John Cochrane on Finance, the Fiscal Theory of the Price Level, and Blogging

Inflation remains as puzzling a phenomenon today as ever before, and the fiscal theory of the price level can help explain it.

John Cochrane is a senior fellow of the Hoover Institution at Stanford University, and a former professor of finance at the University of Chicago. He is also a distinguished senior Fellow at the Becker Friedman Institute, a research associate of the National Bureau of Economic Research, an adjunct scholar of the CATO Institute. John joins David Beckworth to discuss John’s journey into economics and finance. They also discuss the controversial fiscal theory of the price level, which argues that fiscal policy, not monetary policy set by central banks, primarily determines inflation.

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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: John, welcome to the show.

John Cochrane: Thanks, a pleasure to be here.

Beckworth: I want to begin by asking you how you got into finance and economics. I was looking at your bio. It said as undergrad you were a Physics Major. How does a Physics Major find his way into the world of finance and economics?

Cochrane: I wandered around a long time figuring out what I was going to do, as I think we all do. I loved physics in undergrad. Towards the end of my undergraduate career, I realized I wasn't a good enough mathematician to be a theorist. I'm a terrible manager so I was not set out to be an experimentalist, and I loved economics.

I had taken some economics classes, and just had a conversion moment in my micro class when I first saw the budget constraints facing people with welfare. I realized I would have done the same thing they did. That was just so beautiful. Here's a social scientific question that's wrapped up with all this moral, and culture, and so forth.

You'd look at the budget constraint and you'd know, "Oh boy. I would do the same thing they would." I went off to a grad school in economics, the sort of thing that's very hard to do these days. I called up in August the places that let me in in Physics and said, "Hey, how about I do economics instead?"

Beckworth: Really? Wow.

Cochrane: Berkeley in Chicago believe it or not, let me in. I went to Berkeley, because I knew it didn't snow. I studied in micro because I loved it. It was so beautiful, but I didn't think I could do any research in micro. It all seemed like it had been solved. I got interested in time series in macro, mostly time series. It's a good time series.

I came to Chicago and got to know Lars Hansen, and Bob Lucas, and Eugene Fama. They got me more interested in the macro end of things, and then I wandered over to finance. What's great about economics is, it's the same kind of tool. You can jump around and do a lot of things these days ,at least.

Beckworth: Is it true that you're related to Eugene Fama?

Cochrane: Yeah, that's right. I moved to Chicago and married the boss's daughter.

Beckworth: I'm just curious. What is it like at Thanksgiving dinner? Do you guys debate the intricacies of finance and economics?

Cochrane: Not really. Eugene likes to talk about business in the office, and other things at home. We do sometimes talk about economics at home, but mostly we keep to that schedule.

Beckworth: I'm impressed that you're able to compartmentalize your life like that. Let me ask about something you've gone into more recently and that's blogging. You've been a very effective blogger. When you pose something that seems to be widely circulated, it goes through Twitter.

Have you found blogging to be useful for your work and for your overall enjoyment as an economist?

Cochrane: Yeah, very much so. I'm very glad I did it. I think it's a useful thing. I think we're in a moment of evolution for how economic ideas go around and get debated. Believe it or not, journals used to be how people communicated ideas.

People would actually read journals to find out what's new and what's going on. Of course now, they're five‑year‑old stuff. It is important. It's where things are carved in stone and they're fully refined, and so forth.

The blogs have been, I think, quite useful in both applying economic ideas to public policy in a way you just can't do in an office/ It's a way to have debate about how does economics fit public policy and debates about economics.

One of the high points is, I wrote a one‑week essay thinking some things through out loud and then Mike Woodford picked it up and wrote a paper about it. We had a written interchange at the level that you normally wouldn't have. I don't know how you'd have that, how much the back and forth happened.

I think blogs are emerging. Now, blogs are a combination of commentary and a little bit political stuff. There's people who like to fight with each other on blogs. I think that's got to sort itself out. I think we'll find a better way of disseminating and talking to each other in a structured way, but with the immediacy of the blogger format.

Beckworth: It's been fun for me to watch policy be at least influenced or informed in real time by blogging. I remember TARP, when TARP was first announced the blogosphere went postal against that, the initial two‑page, one‑page document. I remember this, the feedback occurring and the Treasury actually invited some bloggers up to the Treasury building and talked to them about it.

In some of the QE debates, what the Fed's doing, it's always interesting to see Janet Yellen get asked questions that we were just discussing the day before in the blogosphere at her press conferences.

Then what you're suggesting ‑‑ more formal thinking. Develop an idea out loud, you get feedback, and then you can turn it into some serious research. It has been great watching this. I feel more informed. I feel more engaged. Maybe, I can say I found my people through blogging and Twitter. In another world, another time, I wouldn't have been able to do so.

Let's move on to your research. In particular, in one area where you've made a big contribution, and that is the fiscal theory of the price level. As a way to motivate our discussion to get us going, I want to mention some articles that came out late last year, some in August in a Wall Street Journal story and an Economist story.

They were beside themselves trying to make sense of the low inflation that's going on around the world, either from the US, to Europe, to Japan. It seems like Central Banks are trying really hard to get at least in Eastern Europe, you've got massive QE. Japan is still doing ergonomics. The Feds had rates really low. They've stopped their QE, but they still have a large balance sheet.

