Jon Hartley on the Shadow Open Market Committee and Macroeconomic Policy

Jon Hartley is a macroeconomist and affiliated scholar at the Mercatus Center, and he is also the host of a Hoover Institution podcast titled, *Capitalism and Freedom in the 21st Century.* Jon joins David on Macro Musings to talk about the Hoover Institution’s recent monetary policy conference, *A 50-Year Retrospective on the Shadow Open Market Committee and its Role in Monetary Policy* as well as some of his own related work. Specifically, Jon and David also discuss the origins, purpose, and influence of the Shadow Open Market Committee, the tension between the fiscal theory of the price level and Fed policy, the significance of government debt management, and more.

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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].

DISCLAIMER: The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.

David Beckworth: Jon, welcome to the show.

Jon Hartley: Thanks so much for having me, David.

Beckworth: It's great to have you on. Now, Jon, you have your own podcast, as I just highlighted. Tell us a little bit about it.

Hartley: Sure. One, I've been a long-time fan of Macro Musings, and it's an honor to be on your podcast here, and as someone that has their own podcast, really appreciates everything that you do, and certainly takes a lot of cues from your own style. So, my podcast is titled, Capitalism and Freedom in the 21st Century podcast. It gets its name after the 1962 book by Milton Friedman, Capitalism and Freedom, but also the 2014 book, Capital in the Twenty-First Century by Thomas Piketty. It's a funny amalgamation of those two things.

Hartley: But what I do in the podcast is similar to yours in that I interview largely other economists, policymakers, sometimes financial market participants, in one-on-one interviews, and I'd say that my scope with the podcast is a little bit broader than, perhaps, yours, which is, I'd say, more focused on business cycles, finance. It's a little more focused on growth, sometimes some applied micro topics, in addition to all of those great macro topics that you cover.

Hartley: It's hosted at the Hoover Institution now, where it's been since earlier in the summer. I started it a few years ago, basically in my dorm room. It's been an amazing ride in that earlier this year, I had an interview with Steve Levitt that went viral. He announced his retirement on the podcast. Since, I've had some really amazing economists come on from Daron Acemoglu, who just won the Nobel Prize, as well as Simon Johnson, who was on earlier this year, as well as Greg Mankiw, Hoover's very own John Cochrane recently, Rich Clarida, and I've got David Malpass coming on soon. So, it's been amazing in terms of just the scope of guests I've been able to get and the sorts of topics we've been able to talk about.

Beckworth: That's great, a lot of great guests. We'll provide a link to your podcast in the show notes as well. So, check out Jon's podcast. Let's talk about this event, though, that's brought us together here at the Hoover Institution. Now, this was an all-day event. It is probably the longest one-day event with as many panels packed in. We started at 7:00 in the morning, had a little breakfast. We finished at 9:00, 9:30PM. I got back to my hotel at 10:00PM. I was exhausted. But it was also exhilarating because there [were] a lot of great speakers. We had panels on the history of Fed policy. We talked about international experience at the Swiss National Bank, Bundesbank, [and the] Bank of England. We talked about the Fed's search for a nominal anchor— these were all panels— the Fed's operating system. I loved that— Corridor versus floor, monetary-fiscal interactions, the role of fiscal dominance potentially emerging, the evolving nature of the Fed's lender of last resort role. Then, [there was] some discussion by Fed officials. Chris Waller gave a keynote speech as well as a nice panel discussion at the end by some former Fed officials as well.

Beckworth: So, this was a great conference. Now, the title of the conference was, *A 50-Year Retrospective on The Shadow Open Market Committee and Its Role in Monetary Policy.* So, this was a conference about the Shadow Open Market Committee, and what's interesting is that [Condoleezza] Rice, who is the head of this think tank here at the Hoover Institution— she gave the opening talk, and I like what she said. She goes, "The title is a little ironic or maybe confusing, because it says Shadow Open Committee." So, maybe explain to the listeners, for those who don't know, what is the Shadow Open Market Committee and what was the purpose of this conference?

The Origins, Purpose, and Influence of the Shadow Open Market Committee

Hartley: So, the Shadow Open Market Committee has been around for 50 years now. This conference is celebrating the 50th anniversary of it, and it's had a very, I think, important and interesting history. One, it was started by Karl Brunner and Allan Meltzer, two great macroeconomists, in the early 1970s. And in large part, it's attracted a number of leading monetary economists who happen to be monetarists. They believe in money as being essential to driving inflation, and they, to varying degrees, believe in monetary non-neutrality as well. But they, very much, for the past 50 years, have been holding on to that mantle that was popularized by Milton Friedman and many others before him, but most famously Milton Friedman— MV equals PQ. That, I'd say, would summarize them most broadly.

Hartley: Now, obviously, monetarism has fallen out of favor in some respects, but I think that it's important to understand the history of monetarism and just how important it was in the 1980s. There were several governments in Europe that were explicitly targeting monetary aggregates. The Fed was talking about monetary aggregates a lot, maybe not quite explicitly following them, but certainly paying attention to them. And this played a very important role during the Volcker disinflation. Essentially, what the SOMC does is that they meet twice a year and they criticize or critique the current stance of the FOMC, the Federal Open Market Committee, the Fed. So, they meet twice a year. When I was living in New York, I would regularly go to their meetings in person. They've had a wonderful stable of economists over time. But I think what's interesting, too, is that that period in the '80s was very important, certainly to the Volcker disinflation, getting inflation back down, but then something did happen, which was that central banks realized that they couldn't really target monetary aggregates very well.

Hartley: Money demand was unstable, a lot of US currency is outside the US, [and] there's not much they can do about that. So, what happened very quickly is that over a short period of time, money started to fall out of favor, and very quickly, the Fed started targeting interest rates. Along came the Taylor rule in 1993 that, one, was able to make models more tractable in finding unique solutions to equilibrium. On top of that, it just gave a framework for closing a New Keynesian model, but really just a tool that central bankers could use, not as something that's a rigid tool to dictate policy, but really as a guideline and a framework. And so, what's happened over time is that interest rate targeting has taken hold along with inflation targeting. So, inflation is more the goal, but interest rates are the actual policy tool. And what's happened is that, also, you had the start of inflation targeting that started in New Zealand around the same period of time.

