Why Inflation Happens, with John Cochrane

Episode one of the three-part series "The Economy: Inflation, the Fed, and You." 

Inflation in America is happening for the first time in forty years. Why have prices gone up and when might they come down? What role do monetary policy, the Federal Reserve, and legislators play? And what is the fiscal theory of inflation? Hoover Institution economist John H. Cochrane joins Liam Julian, director of Public Policy at the Sandra Day O'Connor Institute, for a discussion. The Economist magazine wrote that Cochrane's new book, The Fiscal Theory of the Price Level, "builds a theory of inflation as ambitious as that proposed by John Maynard Keynes’s The General Theory or Milton Friedman’s and Anna Schwartz’s A Monetary History." Cochrane is the Rose-Marie and Jack Anderson Senior Fellow at the Hoover Institution and a research associate of the National Bureau of Economic Research. 

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Transcript

Liam Julian:

Welcome to an O'Connor Institute and Civics for Life conversation with John H. Cochrane. John H. Cochrane is the Rosemarie and Jack Anderson Senior Fellow at the Hoover Institution. Before joining Hoover, he was a professor of finance at the University of Chicago's Booth School of Business, and earlier at its economics department. He earned a bachelor's degree in physics at MIT and his PhD in economics at the University of California at Berkeley. He was a junior staff economist on the Council of Economic Advisors from 1982 to 83. He frequently contributes opinion essays to the Wall Street Journal, Bloomberg.com, and other publications, and he maintains the Grumpy Economist blog. His new book, which we'll be talking about today, is The Fiscal Theory of the Price Level, which The Economist magazine said, quote, builds a theory of inflation as ambitious as that proposed by John Maynard Keynes' The General Theory or Milton Friedman's and Anna Schwartz's A Monetary History. John, thank you for being here with us.

John Cochrane:

It is a great pleasure. Thank you.

Liam Julian:

Yeah. So, John, you've been thinking seriously about inflation for over 40 years now, and you write this great book, and just as it comes out, we get the highest inflation we've had in over 40 years. So, you must feel like you've come a little full circle on this.

John Cochrane:

Well, I certainly got supremely lucky. I turned the draft of the book in, in March 2021, just as the very, there wasn't really much inflation. And the introduction said, you know, guys, we haven't seen inflation since the Reagan era, but you know, this is what I know how to do. So, you know, put this up on the bookshelf and someday take it off, dust it, might come in useful. I got to change the introduction.

Liam Julian:

Yeah.Was it like a stop the presses moment in Princeton, like pull the lever and the gears, you know, stopped, or were you able to get it in pretty easily?

John Cochrane:

No, I mean, they processed it quite well, like they do all other books, but they, they're an academic publisher. So, there was lots of emails from me saying, you know, get this out faster. You know, God forbid, inflation goes away and we won't sell any books.

Liam Julian:

Right. Right. That's funny. Well, I was thinking, you know, John, before we, before we go, get into fiscal theory, that maybe a good way to start would be for you to give us a little bit of a walk-through macroeconomic history, a brief walk, brief walk where, you know, maybe you could tell us about the theories of the price level that have preceded fiscal theory. And maybe as part of that discussion, you might identify some ways in which there are holes that you and others felt should be filled. Maybe that would be a good way to start.

John Cochrane:

Yeah. Well, the predominant theory of inflation since the 1960s has been monetarism, based on the quantity of money. Inflation is too much money chasing too few goods. And the problem with that is that, first of all, what is money? Now, we know what cash is, but do you count checking accounts? Do you count money market accounts? Do you count credit cards? The most, the deeper problem is that the Federal Reserve does not control the quantity of money. Now, monetarists keep saying, well, it should control the quantity of money. That's nice, but it doesn't. So that theory, it's a beautiful theory. It's logically impeccable, works fine.