They were perplexed. They couldn't make sense of why do we have low inflation. Even some Fed officials who are going to the Jackson Hole meeting in one of these articles mentioned they weren't sure themselves. They were losing faith.

My question to you is, what is this fiscal theory of the price level and can it be used to help us make sense of what's going on with inflation in the world today?

Fiscal Theory of the Price Level

Cochrane: Those are two big questions.

Beckworth: Let's do one at a time. Start with the fiscal theory, then we can apply it.

Cochrane: The fiscal theory is not a "Let's explain the latest data point" theory. I think it's the framework that helps us understand these things, very much so. Let me back up. Let's talk about the fiscal theory and what it is.

Let's talk in general terms, not about the latest why is inflation so puzzlingly low. I'm not going to give you a magic bullet on that one, although I will give you an interpretation.

Let's go back to the puzzling question of all which is where does inflation come from? Why does money have value? When you think about it, you work really hard for pieces of paper. These pieces of paper didn't cost a lot to me. Why in the world are those pieces of paper so valuable?

That's a deep puzzle in economics. The fiscal theory of the price level answers that with a very simple answer. The reason people are willing to work so hard for those pieces of paper is because the government accept those pieces of paper for tax payments, at the end of the day.

You need to get some US dollars on April 15th. You need to get them to pay your taxes with. You're willing to take those dollars from somebody else in return for say, your work. You know you can give those dollars to another person in return for something, because he needs them in order to pay his taxes.

That's the bottom line. Why does money have value? Because the government accepts it for taxes. That's not just an olden thing, it's from Adam Smith actually. It's kind of revolutionary. I think it is the only theory that is coherent at the moment that makes any sense as a matter of economic logic in current positions..

The alternatives are money is kind of like clam shells. We only use one thing. That doesn't really describe our money anymore. The Milton Friedman monetarism view that it's just something, an arbitrary silver convention in restricted supply ‑‑ well, it's not in restricted supply.

Our government's target interest rate, the classic theory says that if your target interest rates, inflation is undetermined without the fiscal theory. That just doesn't work. The other view is that the Fed by manipulating interest rates and so forth, that's what determines inflation.

That's not really an economic theory. I simply feel that the whole view, as far as I can tell, it's the only coherent theory we have. Then the job is to make it work.

Cochrane: That explains the basic idea. Ask me some questions, though.

Beckworth: Yeah, I will. I want to actually get into the weeds a little bit. Before I do that, stepping back, in the fiscal theory the price level, is it accurate to say it explains the velocity of money? If I take equation of exchange, what it really does is it explains to a large extent what drives velocity, whereas as the standard monetary theory focuses more on the supply of money.

Cochrane: No, no. The fiscal theory says velocity is pretty much irrelevant. The standard monetary theory, there's two kinds of government debts. Money is just the government's debt. Money is zero maturity, it's non‑existing government debt. The only difference between money and a Treasury bill is that a Treasury bill pays a little bit of interest.

The standard monetary theory says it's incredibly important how the government divides up its debt between money and interesting paying debt. The fiscal theory says no, that doesn't really matter that much at all. What matters is the total amount of government debt relative to the government's willingness to soak up that debt with tax payments.

Now, velocity is about the split of government debt between money or short maturity, and longer term debt, and so that split is really important. It's like it's really important whether the government prints up $1 bills or quarters, or $1 bills or $5 bills.

The standard monetary theory says if you print up too many $1 bills and not enough $5 bills, you're in trouble. The fiscal theory says, no, no, no, $1 or $5 bills, what matters is the government's ability to pay back all its debt.

Where inflation comes from is where people don't want to hold government debt of all maturity ‑‑ money, short‑term debt, long‑term debt. When they have faith in the government's ability to repay its debt as all maturities, then inflation goes down.

Beckworth: But doesn't that work through velocity in this story that people want to get rid of government bonds? Then they sell them, and the transactions cause the velocity to go up and that causes inflation to go up?

Cochrane: You're still thinking about the split, the portfolio split, between holding money and government bonds, as opposed to how much of your overall portfolio do you want to have with the government versus with private debt?

What's beautiful about the fiscal theory is it allows you to start with something frictionless, as we do in all economics. You want to start with supply and demand and market clearance, and then add the bells and whistles.

The fiscal theory you start...all government debt is government debt, and it doesn't really make any difference if it's money or bonds. Then if you want, we can add some bells and whistles. The standard monetary economics takes only the bells and whistles, and throws out the basics of supply and demand.

The fiscal theory really says what matters to inflation in the end is the overall quantity of government debt and can the government pay it back, as opposed to the structure of government debt. Is it too much money versus too few bonds, too much bonds versus too little money?

Beckworth: Let me dig into this theory a little bit more. In the model in your papers you've presented, there are two key equations to the fiscal theory as I understand it. One that relates to the government current liabilities ‑‑ both the bonds and money, the monetary base in government bonds, to the present value of expected surpluses over the long run.

That's a mouthful. On the blog for this interview I'll post the equations so the listeners can see it, but there's that first equation. Then you have the second equation, the equation of exchange ‑‑ money times velocity equals the price level times real GDP.