Hartley: The history there is fascinating. The finance minister of New Zealand went on TV once and said that the inflation target should be 1%. The central bank of New Zealand did some work, figured that it should actually be 2% according to their models. Then, quickly, Canada jumped on, and later the US. The early '90s, late '80s were a very important time in terms of influencing the future of modern central banking. I think that it's interesting how you have both this confluence of people— people on the Shadow Open Market Committee, the monetarists— that were very, very influential in the 1970s and the 1980s— Milton Friedman— people that were very much trying to help get inflation back down. 

Hartley: They thought that money was the main culprit in the 1970s behind those inflation spikes in the US, but as people realized that money demand wasn't something that was stable quickly— and thanks to the great work of John Taylor and others— that framework shifted quite considerably, and I would say, today, that our framework, or the framework of many central banks, isn't that different from what was incepted in the early 1990s. The monetarists, I think, were definitely part of that evolution.

Beckworth: For sure. So, the SOMC, the Shadow Open Market Committee— they were the early group of observers from the outside critiquing what the Fed did. And maybe a question we can talk about is, how relevant are they today compared to when they first came out? In my mind, there weren't many other competitors, because the Shadow Open Market Committee brought together mainstream economists but who were willing to look at and think about these issues at the Fed. A lot of them were monetarists, and as you noted, it changed over time. Their influence was immense during the Volcker disinflation and around the world. Today, you look around, [and] there are blogs, there are podcasts, there's the Hoover Monetary Policy Conference, there are lots of other venues that are very similar to what the SOMC does. So, would you put the zenith of their influence [at] that Volcker disinflation period, or would you say it's still pretty--?

Hartley: Oh, for sure the zenith was in the period of the 1970s, 1980s. People like Anna Schwartz were on the committee. Even people who were on the FOMC at that time were very much persuaded by this fact that we need to be paying very close attention to monetary aggregates. And I think what is, perhaps, a bit of a shame is that monetary aggregates have fallen completely out of favor, both in our models— If you open up any macroeconomics journal today, whether it's a top five journal or a macroeconomics journal, money is very scant. It's all about interest rates. Similarly, when you go inside central banks, that's very much the case, too. They're very big on three-equation DSGE models, or maybe much more complicated versions of that, and money is still pretty scant. What's interesting, though, is that certainly in the recent period with the great inflation— the early 2020s inflation— I don't know if it's a great inflation yet or not— [is that] M2 is something that surged during that period of time.

Hartley: And so, there's a lot of, say, armchair economists, Wall Street economists that do pay attention to M2— people who maybe aren't in top academic departments. But certainly, people have been using it or at least paying attention to it. There are all sorts of debates about how to measure it— Divisia, M4, all of these different measurement issues— but people in Wall Street at least pay attention to it, at least as a mode of forecasting inflation or trying to understand what the economic conditions are. Obviously, it's not a great policy instrument. I don't think it will ever be, at least anytime soon. But I think that it's a bit of a shame that money has completely fallen out of favor in both central banks and academia.

Beckworth: Yes, so, the SOMC did have a heavy money focus early on. Now, it's pretty standard fare, if I can say that. But it still provides critiques from the outside. It still says, "These are the ways that you should do your inflation target." "This is how you should have governance at the Fed." "This is how you should manage your balance sheet." So, it's still providing great advice, constructive criticism. I will mention that Peter Ireland was one of the discussants last night, and he had a paper where he did make the case for monetary aggregates. 

Beckworth: And just briefly, because I don't think it was highlighted, I'll just note here that his work is premised on these Divisia measures of monetary aggregates, which allegedly gets around the problem of not having stable money demand relationships. So, there are people who are working there, but as a matter of fact, it's not a very large group. So, it's there if you're interested in it. It's just not something—and I think you have to speak the language of central bankers, right? You have to show them. But Peter's point is, look, keep doing the new Keynesian model, but as a cross-check, you should at least look at these Divisia measures, especially when you have periods of great uncertainty.

Hartley: Absolutely. I agree with that in the sense that I think that it's always good to have more information. I think that there's some predictive power with M2. Now, to be fair, I don't think that DSGE models work that well either, and I think that we're kidding ourselves-

Beckworth: Sure enough.

Hartley: -if we're claiming that the leaders of central banks are actually following every estimate coming out of a DSGE model. They do use VARs quite frequently for forecasting purposes. But again, I think this is all about just helping to develop some economic intuition and to give policymakers the best idea of what economic conditions are so that they can make the best policy decisions.

Beckworth: You want to hear my theory on why money has fallen out of favor?

Hartley: I'd love to hear that.

Why Has Money Fallen Out of Favor?

Beckworth: Okay. I think that when the Fed does its job well— so let's take the Great Moderation— you don't see a relationship in the reduced form between money and nominal demand or output. For the very reason that the Fed is responding to shocks, it is systematic. So, if you think in terms of a money view of the economy, there's money demand shocks and there's the Fed trying to offset them. If the Fed is systematically offsetting those shocks, we would not expect to see any systematic relationship, in the reduced form data, between money and, say, prices.

Beckworth: So, to me, it's an identification issue. Yes, money matters, but if the Fed's doing a good job, you're not going to see it, and, therefore, people will give up on it. And that is why, during the Great Inflation of the '70s or during this inflation surge the past few years, when you could argue the central bank was not doing a good job, that relationship emerges of, "Oh, yes, money does seem to lead inflation." So, it's easier to see the deeper structural relationship when there's policy that's not doing its best job than when it's doing a great job. And I think it's similar for the Phillips curve. We have a flat Phillips curve in part, I think, because when the Fed does a good job, it's hard to see it in reduced form data. There's a deeper structural relationship there, [but] it's just hard to identify macro data. It's the eternal struggle of macroeconomists— identification.

Hartley: Absolutely, and I think that that's a big part of why I'm an empirical macroeconomist. I think that identification has been probably the single most important development in economics in the past 30, 40 years. Now, it's taken hold largely in applied micro, RCTs, natural experiments in labor [economics], public economics, development economics. But, one, it's very hard to get identification in macroeconomics, because many things, like monetary policy, are endogenous to the economy. But I think that it's just really so important to understand how cause and effect works in macroeconomics, and I think that there's so much work to be done in that field, and that's where a lot of my research is dedicated toward.

