. That's going to make the present value of a given stream of surpluses really high and that's going to be deflationary. So by the way, this is an interesting point that once you start thinking about monetary and fiscal policy jointly this way, low real interest rates, which are central bank's bread and butter for expanding the economy actually are contractionary in the sense that they raise the value of primary surpluses and make debt more attractive.

Beckworth: So effectively it's raising their primary surplus path which is deflationary in the present. Let me take on a side here, Eric and ask about those low interest rates. So I'm a big fan of the safe asset shortage literature that's been out there. A lot of prominent academics have written on this and maybe it's harder to make that argument now. We still see ten-year treasury, it's just over 2% despite the 5 trillion added to it. But there's a host of stories you could tell everything from the emerging markets to the demographics of the world, the world's aging to maybe on the margin, people more risk averse after going through multiple recessions in the past decade. Do you see that as a key part of why rates are low versus the other interpretation often is the central banks themselves are propping rates low? Is it fundamentals that are pushing rates low around the advanced economies? Or is it policy choices by central banks?

Leeper: Well, it's clearly a sum of both, but I think that there's just no doubt at the secular movement of long term real interest rates has been downward. And for reasons that I think are well beyond any central bank's control. And so we've been hitting the lower bound on policy rates pretty quickly. And I think that phenomenon is probably going to persist for decades. The profession is still unclear on exactly what's… as you alluded to, there are lots of stories about it. The one I like the most is the demographics, and until old farts like me die, we're going to have lots of savings.

Beckworth: Right. And I think it also plays into your preferences, what type of assets you hold, it also plays into our growth rates. Declining population growth rate. For me, that's one of the biggest concerns I have long term for the U.S. economy is our declining population growth rate and not only is it the labor supply, but it's where we get ideas from innovation, endogenous growth theories here. Well, let's move to Europe now and talk about the European central bank because I've seen some papers that say, "Oh, the ECB disproves a fiscal theory of the price level. It's completely independent from fiscal policy. I don't think that's quite right. Even the ECB at the end of the day has fiscal links to it. But what are your thoughts on that application that's setting as it relates to the FTPL?

Leeper: Well, I think we have to distinguish between the Euro area as a whole and individual countries. So, for an individual country that's part of EMU, there is no fiscal theory that's applicable because they don't control monetary policy. To them, it's almost as if they're issuing real debt. They have to take that price level as given. I don't see that that disproves anything. Arguing that it disproves the fiscal theory seems to be a statement that they don't understand the fiscal theory because nobody would claim that there's a fiscal theory operating when you're on a gold standard. And that's what EMU is to some extent. Having said that, as a whole, they could operate just like the United States does in some coordinated fashion to generate unbacked fiscal expansion as the fiscal theory would predict. So I don't really see how that changes things, going to Europe.

For an individual country that's part of EMU, there is no fiscal theory that's applicable because they don't control monetary policy. To them, it's almost as if they're issuing real debt. They have to take that price level as given. I don't see that that disproves anything. Arguing that it disproves the fiscal theory seems to be a statement that they don't understand the fiscal theory.

Beckworth: Yeah. Let me lay out the case I see for why they're not completely separate from fiscal policy in Europe. And I think this would apply to the gold standard in the U.S. as well. So you can imagine the scenario, let's say where Italy defaults on its debt, has a lot of debt. It could be a real explosive point in the Euro area system and Germany worried about what that means about the ECBs balance sheet negative equity position or becoming insolvent might step in and recapitalize the ECB. I know there's there's details because a lot of the countries have their own central banks that are linked to the main central bank.

Beckworth: But the point is that from a consolidated perspective, if the ECBs balance sheet takes a hit and it's big enough to create inflation worries, I suspect Germany, who hates inflation, would step in at some level. And maybe get support from other of countries to do it, but it would definitely lead this charge, “we need to recapitalize the ECB.” And that to me would confirm that there's an implicit link, implicit backstop from fiscal policy, same thing with the gold standard. You can imagine if the U.S. had problems with the gold standard at the end of the day, the government might have to step in and buy more gold or intervene in gold markets. Is that a reasonable take on the linkages there?

Leeper: Yeah, I think so. Another way to word this is when Draghi made his famous pronouncement that they'll do whatever it takes. He was making a fiscal statement. He wasn't saying anything monetary. He was saying, "Hey, we've got the tools. We can buy as much debt as we want." And so if a country gets in sovereign debt trouble, we can step in. You then added the... Now if they end up defaulting on that debt, then there could be balance sheet issues and somebody is going to step in or some collection of countries will step in to recapitalize.

Leeper: But I think this recapitalization, so there's a nice paper by Marco Del Negro and Chris Sims, where they look at the Fed and they ask, how likely is it that Treasury would have to step in and recapitalize the Fed? And what matters is the present value of seigniorage revenue? It's not just current conditions and they ended up concluding that seems pretty unlikely. Now the rub is you can't be controlling inflation if you're going to be generating seigniorage revenue to make sure your balance sheet is in good order. So Germany might step in for that reason. That the alternative is very high inflation.

Beckworth: Well, Eric, we are nearing the end of our time. Any final parting thoughts on this discussion?

Leeper: Yeah, I think I want to go back to the paper by Brunnermeier and co-authors where they talk about the possibility of there being a bubble in the pricing of government debt. And this connects to what I was saying about Japan, but it's an even more drastic example. If you look at Norway, Norway is not a net borrower, by any means it's a net saver. It has a huge sovereign wealth fund. And when you think about Norway in the context of this equilibrium condition that equates the real value of government liabilities to primary surpluses, Norway should be running primary deficits forever because they have so much wealth. And so you don't necessarily have to attribute that the absence of primary surpluses to a bubble term as the Brunnermeier paper seems to do. It just goes back to, "You got to do the accounting right to figure out what the government's net indebtedness position is."

Beckworth: Very fascinating. Well with that, our time is up. Our guest today has been Eric Leeper. Eric, thank you so much for coming on the show.

Leeper: Thank you. It was a blast.

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