This is a very basic model that you are describing. I wanted to get into it and ask a question. In terms of the expected surpluses in the long horizon, what horizons should we be thinking of? If the present value of these expected surpluses determines the value of current government liabilities, how far out should we be looking?

Cochrane: Let me just to try to demystify those two equations  you just talked about. There's a lot here that's imperialistic from finance. When we think about the value of a company, we think about the stock price as determined by the present value of the profits you're going to get, primarily, right?

Beckworth: Right.

Cochrane: Then secondarily there might be some market friction, so it matters if you have common stocks or preferred stock. Do you have lots of stock and less bonds?

The value of the company is the present value of all the profits, but maybe there's this Modigliani‑Miller theorem that says doesn't matter if you issue stock or bonds, but maybe it really does matter that some kinds of stock bonds of each. You could tweak the value of the company with these changes.

This is the same idea applied to government finances. How much is all of the government's liabilities worth? That's the present value of the "profits" and how much the government will soak up from taxpayers to get back from bondholders.

There might be a secondary friction. In frictionless economics Modigliani‑Miller theorem it doesn't matter if the government issues long‑term debt or short‑term debt or money debt, or whatever. Just like stocks and bonds, the total value of the company is at present... the total present value of the profits is the total value of the liability.

Maybe there's some frictions that people really want green‑colored money, not red colored money or they want money not bonds, and that's the second equation you mentioned. In standard economics, standard monetary economics, we focused all on this little friction and kind of forgotten about the underlying value of the company, it's present value to profits of course.

What we're doing with the fiscal theory is, just as we did with finance in about 1968, putting value of all government debt is present value of how much the government is going to pay back that debt. That comes first and only second comes little frictions between different kinds of debts.

In fact, serious inflations, I can't think of a single serious inflation that happened to a government that was running big surpluses and just its central bank did something stupid. All serious inflations come when governments don't have the capacity to pay back their debts.

Then what happens? People say, "The government can't pay them back, so I guess I better try to get rid of this. Let's go out and try to give some of this debt to the grocery store, and get some more food." Everyone's doing that and that ends up driving up the price of food.

When people lose faith in the government's ability to pay back its debt, that feels like aggregate demand, and it drives up prices, it's real simple. That was the first part of question. Now I've forgotten the second part of your question.

Beckworth: I was just asking, in that present value equation for the government liabilities there's two parts to it. First the numerator you have the actual surpluses, and then the denominator you've got a discount rate. Which one's more important over what horizon? Let's go with that.

Cochrane: Yeah, that depends on the maturity structure of the government's debt. Typically, governments are very...what makes this hard, the fiscal theory is hard to apply to the data, much hard than MV equals PY.

MV equals PY is a simple tool, money times velocity equals price level times nominal income, and Friedman Schwartz can go write a book on interpreting it every month. It's much harder with the fiscal theory, because the equivalence of the PY is not this year's income. It's this present value of future surplus.

Governments are very, very long‑lived. In fact, if the United States wants to run surpluses, we're taking 40, 50 years of surpluses. Governments pay back their debts over extraordinarily long amounts of time.

When you want to pick up empirically, you have to think about these present values taking place over enormous amounts.

The World War II debt in the US, very big debt, I think like 200 percent debt to GP, that was paid back over 30 to 40 years. The Napoleonic War debt of Britain, that's one of the biggest we've ever seen, I think, 250 percent debt to GP ratio. They paid that back over a century. There's a very long horizon there.

Then the second difficulty is the one you've just mentioned. One thing we've learned crystal clear from asset prices. One thing we've learned crystal clear from asset prices is that stock prices reflect discount rates as much or more than they reflect the actual cash payment to dividends.

When stock prices are high relative to dividends, that means the expected returns and discount rates are low. It doesn't mean dividends are going up in the future. If you want to try to interpret data, the only hope to interpret data is to think that the same thing is true of government debt.

I'll give you an example. 2008 we had a big recession, huge deficits, and yet inflation went down like crazy. How could a company be having huge losses and its stock price go up? That's the equivalent of what we just saw.

The government is hemorrhaging money, and yet everybody wants to hold his debt and is driving up the price of government debt and getting away from other stock.

Well, you kind of know what was going on then. Everybody wanted to hold government debt, and they were willing to hold government debt at a low rate of return. The discount rate for government debt went down like crazy, even though the deficits looked terrible.

In accounting for inflation with the fiscal theory we have to face up, I think, to the fact that discount rate variation in the short run is going to be really important for understanding short runs of fluctuation and inflation.

Beckworth: So the discount rate is what really what drives business cycles, is that another way of saying that?

Cochrane: Yeah, that's my view.

Beckworth: Or is that too strong?

Cochrane: No, no, no. As I integrate what I've learned in the last 30 years about finance and macroeconomics, macro isn't really paying attention to this fact, but finance is all about changes in risk premiums.

Not changes in the level of interest rates, which we all spend a lot of time on ‑‑ changes in risk premiums. How much do you expect to earn on stocks over bond? What's the spread between mortgages and treasuries?

The risk premiums vary tremendously and they vary with the business cycle. The business cycle is about people's willingness to take risk, not really about the level of interest rates. In a recession, people's willingness to take risks plummets.