Hartley: But I think that you're spot on, and in particular, I think what's interesting about money is that money seems to really matter when inflation gets big, or money matters when you have big shocks to M. There's some great reduced form work that's been done over the decades. If you just plot M, monetary growth, across countries, versus prices, it's much more compelling, especially over longer periods of time. I think that if inflation's hovering just below 2% or around 2%— the Fed did a wonderful job anchoring long-term inflation expectations since the early 1990s up until the pandemic inflation. But I think that, perhaps, we're maybe worrying about very small movements in inflation. I think that, famously, Jay Powell once said that inflation just below 2% is one of the biggest problems of our time, and all of the bending over backward to get inflation up from 1.5% to 2%— I think that maybe it's much ado about very small issues, certainly compared to what we've seen in the past few years with the early 2020s inflation.

Beckworth: Yes. So, there's still room for research and work on money and monetary policy. Just be aware of what you're stepping into. There's going to be measurement issues, identification issues, and the question of who's going to be interested in the work of money if no one else is.

Hartley: There are some really great papers out there, that I think are empirical, of this flavor of natural experiments. There's a great paper by Nuno Palma and co-authors in the Review of Economic Studies that looks at gold extraction from the Americas during the colonial era and how that was basically a monetary shock to Europe, and [they] used that for reduced-form identification. There's another paper by François Velde, a long time [economist] at the Chicago Fed, [titled], *Chronicle of a Deflation Unforetold.* It was published in the Journal of Political Economy around 2009. It's a really terrific paper that looks at the court of the king of France in the 1720s or 1730s and how there were these big exogenous shocks to money supply and contracting the money supply, and he shows that there are some real effects, so, some evidence of monetary non-neutrality.

Hartley: So, those are the experiments. I have my own paper that I'm working on related to that, looking at a big monetary experiment during the Civil War. It's a much longer story, but there was a big shock in the eastern Confederacy— lots of good experiments. They're rare, but I think they're great ways to actually come up with convincing arguments that money does matter and monetary policy does matter and is maybe not neutral in the short run. Bob Lucas— his famous Nobel Prize address was all about monetary neutrality, and that's still a debate that goes on. We just don't have a ton of evidence for monetary non-neutrality. I think that we could use more papers on that.

Beckworth: Absolutely. So, there were some interesting papers presented at this conference on money. So, the Swiss National Bank— which I learned, for the first time, at this conference, targeted M1 and then the monetary base from 1974 to 1999. As recently as 1999, there was a money supply targeter out there— the Bundesbank. Of course, the ECB had a dual pillar approach where they actually tracked M3. But I think that the ECB's approach was much more what Peter Ireland was suggesting at the conference. Use it as a cross-check to the other normal indicators.

Beckworth: But let's move on from money. And again, money is an important part of the history of the SOMC. That's why we're spending so much time on this. Let's move to some of the other panels. There were a number of interesting ones and some big names, some great guests. And I know that this is something you've been working on, so, probably, this was a panel of interest to you. You've been working on the fiscal theory of the price level, and there was a really interesting panel at this conference on the monetary-fiscal interaction. So, they had Deborah Lucas, Patrick Kehoe, John Cochrane. Charlie Plosser presented, and Deborah Lucas had a great paper where she asked this simple question, “When are central bank policies fiscal?” It seems simple, but it's not so simple, and she goes through all of these definitions. Her answer that she ends up with— she says that a central bank policy action is fiscal if it causes a direct transfer of value to or from the government.

Beckworth: So, there's a lot of things that don't fall into that, but she gave some examples where this would be the case— if the Fed is paying [an] above market interest rate on interest on reserves. And she gave some estimates for a period when it first started doing it— I believe up to 2019. She estimated $30 to $40 billion. That would have been a kind of fiscal transfer. She mentioned the credit facilities during the pandemic. Now, a lot of those were backed by Treasury. She mentioned the large exposure.

Beckworth: So, she mentioned a few things. She also talked about the way we do accounting. The central banks can sometimes hide the fiscal impact— a very interesting paper she presented. I also liked Patrick Kehoe's paper— he talked a lot. He took a Lucas-Stokey 1983 view of public debt, where, basically, you want to make public debt state-contingent. I could go into details, but the summary, the punchline, which I think is very relevant to today where we are in this world, this tense world, is to keep your powder dry, to have fiscal capacity ready to go should we go to war with some other country.

Beckworth: If Taiwan were invaded, how much fiscal capacity does the US actually have to support that, support Ukraine, support Israel? So, he made some great illustrations. He showed that the UK really followed the Lucas-Stokey view, and just, really, that we need to get fiscal consolidation under the way. John Cochrane, of course, got up there. He had a great presentation. Fiscal theory of the price level— he showed that it actually fits the data really well for this past inflation surge— that we have a sudden increase and then a decrease. Of course, the fiscal theory of the price level— it's an asset pricing view of the price level.

Beckworth: You look at the discounted present value of primary surpluses, and that should shape the price level today. The argument he's made, and I know my colleague at Mercatus, Eric Leeper, has made is that, effectively, the big transfers were helicopter drops, and the public understood it. They were never going to get taxes in the future to pull that out. It was not paid for. It was completely a transfer. It was permanent. It had to be inflationary. Then, he illustrated that and he said, "Look, if that's the case, you'd have what we saw, transitory inflation. It goes up, and then it comes down."

Beckworth: So, Jon, one question I had— and I know you're something of an FTPL person yourself, so maybe you can help me understand this. I can concede that this does do a good job to explain this experience. I know that there's other folks who can explain it with their theories as well. The question I have is that, right now, we've come down, effectively, to 2%. If you look at month-on-month measures, we're at 2%. So, the Fed has returned inflation to target. Yet, we continue to see CBO forecasts going up, going up. We see budget deficits getting larger. Should we not see some upward pressure on the actual inflation rate today? Now that we're out of the whole inflation experience, the surge and the disinflation, why don't we see something happening today given the claims of FTPL or maybe I'm misunderstanding it?