But when the Fed does not control the quantity of money and instead sets interest rates, it just doesn't apply to our world in the same way that, you know, the gold standard is a nice theory of inflation, but we don't have a gold standard. The clamshell theory of money is a nice theory of inflation, but we don't use clamshells. So given that the Federal Reserve doesn't control the quantity of money, that money is kind of an amorphous thing, there's lots of different kinds of money. And most importantly, that it's its interest rate targets. We need a theory of inflation compatible with the fact that the Fed sets interest rate targets. So, I think that's the biggest, what I'll mention now of the hole in prior theories. There's lots of other prior theories with holes in them, and maybe we'll come back to that later. But I should tell you what the fiscal theory is and how it differs from that classic view of too much money chasing too few goods.

Liam Julian:

Yeah. Yeah.

John Cochrane:

Ready to go on that?

Liam Julian:

Well, yes. But before we do, and this may sound, this question may sound sort of, but I think we should touch on it. Just, just, what about somebody who would, who asks you just generally, John, says, why do, what do we need these economic theories for in the first place? When John Cochran and other economists look at the history of economics and what's happened, why do we need the theories? Can't they see historically what has happened and tell us how that's going to happen again in the future? Don't we have enough data to be able to do that without constructing theories? I know that question seems sort of simplistic, but maybe it's good to sort of identify the outset what these theories are attempting to do.

John Cochrane:

Well, that's, that's actually a very good and very deep question. You know, why don't we just let the AI and machine learning tell us what to do? The problem in all non-experimental sciences is correlation versus causation. So, the data don't tell you how, they can tell you correlations. When does inflation happen? Inflation typically happens when governments are having trouble with their deficits. It's kind of obvious in historical correlations, but it doesn't tell you cause and effect. Rich guys drive BMWs, so drive a BMW, you'll get rich. Well, that's a great ad for BMW, but it's got the correlation, but it misses the cause and effect. So how can, this is like the central question right now, what tools of the government, including the Federal Reserve, but also the rest of the government, will bring down inflation?

That's the cause and effect question we need to know, and pure correlations don't deliver it. Furthermore, pure correlations, you need to understand the structure of a system. That's what science is all about. And pure correlations, you know, in medicine, the doctor came, he gave, he bled the patient and gave him leeches. The patient got better. He said, hey, look at me. And even good things, we, the story of scurvy is a great one. You know, scurvy was a real problem on sailing ships, and people kept learning and then forgetting that lemon juice cured it, because they didn't know the causal mechanism. The minute you get the causal, why did people not learn to wash their hands for 10,000 years and die of horrible diseases? Well, you didn't understand about the bugs. So, understanding the causal mechanism behind a correlation, even behind some wisdom is, that's really important for knowing how to do things better. So, thank you for that philosophical introduction.

Liam Julian:

Yeah. No, I thought it was worth touching on. Yeah. The difference between causation and correlation and how, especially in the social sciences, you know, that's where these theories are so important. Okay. So, tell us, what is physical theory?

John Cochrane:

So, the simplest version is, what causes inflation? What determines the value of those little pieces of paper? You and I, why do we work so hard for these little pieces of paper? And why do people take them when we want to, you know, you can go down and buy some nice stuff and you just give them little pieces of paper, how does that work? The physical theory's basic answer is that money is part of overall government debt, just a kind of government debt. And inflation happens when there's more overall government debt than people think the government will repay by running surpluses, by running taxes greater than spending at some point in the future. So, it's overall government debt, which includes money, but also includes treasury bonds and treasury bills, relative to what people think the government will repay. 

And why? Simple. When we wake up, when we may well wake up tomorrow morning and decide the government isn't going to pay back its debts, we look at our money and our government debt and say, boy, we've got to get rid of this stuff fast while we still can. And we go out and spend it. Go out and spend it, that drives prices up. So too much money and government debt relative to what you think over the long run the government will repay, that's what causes inflation.