They all try to buy government bonds. That's sends the price of government bonds up and inflation down. That's, I think, how the fiscal theory will understand the data. It's not just the fiscal theory itself. It's also how it's going to have to be used to understand the data.

Beckworth: Going back to my original motivation for the fiscal theory of the price level discussion, we have these low inflation rates throughout most of the at least advanced economies of the word, Europe, the US, Japan.

Is that the explanation you would give now is that discount rates have changed such that people are clamoring for...well, rates have changed as a reflection of the clamoring for safe assets across the world, and that's what's causing inflation to fall?

Explaining Low Inflation across Advanced Economies

Cochrane: There are two possibilities. The government bonds are at an all‑time high. The prices are high, interest rates are low. Either people think governments are going to be running really big surpluses in the future and this is a good investment, or they are willing to hold government debt despite very low rates of return, the discount rate effect.

As I look out the window it smells of discount rate effect to me. It smells of demand for safe assets, demand for nominally safe assets. Government debt might inflate, but it won't explicitly default. You'll never go to bankruptcy court in a financial crisis.

As I look out the window it smells to me like a discount rate rather than our governments are all just, "In 10 years the tax revenues are just going to be flowing in.." You think, yeah.

Beckworth: Right, unlikely, unlikely.

Cochrane: Now there is a danger. I don't like to use the word bubble, but I will, because government debt is very short‑term, so people holding government debt on average...even the US , we roll over half our debt every two years.

Short‑term debt is very prone to having a high value for a long time and then everyone tries to get out at once. When you think about things for the fiscal theory, we have low inflation now, but it doesn't give you...if it's a discount rate effect and it's a short‑term debt, everyone could head for the hills at any time at any moment.

Greece's debt had very low interest rates and very low inflation in about 2006, and they discovered that things can change quickly. I think it does warn us that things can change quickly.

Beckworth: A couple questions. First, what would be the alternative? Let's say that moment arrives, that moment when suddenly discount rates change dramatically. People don't want to hold government debt.

Would they not move into some other kind of asset? What would they go into, commodities? What would happen in that type of environment?

Cochrane: Absolutely. Let's paint a picture. Suppose, heavens, we discover that all the books are cooked in China and  simultaneously, we discover that California can't pay its pensions, Illinois can't pay its pensions. Usually things start with some sort of scandal, and a bunch of banks go under, or whatever.

People decide, you know what? The great sovereign debt bubble is about to burst, so what do they do? Yeah, they try to get their money out of government debt. What do you do when you want to get your money out of government debt?

Well yeah, you buy stocks, and real estate, and bonds. You buy assets, real assets that the government can't get at. That drives up the prices of those assets. People call it asset price inflation, a word I hate.

Cochrane: Then the price of those assets goes up when people say, "Wow, my house is worth a lot. Why don't I refinance the mortgage and buy a new car?" Now we get what feels like aggregate demand pushing up the price of goods and services.

That effort to get out of government debt would lead to inflation. That's how government debt loses its value. Inflation breaks out, which governments can't really do a whole lot about. The Federal Reserve couldn't do anything about this.

Everyone said, "We don't want to hold government debt anymore," and then the Fed said, "Here, have some money." People said, "Hey, wait a minute. Money is just the same thing as government debt. I don't want any of this stuff." Now we're in trouble.

Beckworth: Another question relating to the discount rate, it's been a reflection of high risk premium ever since the crisis has emerged. My question to you is, why has it taken so long for risk premiums to adjust back to more normal levels?

It's been seven years, and still we see these record low interest rates, high prices for government bonds in safe countries. What's your story for the slow adjustment?

Cochrane: Here we're telling stories, which is dangerous.

Beckworth: These stories can help us understand better the theory, so I think it might be interesting.

Cochrane: One should do theories and compare them. There's always a story, and it's always good. For every theory there's always an excellent story, so let's start with, can we cook up an excellent story? But recognize that everybody's theory can always cook up an excellent story. It gets puzzling. There was a huge risk framing early on in the recession where everybody wanted to hold government bonds.

Now the stories are that piece of a risk has gotten better, and so the stock prices have been driven up and so forth, yet still the demand for government bonds seems to be very, very strong.

What drives these risk premiums? John Campbell and I wrote a paper that formalized this. It's called, "By Force of Habit." There is a strong tendency in the business when things are going pretty well, and your business is pretty safe, and your job is pretty safe, people are willing to take more risks.

When it gets dangerous there's a recession, and a lot of people around you are getting fired, the guy keeps coming to repossess the house, and the car, and the dog, you might say, "Wow, stocks are a great deal right now, but I'm just not investing." There's a natural way in which risk aversion rises in bad economic times.

Beckworth: It's just taken a long time to change. It's almost like the market needs a slap to the face. Hey, time to get that risk premium back to more normal levels.

Cochrane: It's kind of puzzling, because demand is very strong for stocks and for government bonds and corporate bonds. The risk premium is actually quite low right now, in the sense that stock prices relative to dividends are quite high. There's this drive for risk.

But people are also buying a whole lot of government bonds. Some observers call this the savings glut. I hate devaluating words like that, but there's overall a demand to save a lot, and a lot of that comes in the form of demand for government debt.