How Well Does the Fiscal Theory of the Price Level Hold Up?

Hartley: Sure. I think that you're understanding it very well. First of all, I think that no matter what our framework of the world is, whether it's fiscal theory, whether it's new Keynesian, whatever, ISLM, we should be concerned about governments running 6% deficits in good times. I think what FTPL would say is interesting— and I think you put this well in the sense that, what's Eric and John's story, what's the FTPL story behind the Great Recession versus the early 2020s inflationary period?

Hartley: Why did you not see inflation during the Great Recession period despite there being lots of stimulus spending there was, essentially, in that, in the 2008-2009 episode, the government was actually promising to pay back the debt. That fiscal spending was promised to be paid back. Fiscal theory is all about expectations. That's really what it is. Whereas, what they would argue in the early 2020s period, [was] that there wasn't a promise to pay back that debt, and that's why we saw inflation jumping 8% or so.

Hartley: Now, what you could argue, what a fiscal theorist might say about why is it the fact that we're still running 6% deficits now— and I guess CBO forecasts are more and more dire— but why aren't we seeing inflation now? Well, you could argue that there's actually something about expectations going on there— that, basically, consumers, bondholders expect the debt to be paid back at some point in time. Now, remember about CBO forecasts— CBO forecasts aren't, in my opinion, a great measure of fiscal expectations, because they're based on current law. That's, essentially, based on what the government is currently doing. It doesn't reflect what people really expect the government will ultimately do in the future, which might be to pay back some of that debt. So, that might be one story.

Hartley: I don't know if that's necessarily true or not, and it's kind of what I think is important, and what I do in my paper with Mátyás Farkas and J.R. Scott called, *The International Public Debt Valuation Puzzle.* With a long history of public debt, we have wonderful databases that have centuries of data on debt. And what you can do is you can try to test the fiscal theory, and that's essentially what we try to do. We try and test this government debt valuation equation. And what is that government debt valuation equation? It says that the real value of government debt, your debt-to-GDP, scaled in real terms, should be equal to the present discounted value of future surpluses.

Hartley: And so, what we do is we look at cross-country data, and we have a more reduced form version where you imagine going back to 1800 with the knowledge of what our surpluses will be for the next 220 years or so, and you discount all of those future surpluses back to 1800 using the discount rate in 1800, and you compare that to the real value of government debt. Imagine doing that for every year until the present day. What we find is— whether you're using that method or you're using something a little bit more complicated, a little bit more structural, which is what's called a Campbell-Shiller VAR decomposition, something that Hanno Lustig and some of his co-authors use in a paper where they look at the US, as a forthcoming Econometrica [paper], and their paper is called, *The US Public Debt Valuation Puzzle.* You find that there are periods of time where the government debt valuation equation holds and periods where it doesn't.

Hartley: Now, in Hanno's case, and with his paper, he makes a claim that it's really exorbitant privilege, that the government debt valuation equation doesn't work well in countries that have the world's reserve currency. So, in the US, there's what he calls a puzzle. So, a puzzle is when the government debt valuation doesn't hold, that the real value of debt-to-GDP isn't equal to the present discounted value or anywhere close to it. But he finds that it does hold in the pre-World War II period for the US, but conversely, in the UK, it doesn't hold when they were the world's reserve currency pre-World War II, but suddenly, the puzzle disappears after the Second World War. 

Hartley: Now, the challenge that we find is that if you actually run it over the entire sample, that puzzle goes away and that it's not quite as clear of an exorbitant privilege story. And so, I think, at that high-level view, [if] you look across countries, across time, there's periods of time when fiscal theory or the government debt valuation equation looks great and other periods where it doesn't look great. Why it doesn't look great in certain periods is a good question. Maybe there's a bubble term in the fiscal theory equation, equilibrium condition.

Beckworth: Markus Brunnermeier has a paper on that.

Hartley: Exactly. Maybe that's one story. Maybe we're using the wrong discount rate. Maybe that's the story. Maybe we just don't have the right discount rate, but it’s hard to know. But as a macro theory, how you would judge this is, I think, a little bit in the eye of the beholder. There are some countries where it looks, actually, really good, even in the reduced-form version, like in Japan. Compared to other macro theories, maybe the fiscal theory does work better compared to others, but there are certainly many periods of time where I think it doesn't look great, too.

Hartley: So, I guess that's just the empirical take on trying to assess this government debt valuation equation. Again, it's very hard to get fiscal expectations data. So, I don't think that coming out of any of these papers is something very conclusive about fiscal theory, and [it’s] just because we don't have a great measure of fiscal expectations over time. But I think that this historical exercise is perhaps the best that we can do, and I think that there are some periods of time where it actually does look like it has some value and other periods where it doesn't.

Beckworth: Well, John Cochrane and Eric Leeper always remind us that even if we don't subscribe per se to the fiscal theory of the price level, the implications of it are in every macro model that's well-founded, well-grounded— that there's a budget constraint for the government, monetary policies linked to fiscal policy, and lurking in the background, if the Fed is able to bring inflation down, it's because fiscal policy is actively doing its part. It's making sure that it is pulling debt back out. It is retiring debt. And so, I think that they make a good point there. Going to the next step, the asset pricing equation is where it's tougher to find the empirical support. Has that been kind of the holy grail for the FTPL literature, to find the empirical smoking gun to say, "Ha, this is it"?

Hartley: Well, as an empirical macroeconomist, I think it is, in a sense, for FTPL. I do think that, in my mind, for macroeconomics to have more credibility, particularly with our applied micro peers who really care very dearly about identification, that we do provide this evidence. So, fiscal theory traditionally has really come out of, I would say, the macro theory world. You can derive the fiscal theory equilibrium condition. Again, it’s that this real value of government debt equals the present discounted value of future surpluses with not a ton of assumption.

Hartley: But at the same time, I think that you definitely need empirical backing, because, ultimately, you can get models to say almost anything you want at the end of the day, and I think that it's very, very important to bring that evidence, especially to convince our applied micro friends. I think that this is a serious challenge for macroeconomics, and I say it very seriously as somebody who's invested in it— I do think that macroeconomics is under threat in the sense that there are fewer macroeconomists employed in top economics departments. I think that this is a very serious challenge.