Now, quickly, that doesn't mean today's debt and deficits matter tremendously. It's the long run that matters. Our government can borrow immense amounts of money and print immense amounts of money if people think that it has a credible plan for paying it back in the long run. We borrowed a huge amount of finance in World War II. So little bits of austerity and magic debt to GDP ratios, it's not that easy. You've got to think about this long run faith in the institutions. And one more point, then I'll shut up. How is this different from the monetarism we started with? Both theories say if the government prints up $5 trillion and writes people checks, which is basically what we did in the pandemic, you're going to get inflation. Too much money, too much government debt, no plan for repaying debt. All the budget rules were suspended in the pandemic. Both theories say, hey, yeah, it's going to work. The crucial distinction is suppose the government gave you $5 trillion in checks but took back $5 trillion of Treasury bills. There was no deficit. There was just too much money and not enough debt. So classic monetarism would say that causes exactly the same inflation. But think about it. If I give you $5 trillion and take back $5 trillion for the Treasury bills, you have no overall, you've got the same amount of stuff. It's just in a slightly different form. Why do you care? That's not going to send you to go out and spend things. So that's the crucial distinction between just focusing on money and focusing on overall government debt.

Liam Julian:

Yeah. So, the core idea here is that we should be thinking about money as debt. And also, almost as stock. Is that correct?

John Cochrane:

Yeah. I have a paper called money as stock.

Liam Julian:

What's that? Sorry, what's that?

John Cochrane:

I have a paper called money as stock. And it is, in fact, so as you mentioned, I used to be a professor of finance. And I'm like a two-year-old with a hammer where everything looks like a nail. And the one thing I learned in life is price equals present value of dividends. So, this is exactly an asset pricing perspective on money. Government debt works exactly the same way as a stock price. The value of government debt is the present value of the taxes in excess of spending that it's going to use to pay back that debt. Now given that the face value of government debt is fixed, it's $32 trillion, whatever it is, the only way, if there's not enough dividends to repay that debt, how can the debt be worth less? Well, the price level has to go up so that the real value of that debt goes down, just like a stock.

Liam Julian:

Yeah.

John Cochrane:

If a stock doesn't have enough dividends, the value of the shares has to go down. The number of shares is fixed. So how does the value go down? Well, the price of the stock has to fall. So exactly the same mechanisms drive inflation as drive asset prices.

Liam Julian:

Yeah. A big part of fiscal theory is this notion of expectations. Can you talk a little bit about that, what that looks like?

John Cochrane:

Well, that's both the advantage and disadvantage and the, you know, critics, we don't like something a lot more, a lot easier to get an independent measure of, you know, the same as stocks. The stock price is the expected present value of dividends. Well, where do these expectations come from? Well, you do your best, right? What do you think Tesla's revenues are going to be in the year 2020, 2035? I don't know. But people who buy stocks have to think about those questions and come up with a good guess. Same goes for government debt. So yeah.

And now let's where is that? No, the vision of the theory is not that Joe and Jane sit down over the kitchen table and say, well, honey, I think the CBO forecast for the Social Security Trust Fund in the year 2050 is a little off. Let's get rid of some government bonds. No, that's not how it works. The same way that that's not how stocks work either. There's, you know, whatever social process it is that leads people to guess what stocks are going to pay off in the future. That applies to government debt. Now, for government debt, we have a huge number of good institutions.

This is the O'Connor Institute. So let me let me praise the institutions and the legal structure of American government, which is designed to commit the government to pay back its debts so that really what you need is a faith in the institutions that somehow or other we know Congress and the administration, everything's a little bit chaotic, but somehow or other, they are going to come around and solve the budget problems and pay back the debts. People have expectations. They have they have faith in the institutions rather than just some nebulous set of expectation.

Now, that's both good and bad news. That is how a well-run society builds a reputation for repaying its debts and not inflating them away. And so is a faith that can be lost. And we don't just see inflation when there's too much debt relative to capacity to repay it. We also see inflation sometimes just break out. Why will people lose faith? This happens in Argentina. You know, Argentina's had debt crises with debt at 40 percent of GDP and no particular inflation. But people, you know, they lose faith in that long run and they try to get rid of the government debt. Boom, here comes inflation. So that's why inflation is often very hard to predict.

Liam Julian:

Yeah. In Argentina, I suppose, would be an example of a situation where a monetary or monetarism doesn't kind of the central bank in those cases can't control inflation. Is that being that accurate to say? It’s important but the central bank is not determinative in that situation.