Beckworth: How about this scenario...?

Cochrane: The puzzle is that government debt doesn't look...objectively it doesn't look like that great a long‑term investment. How are you guys going to pay this stuff off?

Beckworth: Maybe there's no better alternative risk adjusted basis. Let me throw this story out there.

Cochrane: There is this thought, "I'm going to hold it for a while and get rid of it before things get bad," which is the danger I smell. When I talk to bond traders I say, "Why are you holding these 30‑year bonds?

Our US government, do you think's like two and a half percent. Do you really think inflation's going to be 2.5 percent for 30 years?" They answer, "I'm not holding it for 30 years. I'm holding it for the next six months, and then I'm going to sell it to some other sucker before the rate goes up." Thanks a dangerous psychology.  Sorry, you were going ask a question.

Beckworth: No, no, I wonder to some extent also if we got a couple things going on. You mentioned the savings glut, which is another way of saying the emerging world's growing rapidly. They too, want safe assets.

They can't get it at home so they come to the US, and we provide these safe assets. In fact, we are a bank to the world as far as we provide safe liquid assets, and treasuries being one of them. They continue to grow so there's that issue. But there's also...

Cochrane: Let me just say. Let's stop and look at it, because it's often, "Oh, this is terrible. The savings gut, the global imbalances, and so forth." This is wonderful.  When things happen, not everything that happens is something awful.

Yeah, it's wonderful for us. People in emerging markets and China want to get their money out of China, and they want to put it somewhere that's safe. The US has financed an entire year of GDP of deficits off of selling paper to these poor Chinese people, who should be investing in China.

The sad part is that the people are too scared of the property rights in China to put their money in China. Large global flows, lots of people saving and then hopefully later being able to buy stuff, this is not a terrible economic problem. This is the economy working the way it's supposed to. Sorry, go ahead.

Beckworth: I think that speaks to there aren't really any good alternatives for these people, right? It's a puzzle, but at the same time maybe it's pretty clear. They don't have many good alternatives at home. But the second thing is...

Cochrane: There are good alternatives, but not safe alternatives.

Beckworth: You're right. There's high yielding...right.

Cochrane: The marginal private capital in China is really high, but they're worried about the legal systems. They're worried about, I should be investing in a factory. Investing in a factory in China versus an overpriced house in Palo Alto...from a social perspective they should be buying that factory.

Beckworth: I agree, absolutely.

Cochrane: They're worried.

Beckworth: Stepping back and trying to explain these low discount rates on government bonds, one factor is this global saving glut, the demand for safe assets from around the world. The second thing ‑‑ and this is a story I'm going to tell, expose, but we had the Great Recession, we had the crisis.

Ever since then we've had a spate of other mini crises that keep some investors rattled. We had the fiscal cliff. We had the sequester that created maybe nothing substantive, but created fears of government shutdown.

We had the Eurozone crisis that keeps re‑emerging. Now we have concerns from China. It seems we never really got a clear break from the bottom of the crisis. There's always something that keeps nagging at us that may be explaining why people still demand treasuries. Is that a reasonable story?

Cochrane: It's a story, but it's a troublesome one. All of these problems are government problems. Government debt objectively does not look like a great investment. The fiscal cliff...we almost had a technical default on US treasuries, which is supposed to not be able to happen. I have to admit, I scratched my head and wondered. I'm not holding 30‑year nominal government bonds.

Beckworth:  It was interesting. I think it was the fiscal cliff when US government debt was downgraded a notch and nothing happened to interest rates. In fact, they probably went down even more if I had to go back and check. No one's paying attention to the rating agencies, and they still want those bonds.

Cochrane: In big terms, the US is not likely to formally default on its debt, because the US can print up money to pay off its debt. The danger is for the US to inflate away its debt rather than default on its debt.

The rating agencies know that when they're lower them up, they say, "We're worried about inflating away your debt." Bond holders seem to treat those two things very differently, and I think with good reasons. A default is different from an inflation.

Beckworth: Let's go ahead and apply this theory to some historical cases. I think we've already touched on my initial observation about, right now, what's going on in the world of low inflation. Let's talk about the great inflation of the mid‑1960s to early 1980s.

In the 1960s President Lyndon Johnson tried to fight a war in Vietnam, also do the Great Society, that's one of the stories told. There's also the story that the Federal Reserve lost control, had bad measurement or was influenced politically. How does the fiscal theory of the price level explain that period?

Applications to Historical Cases: 1960s, 70s, and 80s

Cochrane: As you noticed, and I want to not toot too many horns here, that present value equation that you stated does hold. It holds in every theory. Really the question is, by what mechanism does it hold?

The value, suppose there's a big deflation that happens for other reasons. Does the government then go out and raise taxes in order to pay off a windfall for long‑term bond holders? The causality can go both ways.

Beckworth: Well, look at that. Let me ask one question.

Cochrane: It can cause those events.

Beckworth: Before I get back to the historical cases, one question. Would you say then that the fiscal theory of the price level is a more general theory that has, as a special case, the standard monetary theory?