Hartley: I think that there are a lot of applied macroeconomists who don't take macroeconomics serious whatsoever. They call it science fiction or other sorts of things that they like to call it. But macroeconomics is so important. You're trying to answer the big questions, and even if we can't get a great answer, I think it's important that we get better answers, and I think that's the goal of empirical macro with good identification. Using microdata, there's a lot of great work that's been done by Emi Nakamura, Jón Steinsson, and many others— ‪Jonathon Hazell, you've had on your podcast a few times. I really, in my mind, think that this is such an important subfield of macro to be focused on.

Beckworth: So, two things on the FTPL before we move on. First, I think we need to be fair and say that every macro theory has unobservables that you need to really work with the model. So, we just shared the one, the fiscal theory of the price level. You've got to know the expectations of primary surpluses in the future, and we simply don't observe that. So, we do tricks, we look at historical data, we do things, but we don't directly observe this real variable, which is the key to making sense of this model. But if you go to an old monetarist model, you have to know real money demand. We don't observe that either. If you go to a new Keynesian model, potential real GDP or the natural rate of unemployment, we don't observe those either. Every macro model is going to have some latent unobservable variable that's very key to making sense of the rest of it. So, everyone in macro wrestles with this issue.

Hartley: I think that's true, and you're absolutely right that FTPL is observationally equivalent with, I think, the new Keynesian model and, to some degree, many other macro models, too, and ISLM and so forth. But I think you're right. I think that we do have to think hard about these various unobservables. I think that we can't just keep treating them as unobservables, and I think that there are a lot of ways that we can get clever about how we want to think about them, whether it's ‪Jon Hazell's work with co-authors on trying to come up with better estimates of R-star, using these leasehold versus footholds.

Hartley: There's been a lot of similar work that's been done trying to estimate that from Matteo Maggiori and co-authors. Thinking about this example of using just history— I think that there's so much treasure and so much value in using history, especially with something like fiscal theory, where we can at least suggest, well, maybe agents had unbiased expectations about future fiscal paths, and use that data. Again, that's not perfect. We don't have the exact expectations, and maybe the discount rate's not right. Maybe there's some degree of some specialness or some other things that we're missing there, but I think that we have to try, and I think that that's the best that we can do. But I think that there are clever ways of teasing out some of these things with the unobservables.

Beckworth: So, Jon, the second thing I wanted to say about the FTPL, before we move on to some other issues related to the monetary-fiscal interaction, was a question that was raised on the final panel yesterday at the conference. And this was a panel of former Fed officials, including Donald Kohn, Roger Ferguson, Robert Heller, and Esther George. Now, Esther George, [as] many of our listeners know, was the former president of the Kansas City Fed. The first three individuals were governors. So, these are people who bring a rich perspective and experience to the question of, what influence did the SOMC and outsiders have on monetary policy? But Deborah Lucas was the moderator, and she asked a much more pointed question just right out of the gate when the panel started, and she asked, how much bearing does the fiscal theory of the price level or some version of that have on your thinking at the Fed?

Beckworth: Now, if you take this theory seriously, it really undermines the whole point of the Federal Reserve, because the Federal Reserve says, "We determine the price level. That's something that's been given to us by Congress, our mandate." And Don Kohn made this point, he goes, "You're never going to hear us say anything close to resembling the fiscal theory of the price level, because if we do, that undermines our role." Now, you could quibble with that and say, "Hey, but it's not true," or "You're not taking seriously the linkages between fiscal policy and monetary policy," and they did acknowledge that. They recognized that they're there. But I guess it hit me that even if we take the extreme view of the fiscal theory of the price level, it's still important for the Fed to signal that they're in control, I would think. It's still important for them to say something like that. Maybe FTPL sets the broad guardrails, but within them, the Fed is still navigating. How do you deal with that tension?

The Tension Between the Fiscal Theory of the Price Level and Fed Policy

Hartley: I think that you're absolutely right in the sense that the Fed controls interest rates. They don't control fiscal policy. I think the last thing they would want to be in is some sort of a fight with Congress or the White House over the stance of fiscal policy, which gives them fodder to attack the central bank and interest rate policy. And so, I think that Chris Waller had a great comment on this, which is, again, you don't want to be in some situation— If it were the case that the central bank was opining on fiscal policy all of the time, then that almost gives them every excuse for Congress and the White House to attack central bank independence. So, I think that it's clear that central banks manage to control interest rates. It's Congress's job to control fiscal policy, and that's just how their separate powers work.

Hartley: Now, I think that you're right in the sense that the Fed has a responsibility to actually fight inflation in its mandate. It's less so clear with Congress, right? So, that does potentially make things more difficult for the Fed. Does the Fed have to basically raise interest rates to offset big fiscal bursts? That's totally possible, and you could argue that maybe what happened in the early 2020s was that there was this fiscal burst and maybe it wasn't expected to be paid back, and that's why we saw the inflation. I don't know. That's maybe what the fiscal theory story would say. But there was inflation. That's true. That's factual.

Hartley: The central bank was trying to respond, and it got caught up in this whole transitory narrative, and it, ultimately, in my opinion, raised rates six months too late. Some people say that it's not a ton of time. I actually think that it is a policy mistake. It was very clear, by October 2021, that it wasn't just sort of [about] used car prices. Rich Clarida had this great saying during that period that, "I'm not going to put people out of work because of used car prices." But by October 2021— the inflation surge started in April, May 2021, but by October 2021, it was clear that inflation was broad-based across the price basket. Things like owner-occupied rents were increasing.

Hartley: At that point, I think that it was very clear that the Fed needed to act. Why they waited six months is not totally clear to me. I'm sure that when we get the transcripts and the Tealbooks and so forth, that we'll understand more of what was going on there. But you do have quite a few former FOMC members now saying that, "Yes, we should have raised rates earlier,” to some degree. I think that Rich Clarida, to some degree, and Randal Quarles have said this. I think, on your podcast, I recall Randal saying this. But yes, I do think that that's kind of a policy mistake, but also not a great place to be in, too. As a central banker, you're cleaning up for some excessive fiscal policy. So, [it’s] not an envious position to be in, but that is their job.

