LONDON, April 14 (Reuters Breakingviews) - Economic theories become fashionable when their ideas meet the needs of the age. John Maynard Keynes’s “General Theory of Employment, Interest and Money” offered an escape from the 1930s depression. Hyman Minsky’s financial instability hypothesis became popular after Lehman Brothers filed for bankruptcy. Modern Monetary Theory, which endorses unlimited government spending, was all the rage during the years of ultra-low interest rates. Having given the magic money tree a good shake, governments are now grappling with inflation and swollen debts. A more sombre age calls for a more serious approach to economics. John Cochrane’s fiscal theory fits the bill.
Cochrane, a senior fellow of the Hoover Institution at Stanford University, recently published “The Fiscal Theory of the Price Level”. His key insight is that inflation is not caused simply by an increase in the money supply, as monetarists maintain. In Cochrane’s view, money is just another form of government debt. Inflation, he maintains, occurs when government liabilities, which consist of money and debt, exceed the state’s borrowing capacity. Adapting Milton Friedman’s famous dictum, Cochrane states that inflation is always and everywhere a fiscal phenomenon.
Fiscal theory uses standard asset-pricing models to assess the sustainability of government debt. Just as investors value stocks and bonds by applying a discount rate to future cash flows, so the present value of government debt is derived by discounting prospective fiscal surpluses. When the public debt becomes too large relative to future tax receipts, the government is expected to inflate away the excess liabilities. The price level moves in line with changes in those inflation expectations. As Cochrane puts it, “prices adjust until the real value of all government debt, including money, equals the present value of current and future government surpluses.”
From this perspective, past inflations should be viewed as episodes of debt default. At the turn of the 4th century BC, Dionysius of Syracuse became the first ruler to debase the coinage in order to reduce his debts. In the modern age, over-indebted governments usually turn to the printing press. After World War One, hyperinflation broke out in several European countries with impossibly large debts whose ability to raise taxes was impaired by civil unrest. The root cause of Germany’s monetary disaster was not the actions of the Reichsbank, says Cochrane, but the insolvency of the Weimar government.
Fiscal theory states that central banks alone cannot stop inflation. Politicians must credibly commit to balance the books. The German hyperinflation only ended after monetary and fiscal reforms put the government’s finances on a sound footing. Not only are high interest rates incapable of arresting inflation, fiscal theory suggests they actually make the problem worse. This conclusion flies in the face of conventional wisdom. Here’s how Cochrane explains it: an increase in the real interest rate – the cost of borrowing adjusted for inflation – means the government must spend more on servicing its debt. This extra fiscal burden is inflationary. Conversely, lower real rates reduce debt-servicing costs and are seen as disinflationary.
Cochrane goes on to provide a fiscal explanation for the curious behaviour of inflation over the past 15 years. When the U.S. Federal Reserve introduced quantitative easing in 2008 many predicted that inflation would soon take off. Cochrane suggests otherwise. The Fed was offering short-dated debt, in the form of central bank reserves, in return for bonds with longer maturities. QE therefore had no fiscal impact and wasn’t inflationary. Inflation remained stubbornly low, as fiscal theory would predict. It’s true the financial crisis led to increased fiscal deficits. But Cochrane argues (somewhat less convincingly) that the U.S. administration had publicly committed to rein in borrowing, so inflation expectations didn’t become unhinged.
There was no such fiscal commitment during the Covid-19 pandemic, when Western governments ran up the largest peacetime deficits in history. Inflation took off in 2021, as Cochrane had warned. Fiscal theory also explains the failure of the short-lived administration of British Prime Minister Liz Truss, whose announcement of tax cuts and unfunded spending plans last September spooked the financial markets. Truss’s replacement, Rishi Sunak, acts like a true believer in fiscal theory, with his promises to bring down inflation by reining in the deficit.
The assumptions embedded in Cochrane’s model are far removed from our modern financialised world. In reality, there are no fiscal surpluses in prospect. Instead, public debt resembles a giant Ponzi scheme whose viability depends on investors rolling over government bonds when they mature. Nor do bondholders operate with rational expectations, as fiscal theory suggests. Their expectations are partial and myopic. A more serious criticism is that Cochrane allows monetary policy only a small role in stabilising the price level. Yet interest is also the cost of leverage. When interest rates decline, borrowing tends to rise. As Cochrane himself acknowledges in his blog, rock-bottom borrowing costs induced governments to run up too much debt, which by his lights is inflationary.
The statistician George Box stated that all models are wrong, but some are useful. Despite its unrealistic assumptions, Cochrane’s model may prove useful for the post-pandemic age. First, it emphasises that controlling inflation requires monetary and fiscal coordination. Central banks can temporarily reduce inflationary pressures but governments must do the heavy lifting. Second, Cochrane argues there’s no need for central bankers to raise interest rates above the prevailing rate of inflation in order to get prices under control. Given the International Monetary Fund’s latest warning that further rate hikes could trigger a global banking crisis, monetary policymakers will be looking for any excuse to go easy.
Furthermore, fiscal theory can be seen as supporting continued financial repression, with interest rates staying below inflation in order to burn off the excess debt. Since Silicon Valley Bank failed last month, U.S. treasury bonds have recouped some of last year’s losses. But authorities were forced to extend deposit guarantees to support the fragile banking system. As Cochrane warns, bank bailouts render the government’s own finances more fragile and therefore raise the risk of inflation. For investors in sovereign debt, recent gains may prove fleeting.
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