Cochrane: There are two equations you've mentioned. The value of government debt is the present value of surplus, and an equation involving some frictions where people like some kinds of government debt more than others, MV = PY. Those two equations are present in every form of every model. In the monetary model, that present value equation is always there.

It's usually off in footnote 17 where the offer says, "Oh, the referee annoyed me about the government budget constraints. I'll just assume that the government raises lump sum taxes as needed to make this equation hold," so they make other assumptions to make that thing go away.

It's a question of where you focus your attention, on which part of the common theory is the one really driving a historical event. The question you brought up is, yeah, historical inflations in the US don't just have the Federal Reserve screwing up, they have important things going on with fiscal policy.

If you start with the big ones like Argentina, when Argentina had this huge collapse, or Brazil, it's clear. And the government, by the way, is bankrupt, there's nothing the central bank can do monkeying around with interest rates, or swapping one kind of debt for another to do anything about it.

There's clearly people running away from the currency and it's a fiscal problem. The other historical episodes you look at and say, "Wait a minute, the Federal Reserve wasn't just screwing up in the absence of anything going on." There's always something interesting going on with fiscal policy.

The antecedent to the inflations of the 1970s, were yes, Johnson wanted the Great Society and the Vietnam War, and started spending money that wasn't gained in some kinds of taxes. Then 1972‑73, the productivity slowdown happened and growth started honing that up. Now, changes in long‑term growth is just a disaster for government finances because of this very long horizon you mentioned.

1975 was the biggest deficit anyone had seen since World War 2, with trends, growth rates going down, and certainly there's a story to be told. People are losing faith in the US Government's ability to pay back its debt and guess what? We have inflation.

Beckworth: The next part of US history takes us into Volcker and Reagan, and that provides a nice segue into a question I've had. What role does the fiscal theory of the price level have for central banks for monetary authorities in a country?

The standard story told for getting out of the great inflation is that Paul Volcker stepped in. He was a man with a spine, and he ushered in a double‑dip recession, two recessions in the early '80s. In your writing, you also mention the role that Reagan played in this.

I guess my question is, is it possible for a monetary authority to play some kind of signaling role or it signals that the government as a whole is more committed to low inflation and to bigger surpluses in the future?

Cochrane: Absolutely. I'm going to tell some stories, you're going to tell some stories, all of this needs really good articles to be written. I hope you have some PhD students listening. Each of these episodes is worthy of a serious paper to be written. You don't do empirical economics just by telling stories. You start by telling stories and you recount the story whole.

Beckworth:  That's why we're here.

Cochrane: I'm thinking, the Volcker episode is pretty much the gold star for the standard story that's monetary policy that can attack inflation. When we look at the events, there is an important fiscal policy counterpart to it. I think of the Volcker debt as a joint fiscal monetary disinflation.

Volcker raised interest rates, but there was also tax reform that happened, a huge set of tax reforms. In the event, those tax reforms at least coincided with ‑‑ or caused, depending on your view of supply side economics ‑‑ a huge economic boom.

The present value of surpluses in fact with x plus hindsight, rose tremendously. They simplified the tax code, they cut rates, revenue started rising immediately. Then there was an economic boom. By the mid‑Clinton years, the surpluses were so large we were worrying about having to retire the entire US debt, so it actually made sense.

Think about the opposite. Latin America has many failed stabilizations. A central banker comes in and says, "We're going to do the tough thing, cut the money supply and raise interest rates," but then nobody cleans up the government finances. They're still running huge deficits and the tax code is a disaster, and hurting economic growth.

What happens? Two or three years later, the inflation breaks out again and the whole thing falls apart. That fits in my mind very well as a classic, coordinated monetary fiscal policy to stop inflation. The fiscal policy part of it was crucial. Without the fiscal policy it wouldn't happen.

The Fed actually is quite powerful in the fiscal theory of the price level. I have a recent paper on it which sets out the equations if you want to go look at it. We shouldn't go to papers. It's in the Federal,,,

Beckworth: I'll link to it.

Cochrane: Yeah. It's a monetary policy interest on reserves. It kind of sets out what can you do about inflation if you have no control over surpluses in the fiscal theory of the price level? The answer is quite a lot. Basically what you can do, you can set expected inflation to anything you want. It's the unexpected inflation that the central bank can't do anything about.

The simple version of this is the currency reform. Every good monetary theory has to be able to handle the day on which Italy changes from the Lira to the Euro, and cuts three zeroes off of every price. That kind of thing is the kind of thing a central bank can do.

There's no fiscal policy involved. We're simply going to cut three zeroes off the price of everything. That means that the money supply falls by a factor of three, prices fall by a factor of three, government debt falls by a factor of three, but there's no change in real quantities at all.

Central banks can do that kind of thing. They can change the units the same way a company can have a share split. We can say your IBM shares are worth 100 bucks each, we're going to simply do a two‑for‑one split, they're going to be worth 50 bucks each. That's inflation, right?

We just changed the value of that thing. Now, we didn't change any profits, but you can certainly change the units with which we measure things. Central banks can do that in the fiscal theory of the price level. That's a quite powerful tool, and if you add a little bit of price stickiness in there, all of a sudden central banks are affected.

Beckworth: What would you have a central bank target? If you were playing God for a while here, how would you have a central bank operate, given your understanding of the fiscal theory of the price level?