Beckworth: So, you're saying that the Fed did make a mistake. It fell behind the curve. It could have done better. My question is related to that, though. How much could they do if you believe in this really strong view of the fiscal theory of the price level? Now, I think, where I land on this— I'll just lay my cards on the table. I think it is important. I think fiscal policy is working in the background, managing the solvency of the US government, which then gives a degree of freedom to the Fed to navigate where the price is going, right? Then, in extreme cases, [there is] fiscal dominance, [and] then the roles flip. The Fed is keeping the government solvent and Treasury— Congress is effectively determining the price level because of its spending problems. I guess, going back to Don Kohn's point, they can't say, "Yes, we have no control over the price level." They have to keep saying this. Otherwise, I guess that some market— expectations would be destabilized. There's some signaling virtue to the Fed saying, "Yes, we're the ones who control the price level."

Hartley: To be clear, I don't know if I would call myself a fiscal theorist. I just test other people's theories. That's all I do as an empirical macroeconomist. But I think that it is important to remember that, in that fiscal theory equation, you do have interest rates. You are discounting those future surpluses, and the Fed does control those interest rates that are being used to discount those future surpluses. So, the Fed is there. Also, too, if you look at the equation, it's B plus M over P. It's a consolidated government balance sheet. Money is actually in there. It's not just debt. Money is in there. The central bank's balance sheet is combined with the rest of the federal government's balance sheet. So, central banks are in there, but, again, there definitely is tension. This gets into these questions about fiscal dominance. I don't think that we're in a fiscal-dominant regime or anything like that, but it is an issue, and it's a tension that has been explored in depth by people like Sargent and many others, in time.

Beckworth: Okay, let's move on to another topic related to this discussion of monetary-fiscal interaction, and this is related to some work that you're now doing, and it's also related to a previous guest of the podcast, Stephen Miran. He came on the show. He has a paper with Nouriel Roubini. They claim that Treasury has been actively manipulating their public debt management such that it's adding stimulus to the economy in the lead-up to the election year. Now, they make two claims in that. They make [the claim that], one, Treasury is acting in an inordinate manner by issuing an excessive amount of bills relative to longer maturities, number one, by historical norms or some kind of measure. 

Beckworth: Then, two, that excessive issuance is effectively lowering financing costs and adding a little juice to the economy as we head into the election. The second one is more of a hot take. So, you don't buy this. In fact, I remember that when we aired this podcast, you texted me directly and you said, "David…" and you let me know how you felt. So, you are actually doing some work. You're not just disagreeing with the claims. You actually have evidence marshaled against the claims. Tell us about it.

Does Government Debt Management Matter?

Hartley: Sure. This comes from a new paper that's titled, *Does Government Debt Management Matter? High-frequency [Identification] from U.S. [Treasury Quarterly] Refunding Announcements.* This is joint work with Lorenzo Rigon, who's a Stanford economics PhD student here, who actually just graduated. And so, what is government debt management? Government debt management is simply choosing the maturity structure of government debt. So, how much of our debt should be issued in, say, 10-year bonds versus 3-month Treasury bills? That's what we refer to as government debt management.

Hartley: Now, there's been a big stir since the fourth quarter of last year. And for listeners that aren't familiar with the quarterly refunding process that Treasury does, the US Treasury, on a quarterly basis, convenes the Treasury Borrowing Advisory Committee, and they essentially make decisions and make announcements about what the future of government debt issuance will look like. They first announced something that's called the funding estimate— basically how much total government borrowing they expect will be. That's done usually on the Monday. Then, on the Wednesday, two days later, at 8:30 in the morning, they announce what their expected issuance is going to be in the coming quarter, and this is after meeting with the Treasury Borrowing Advisory Committee.

Hartley: These are people generally from private markets, and they consult with them about these issues, because, certainly, they're worried about liquidity and a number of issues, but they get good advice from the private sector on this. But they make these announcements that are very similar to the FOMC announcements that are done at 2:00 PM on Wednesdays, typically. These are done in the morning at 8:30, and, typically— so what we do in our papers [is that] we look at these announcements using high-frequency data on Treasury yields.

Hartley: Essentially, what we find is that most of these announcements don't move yields too much, but occasionally, like the fourth quarter of last year, there was an unexpected shift in issuance, and that caused the 10-year yield to move down by about four basis points, or 0.04%. Treasury announced that they were going to issue [fewer] 10-year bonds than expected and more 3-month Treasury bills. So, you get less 10-year bond issuance, less supply, higher prices, [and] lower yields. The 10-year yield fell by four basis points. I don't think that's huge per se, but it is certainly something that's worth noting.

Hartley: And to Stephen Miran and Nouriel's point, perhaps it does somewhat offset QE, to some degree. Now, I think where we would differ would be in magnitudes. I don't think that four basis points is really that huge. I think that their estimates are on the magnitude of maybe 25 basis points, maybe somewhat greater than that, for the 10-year. They claim that that's equivalent to a 1% cut in the fed funds rate, but, ultimately, I just don't think it's that big. So, I think that that would be my first qualm. What we also do in our paper is we take this expectations data that we were able to get from Bloomberg. Bloomberg, before each of these announcements, collects the expected issuance from the primary dealers— what they expect right before the announcement.

Hartley: So, you can take the difference, look at the magnitude, [and] you can estimate Treasury demand curves. That's kind of what we also do, and what we find is that the term spread is actually pretty responsive to these announcements— that, essentially, a shift in one year of weighted average maturity over the next year is equivalent to a 1.25% shift in the term spread. Now, a 1% shift in weighted average maturity over the next quarter is so huge, and, probably, has never actually happened, even though the weighted average maturity shifts, generally, between four to six years, if you look at the entire history of US debt going back to, say, 1980.