John Cochrane:

Yeah. In fiscal theory, central banks do matter. We're not a theory where we just the Fed is completely unimportant. Back to the sort of Keynesianism of the 1940s and 50s. Central banks and treasuries work together. But no, the central bank can't do it all by itself. And there are times when you're this is sort of one of the tests of monetarism. You're facing a currency crisis, you're facing an inflation, you're facing a debt crisis. Inflation's breaking out. You don't just fly down to Argentina and lecture the central bankers to be tougher. They're not going to do any good.

Liam Julian:

Right.

John Cochrane:

The world's bankrupt. They've got to solve that problem. And I think, you know, similarly in the U.S., monetary and fiscal policy work together. They did work together in the past to bring down inflation and they have to work together to solve inflation. Again, it's not just the Federal Reserve alone does not control inflation, although it has a lot of power to make things better and worse.

Liam Julian:

Yeah. Can I get back to the expectations idea? You know, for us non-economists, the story that we often hear about inflation is that inflation gets very dangerous when people expect inflation itself to stick around. It motivates your actions. So, for example, if I'm going to remodel my house and I think, oh, we're in an inflationary environment, but next year it'll be better. Maybe I hold off. I don't want to remodel my house or something at that point. So, I'm not contributing to the inflation. Whereas if I think inflation is going to continue, hey, I better just remodel my house now because why not? It's going to be even more expensive later. And then that continues the cycle. So, I guess my question is, how does that how do those what we hear again as non-economists, we hear about people's expectations of inflation. How does that relate to what you're talking about? Expectations for a government to repay its debts? Are these somewhat related? Is it a semantic distinction or tell me what's happening there?

John Cochrane:

This this is a very important yes. So, inflation does it almost sounds circular, but it's not. We'll get there. If people expect if you expect a lot of inflation next year, what are you going to do? You're going to run out and stock up on toilet paper right now. If businesses expect inflation next year, then they're going to raise prices right now. If workers expect inflation next year, they're going to demand higher wages right now. So clearly, people's pricing, the prices they charge and the prices they're willing to pay depend a lot on what they expect to happen next year in the same way. So, let's use that stock analogy again. You expect the price of a stock to be high next year. You're willing to pay more for it this year, right? And vice versa.

Now, that's kind of like that. That's the forest. That's the trees, not the forest. Well, where does expectations next year come from? Well, let's use the asset pricing analogy. What will people expect? So, what will what will the price be worth next year? Well, each year, the price is what you expect next year's price plus what you expect next year's dividend to be. The return consists of prices and dividends. So next year, that price is going to be what they expect the price in the following year plus the intervening dividend. Keep going that way. And that's how you get to prices, the present value of dividends, not just prices, the expected price in the future. 

So, if you're looking one year out, price is mostly the expected price in the future. If you keep going on that logic, prices, then the dividends that you expect all the way, you know, forever. Well, same with inflation. Inflation is is and this is common in many theories.

Inflation is driven by expected inflation and a little bit of, in my view, the surpluses, how much the government will repay the debt next year. Keep going and you get to inflation depends on the surpluses alone, not just the future inflation, because future inflation will be depending on its future in the surplus. So, it works in the same way as stocks. Now, it's important to take that long view, right? The same way it's just like if you're a day trader, all you care about is price is expected tomorrow's price. The dividends don't matter. But if you're thinking about the long run view of what's the overall level of stock prices, keep going and think about price as the present value of dividends. And the same for inflation. If you want to just think in the narrow term, yeah, inflation today is driven by expected inflation tomorrow. But what determines expected inflation tomorrow?

Well, take that longer view and that's when you come up with, well, in the end, it's due to fiscal policy. And the reason I think that's important for policy, the Fed understands that inflation in the short run, just like the day traders, you know, today's stock price is expected tomorrow's stock price. The Fed understands how important expectations are and anchoring expectations. But then where's the anchor come from? And the Fed seems to, they put a lot of emphasis on anchored expectations. But they seem to think that expectations come from better speeches. So why are expectations anchored, dear Fed? Oh, because we give lovely speeches about how anchored expectations are. And what if they get on board? Well, we'll just give some more speeches about how wonderfully anchored expectations are. You know, keep going. And when you keep going, things come into focus. It's like you turn the binoculars and instead of looking right up, you get to see what's out in the long run. In the long run, that anchoring comes from faith in the institutions of fiscal policy. That's a little unnerving to a Fed that would like to believe all it needs to do is give better speeches, which is like sort of a pump and dump stock trader who thinks, well, I just need to issue a rumor to make the price go up tomorrow and it'll go up today.