Cochrane: Here you're going to mix in some of my policy preferences and political views about the reliability of central banks to wake up every morning and cleverly offset shocks, and so forth. I think the ideal monetary system is one with a constant price level.

Let's set aside the difficulties of measuring inflation and let's suppose the CPI is perfectly measured. I think we're doing our job if the CPI is 100 forever. The mechanism for doing that that I'd like to see is the equivalent of a gold standard.

Gold doesn't work, because the ratio of gold and goods prices goes up and down. But you can do essentially a CPI standard. I would like them to target expected inflation at zero forever, which they can do.

Beckworth: I think you've mentioned in your writings you would have them target the CPI futures contract, is that right?

Cochrane: There's lots of equivalent ways of doing it. I think it would end up targeting the spread between TIPS and Treasury.

Beckworth: The break‑even inflation rate.

Cochrane: Yeah, that's a way to explain the idea that is closest to current institutions, target the spread. If you target that spread and you say, "We'll do what it takes," expected inflation has to end up being what you say it's going to be, but that can target one thing. The CPI futures contract is another way of explaining the same idea.

People understand how a gold standard works. If you say the price of gold is 100 bucks an ounce, and you buy and sell as much as you want at 100 bucks an ounce, you can see how they set the price of gold. The CPI futures contract is a way of saying, "This works the same way as the gold standard." Now you can see how the Fed could set the CPI to 100 forever.

Beckworth: Just to be clear, you said a price level, so you would have the Fed make up for past mistakes? If it happened to go one year where we had inflation or deflation, it would actually compensate for that, is that right?

Cochrane: Yeah. This, I think, gives them the advantages of the gold standard which is centuries of hallmark of price stability, but without the disadvantages of the gold standard, which are many, many disadvantages, particularly bouts of big inflation and deflation.

If expected inflation is always zero, you get a little bit up, a're not going to have big variability in actual inflation. You're going to squeeze it back out again, because of the value of money. We don't muck around with the length of a yard or the meter.

Suppose you're in a recession and the tailors are in trouble. You don't want to cut down the value of a yard to 35 inches to help the tailors sell a little bit more. That's what we're doing with money.

I like the idea of a standard of value which is...we're not going to use this as a policy tool, the standard of value's going to be, the dollar is worth 100, it's going to be worth this basket of goods forever and ever.

Beckworth: Sargent and Wallace first talked about the fiscal theory of the price level. I think it was them who first talked about it over 30 years ago. It seems to me, other than you and a few other people, it hasn't gained a lot of traction. My question is, why?

Cochrane:  Well, because we're the visionaries who saw it.

Beckworth: You're avant‑garde, huh, you're leading the charge?

Cochrane: There is the fact. You don't get invited to a lot of talks at the Fed talking about get invited to talk to the Fed if you write about goals, but it's not going to appear later. Maybe we're all wrong. Why hasn't it gained traction? I don't know.

I'm jumping into it in full because it hasn't gained traction. I see an opportunity for me to work on what I think has got to be the theory of the future, and get in there early before someone else does.

Beckworth: You mentioned it's not a popular topic at the Fed. I was joking once with a Fed economist that I would love to see Janet Yellen...actually, I wouldn't because this would worry the markets.

Maybe in a play or a skit, have Janet Yellen get up and say, "I give up, this is ridiculous. I believe in the fiscal theory of the price level. This press conference is completely pointless. Every word you hang on is meaningless. Go home and read the fiscal theory of the price level."

Cochrane: In fact, a central bank can set nominal interest rates, and it has a strong effect on inflation and real activity, even in the fiscal theory of the price level. There's actually plenty of things, and central banks can use this.

Back to the policy world, the policy world is and should be 30 or 40 years behind the research frontier. Most of the policy world right now thinks in pretty unadorned mid‑1970s Dornbusch and Fisher ISLM with an acceleration done. That is how the Fed thinks about things, it's how the OECD thinks about things, how the IMS thinks about things.

The people now running it, that's what they learned as undergrads and grad students. That's the framework that they tell stories with. The fiscal theory of the price level is, you have to first embrace certain new Keynesian economics, then you have to understand why it doesn't really work, and then you can move onto fiscal theory.

We haven't done the academic research. The questions you asked me are exactly the right questions. We've done the deep theory, we know the theory works. We've done the framework, we know the framework works.

We've started to think about how you adapt the framework to real‑world prices? We've started to think about how you put in these theories in place? Then we think, you need a convincing account of these historical episodes that you told me about. Not just convincing in, "Oh, here's a story."

We need a convincing, real empirical work saying, "Here's how you understand these episodes with the fiscal theory of the price level." Then you need a convincing analysis of what's happening to the research, what's happening now.

Then maybe you can tell central banks what to do and they'll say, "This is a framework that we could use for every day." You've got to do the work first. That's why policy doesn't do it. Why don't academics jump on board to do this work? I hope they will. That's why I'm doing this podcast.

Beckworth: And you're writing a book.

Cochrane: Yes, exactly.

Beckworth: Let's take this idea and apply it to what the Fed's done over the past seven years with quantitative easing. We've had three QE programs, and you've been very skeptical of them, and I think it's tied to your understanding of the fiscal theory of the price level. Could you share with our listeners why you think they were largely ineffective?