Hartley: But the thing is, the expectations over the next quarter in weighted average maturity don't really capture what's going on beyond that. They're certainly signaling going on. It's very technical. So, I would say that my one response to those who say that the Treasury is doing this shadow quantitative easing thing that's offsetting the Fed's quantitative tightening— I would say that it's possible that maybe it's bigger than four basis points, and it is true that the 10-year yield fell quite a bit in the months following that announcement. Again, we're looking at high-frequency windows in our paper— a very short, say, 30-minute window around the given announcement. But I think that there are a lot of other things going on in those following months, and I think that maybe some of that— there were expectations about, potentially, a recession that could maybe have been weighing on the 10-year yield. I would just say that it's possible that there are a lot of other things influencing that.

Hartley: My second, I guess, critique— and, again, Nouriel and Stephen are friends— Is that I just don't really see the political motivation per se. I worked in the New York Fed Markets Group over a summer, and I know Josh Frost. So, the Assistant Secretary of Financial Markets is, effectively, the person who makes that quarterly Treasury funding announcement. They're, effectively, the Fed chair in this press conference that they have or in this announcement that they do, and you can actually go on the Treasury website and watch it. The Office of Debt Management is such a technocratic office that I really don't see them being a huge tool for politics at Treasury. Maybe I'm wrong. Maybe there is something going on there. I don't know.

Hartley: And for what it's worth, I've been very critical of the Yellen Treasury Department. I'm not a huge fan of their global corporate tax scheme. I'm not a huge fan of a lot of the things that they've been doing, broadly speaking, in terms of economic policy, but I think that there's a good reason, actually, for more short-term bill issuance, and this is a non-political reason for there, I think, to be more permanent short-term issuance, and that goes back to this whole moneyness question of specialness of short-term money-like assets. The issue is this— and this is also borne out in our paper a little bit.

Hartley: If you look at how the 10-year yield responds to these announcements versus the 3-month bill, we do find, occasionally, that these big shifts in issuance will really affect the 10-year yield, but they don't really move the 3-month T-bill at all. And so, what that tells you is that, perhaps, the government could generate savings by issuing more short-term bills, which act as a money-like asset— almost like manufacturing more safe-like assets. And so, if you put this in a model, you could find the social planner's problem. The solution to that would be, actually, by issuing more short-term debt.

Hartley: Now, critics will say that, well, there's things like rollover risk and things like that, but I do think that there is a case for government debt management to issue more short-term bills. What is the job of debt management and the Office of Debt Management? It's to reduce the overall cost of debt to Treasury. It's nothing to do with monetary policy or unemployment or anything like that. It's really just to reduce the overall cost of debt, and I think that's kind of what they're doing by shifting to more short-term issuance— creating more bills that have this money-like property.

Beckworth: Well, that's great, and we'll provide a link to this study in our show notes, so, listeners, be sure to check it out. Alright, let's move on to some of the other sessions at the conference. We're running low on time here, and I'm going to mention one that really lit my fire. Now, again, there were a number of great panels, [and] we will provide links to the programs, the videos for those listeners. I encourage you to check it out. But as listeners of the show know, I love to talk about the operating system of the Federal Reserve. We were under an asymmetric corridor system pre-2008. Now, we're under a floor or ample reserve system, and, of course, Bill Nelson's been on a few times to talk about it. He presented on this, so I won't repeat many of his points, but Loretta Mester talked about it, and I was pleasantly surprised to hear her talk, because she's a former FOMC member. She's just stepped down recently, but her whole talk was that the floor system or ample reserve system is not so simple after all. 

Beckworth: It’s one of the claims of the floor system— you go on that flat part of the reserve demand, [and] you don't need to worry about what reserve demand is going to be from day-to-day and provide the amount of reserves like you would in a corridor system, but she said the problem is that you've got to know where you are on the reserve demand curve, because if you shift back and suddenly you're in a corridor system, your rates are going to go through the roof. So, it's not as simple as saying, "Hey, we don't need to know reserve demand," when you, in fact, have to know where you are on the curve itself, and that's not an easy thing to know, because that curve shifts over time, [and] there's dynamic developments along the way.

Beckworth: She said that you also need to know where the reserves are distributed. It's not as simple as just an aggregate measure. Some of the big banks may have more than some of the smaller banks. You also have to understand where the reserve levels are, because they do change with market conditions. She said that it creates more interbank dependence on the central bank. What do you actually target— the federal funds rate or the SOFR? The federal funds rate is kind of a relic, but it's a communication convenience. And there's political economy considerations. Will the central bank’s balance sheet be used for political purposes?

Beckworth: This is something that was raised, actually, multiple times at this conference, is that the concern is that if it's seen as an easy way to fund projects, it could easily be tapped. We've heard calls for sovereign wealth funds, for example, that the US Treasury and US government could support. So, these things are reasons why she says that it's not so simple to run this. Then, the other person who was on the panel was Darrell Duffie, and he argued that the ample reserve or floor system is going to continue to have challenges because primary dealer balance sheets are capacity constrained. And he said that his solution is this— In order to get around this balance sheet constraint problem, expand the counterparty access to the standing repo facility. He goes, "Now, on one hand, that would solve some of this problem. On the other hand, it increases the Fed's financial footprint." So, he would then say, in turn, "To fix that, the expanded access to the standing repo facility [should] use increased central clearing by the Fed." You were here with Darrell Duffie on this campus. What are your thoughts on his calls for this?

The Floor System, Quantitative Easing, and the Keys to Economic Growth

Hartley: I think that Darrell is generally right about most things. One, I would never challenge Darrell on, I think, just about anything, and certainly anything about market microstructure [or] anything in finance, in general. I think that's a good rule. I think that all of these issues are generally related in the sense that we're essentially— And there was another panel that I enjoyed quite a bit that was led by Jeff Lacker. He gave the history of the Fed's balance sheet, and I think that all of these issues about the floor system are really about this issue that we've had since the financial crisis. Maybe it's not an issue. Maybe it's a feature rather than a bug, and that's—

Hartley: We are in this ample reserve system that, once there was this decision to start expanding the balance sheet, we've had to adapt to it and we've moved the balance sheet around for various reasons. One, I think that it's been used as a tool to provide liquidity to markets, and there was a speech by Chris Waller yesterday that essentially said that that was the purpose of the balance sheet. And you can look at periods like March of 2020, where, clearly, there was a huge announcement effect that calmed markets, even before they started purchasing any bonds whatsoever— any new bonds.

Hartley: I think that there are a lot of consequences, some degree of living in this particular era. My take [is that] there are a lot of people out there who claim that QE is responsible for this massive asset price run-up in US equities in the past 15 years or so. There's a certain narrative about that that's been going on— that it's Fed inequality and [has] done all of these things. I actually think that that's kind of wrong, and the reason why is the following, and it really has to do— I think the story of US growth in the past 15 years, US equity markets, their run-up in the past 15 years, compared to other countries— A lot of my work is international— If you look at Europe, [if] you look at Japan, all of these countries did very similar quantitative easing programs. They bought a massive amount of bonds on a pretty considerable fraction of GDP. But what was the difference between the US versus these other countries? In the US, your GDP per capita— that keeps growing very steadily. You have a US equity market that keeps growing very quickly. But you look to Europe, you look to Canada, you look to Japan, and in all of those places, GDP per capita has been essentially flat since the Great Recession. Even Japan, even earlier, it's been flat.

Hartley: Similarly, you've seen equity markets there that have been flat. But both of these places embarked on the same sort of quantitative easing programs, and I think, for that reason alone, if you think about what quantitative easing is doing, certainly there are these periods of stress, like in 2008 [and] 2020, where they're providing this liquidity in a time of stress and can calm financial markets. Think about swap lines— very effective in doing that, and I think a great case for it. But what's interesting is that after we do that, and after these post-crisis periods, quantitative easing— I don't know whether it has such a great effect on yields.

Hartley: I have a study that looked at some of the QE announcements across countries during 2020. In those cases, most of the effects on yields were maybe 20 basis points or so [and] even less in advanced economies. To some degree, these QE programs become more anticipated, and so it's hard to measure the actual effects of them if they're not so anticipated. But I think what's really going on behind all of this— And also, it's worth noting that central banks buy up government bonds, but they also issue reserves. And so, I think that, at some level, is QE actually putting money into the system? To tie this back to the SOMC and monetary aggregates, I don't think it necessarily is.

Hartley: Certainly, these massive fiscal programs like the CARES Act, you name it— I think that had a lot to do with M2. They're sending stimulus checks to many people. That goes to their bank accounts. That's included in M2. But I think what's really important about these cross-country differences, what explains the difference between the US versus Canada, Europe, Japan, that have had stagnant growth rates, stagnant stock markets, and so forth, is innovation and growth. And I think, going back to this famous Bob Lucas quote, which is, "Once you start thinking about growth, you can't think about anything else."

Hartley: And the US just has this incredible thing, which is the US tech industry. You've got so many tech firms here. We're actually here in Silicon Valley as we're recording this, and that's just something that other countries haven't been able to copy or produce. You look at Europe— Sure, they've got Spotify. You look at Canada, they've got Shopify. They once had BlackBerry. I grew up in Toronto, and BlackBerry was a darling for a period of time before Apple crushed them in competition. But the US has this innovation story that continues to drive its GDP per capita up.

Hartley: We recently had this report from Mario Draghi that was trying to explore some of the productivity issues in Europe. I think that there are some fair criticisms about some of the recommendations, but I think that it's great that we're actually getting people to actually talk about productivity issues in countries outside of the US. So, I don't think that every growth story is, per se, a monetary one. I don't think that central banks are necessarily dictating the differences in prosperity between countries, per se, but I do think that it's very important. I do think that it plays this essential role in keeping inflation stable and low.

Hartley: Obviously, central bank balance sheets have changed in their nature and now are acting as a way to basically provide liquidity in these moments of stress and crises. And it's been very difficult to withdraw that quantitative easing. I don't think that we'll be exiting an ample reserve system anytime soon, and I think that that was maybe one of the themes across these panels yesterday. But I think that it's something to think about— this issue of growth. Maybe I just have a lot more growth people on my podcast, but if you think about it— for me, I think that this is the real interesting fact, which is that the Great Recession was a 5% divot in the US growth trend. So, that's sort of a business cycle-y macro thing.

Hartley: But then, you think about cross-country differences in GDP per capita, and you look at GDP per capita in China versus the US— maybe like a seventh or sixth or an eighth. It's just a totally different order of magnitude, and I truly hope that we do get more business cycle macro Nobel Prizes in the future. I totally think that it's way overdue for John Taylor, and there'll probably be a new Keynesian macro prize at some point. But we're seeing here— and just yesterday, the Nobel Prize in economics was awarded to Daron Acemoglu, James Robinson, and Simon Johnson, and, certainly, there have been various criticisms of their work, but I commend them for trying to embark on this project of explaining, why are countries rich and poor? And I think that institutions is, broadly, one good explanation, and I think that that alone is worthy of the prize. Look at North Korea versus South Korea. They're basically the same country in 1950, in the mid-20th century, and one chose Communism and the other one sort of chose free markets. We could debate whether--

Beckworth: Great natural experiment.

Hartley: Yes, exactly. It's a great natural experiment. It just really shows you that institutions matter. Push forward that clock 70 years, and South Korea's got a GDP per capita that's on the same level as most Western countries, and North Korea is still one of the poorest countries in the world. So, I think that those cross-country GDP gaps, per capita gaps— why are countries rich and poor is still, arguably, the most important question in economics, and I think that [it’s] all the more reason for people to also be interested in growth macro as well as business cycle macro. 

Hartley: But I think that it's really just something that now, especially in Western advanced economies, we're having to think about again, as productivity rates are slowing, there are all of these demographic shifts, GDP per capita growth rates are slowing, and so forth. And this is something that central bankers are having to grapple with. Carolyn Rogers, the Deputy Governor of the Bank of Canada, last year, sort of decried this productivity issue in Canada, and you see Mario Draghi recently. I think that even as we talk about— is it the cycle? Is it the trend? How do we think about business cycles? How we think about the trend is, I think, going to be very important for central bankers and fiscal policymakers in the future.

Beckworth: Well, on that high note about economic growth and how it's the real issue and how it will solve many of our problems if we get it right, we'll have to end the show there. Our guest today has been Jon Hartley. Jon, thank you so much for joining us today.

Hartley: Thanks so much, David, for having me.