QE Programs as Test Cases for Theories of the Price Level

Cochrane: The QE programs the recent couple of years have been, when you look at it, really wonderful test cases for theories of the price levels. The amazing thing is that absolutely nothing happened. We set off what should have been an atomic bomb. Nothing happened.

Quantitative easing, for your listeners, there used to be something like banks had like $50 billion in reserves of the Fed. The Fed then bought something like $3 trillion worth of treasuries and turned that into bank reserves. The supply of what we call money exploded from 50 billion to 3 trillion.

If you think about money times velocity equals price times income, you'd say, "Oh my gosh, the Fed just did a factor of 60. They increased the money supply by a factor of 60." A factor of three if you depends on what you call money, that's been one of the problems always.

Think of this huge thing. That should have set off hyperinflation, and nothing happened. Think, why did nothing happen? Because to a bank, holding interest‑paying reserves at the Fed or holding treasuries is exactly the same thing.

When the Fed buys treasuries from banks and gives bank reserves in Fed, in my analysis, that's like buying red M&Ms and giving you back green M&Ms, or taking your 20s and giving you two 5s and a 10 for each one of them. We have to remember that about the Fed. They don't print money and hand it out. That's called fiscal policy.

The Treasury is, if you're writing checks to voters, in our system, the treasury writes checks to voters, not the Fed. One of the biggest confusions is to think that monetary policy consists of giving money to people which they then spend. That could cause some inflation. They don't. They buy treasuries and give you back money in return.

At zero interest rates, or when reserves pay interest, that operation is just buying and selling the same thing from the point of view of... The fiscal theory then says that's the reason why I think QE doesn't have any effect. It shouldn't have any effect. Taking your 20s and giving you 5s and 10s is not going to make you go out and spend more.

If you take that view, the problem is then you've lost the traditional of what causes inflation. The fiscal theory is what comes to the rescue. It says, "I can tell you what determines inflation, even if you're in a world where money and bonds are perfect substitutes."

This is like a great experiment. You're wondering if changing the open market operations matter at all. Let's find out if open market operations matter at all. Let's do 60 times bigger than you've ever done ever in history and see what happens. What happens is absolutely nothing.  That really does reinforce the view that money and bonds can be perfect, both synchronous.

Beckworth: In the time I have left with you, I want to ask you, what advice would you give to a young budding macroeconomist? What would you tell him to do? What choices to make in terms of becoming a successful macroeconomist?

Cochrane: Don't listen to old folks like me. Because most of us tell you to do like what we did, and that's usually bad advice, because none of us did what old folks told us to do.  The most successful economists are the ones who blatantly ignored all the advice that was given.

But certainly you can see the trends. We live in the computer age. All successful academics do a lot of intellectual arbitrage. Arrow and Debreu in the 1950s did some intellectual arbitrage from fixed point theorems, and they proved general equilibrium.

In the 1980s, Hansen and Sargent did intellectual arbitrage. They learned how to do dynamic programming, and linear time series analysis, and look what they achieved with that kind of stuff.

Now of course, computers ‑‑ computers, Internet, large data. Raj Chetty, Matt Gentzkow ‑‑ what are the young hot economists doing? They're leveraging computers, Internet, and data handling. The usual advice is "Go out and take measure theory."

I would say, "No. Go and make sure you know how to program computers in a large, structured environment," because that seems to be what's going on, certainly in finance and certainly in microeconomics. We'll see where macro is going.

Macro, I think, we're a little bit stuck in always explaining a lot of data points. Macro too is starting to exploit larger data. It's becoming more empirical. A new, cleaner, and better theory is on its way, I hope.

Beckworth: It will be interesting to see. Noah Smith has written some articles describing this shift in the profession towards more applied empirical work, at least for microeconomists, and it'll be interesting to see what happens to macro, because macro's still a lot of modeled DSGE‑type models, less empirical.

That's because we don't have as many natural experiments to run on. Maybe with increased technology, better data, we can make some progress on that front.

Cochrane: People really don't believe big models anymore, the big black box approach. But can we bring smaller transparent models to work in understanding policy? Clearly there's going to be a shift in what kind of thinking people use to think about the macroeconomy.

The big picture is always, Galileo got famous and he didn't get famous by sitting in his office and thinking about things. He invented a better telescope. He looked at the skies and saw, "Oh my gosh, there's mountains on the moon."

That's what's happening certainly in micro. The telescope of the moment is large data, Internet, and computers. People who can use the new technology are discovering new things, and macro as well. The general advice for any scientist is "Figure out where the new telescopes are."

That's what happened in the previous generation. Eugene Fama, he told me about when he was young and computers were punch cards which you had to take down to the computer machine at 11 o'clock at night ‑‑ well, he was the only one who knew how to do the punch cards.

He said, "I was able to do stuff that other people could just dream about, because I learned how to use the computer." Figure out how to see something new. Don't just do what the old folks are doing. That's always the key.

Beckworth: On that great bit of advice we have to end as we've run out of time. Our guest today has been John Cochrane of the Hoover Institution. John, thanks for being on the show.

Cochrane: It's been a pleasure, thank you.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.