Well, you know, that works a little bit, but let's take the longer perspective. And there you see how important not just the surpluses themselves are, but the solid institutions that people have faith in, that this government will always pay back its debts no matter what happens. So that only comes when you turn the binoculars to long view.

Liam Julian:

Yeah. Well, so, John, this is interesting because there have been two recent episodes in American history where the government has very publicly taken on a lot of debt in the stimulus. You know, so we can remember the stimulus from 2008 during the financial crisis. And then, of course, now the stimulus is attached to COVID. In 2008, we didn't see inflation. And then with the stimulus in 2020 and 2021, we did. So, there's a difference in expectations, according to your theory. Why? What do you think those were?

John Cochrane:

Yeah. So, I got here I'm going to be a little less scientific and I'll at least try to tell you there's a plausible story and whether that checks out, we'll leave to future research. And I want to plug here. So, I have a book which is full of equations, really trying to persuade professional economists. I also have some essays, which you can find on my website, “johnhcochrane.com”, under the fiscal theory tab. And the one I'm going to plug right now is called Fiscal Histories. It just came out in the Journal of Economic Perspectives. And it answers your question with no equations and some pretty graphs and tries to use fiscal theory to understand episodes of inflation without getting all deep into the off-equilibrium dynamics that economists want to see equations about.

So, this is where the answer to your question is going to come from if your listeners want to hear something more coherent, or at least edited. So yes, so printing money and handing it out or borrowing money and handing it out causes inflation sometimes and at other times. So why now and not in 2008? Well, it's about government debt relative to, and deficits, increases in debt, relative to what people think the government will repay over the long run. So how did that work in 2008? Didn't work now.

So, I'll give you a couple stories. One, it was much smaller. 2008 was about a trillion. This is about 5 trillion. So, they really went big this time. Second, in 2008, the government had the decency, the Obama administration had the decency, to say, stimulus now, debt reduction later. And in fact, they were criticized for it because if you want, they kind of wanted inflation. If you want inflation, you want to print it up and say, no, no, we're not going to pay. If you say, here's some money, but by the way, we're going to take it back tomorrow, well, people don't go out and spend it. But they did. To their credit, they said, we're going to borrow, spend today, but then we're going to do debt reduction in the future.

This time, they said nothing of the sort. So, in this stimulus, what did you have? The Congress suspended all of the usual budget rules that says if you spend more money now, there has to be a pay for someone. No, no, we're just going to spend it now and we're not going to worry about the future. The Treasury Secretary, Janet Yellen, in her confirmation hearing said, don't worry about that. Go big. Because interest rates are so low, you'll never have to worry about that anymore. Modern monetary theory, the R less than G crowd, the secular stagnation crowd had won. Nobody's worried about government debt anymore in 2020. So certainly, there was no promises from politicians that we're going to pay this back. Now, I always make fun of them. I made fun of them in 2008. Who believes that? But you know, at least take them at their word.

Second, third, I think, actually, after 2008, interest rates had been in the 5, 6 percent range. They plunged to zero. Inflation stayed at about 1 to 2 percent. So, for a decade, the government paid net negative interest costs on the debt. Isn't that lovely? Wouldn't it be nice for you to take out a loan on your house and the bank pays you one to two percent a year? Now, even if you can't afford the house, which if you come live in Palo Alto, where I am, you can't afford the house. Even if you can't really afford the house, if the bank pays you one to two percent a year, this can go on a long time before anybody notices. So, in the fiscal theory, as in as the pricing discount rates, the interest cost on the debt really matters. And in the end, you know, we have all our fancy finance and prices and present values. But when things blow up is always when you run out of cash and when the annual interest costs on the debt are just swamping the budget. Well, negative 1 percent interest costs on the debt lets you just pay for this over for a long time. That's not going to happen again. And by the time we're going into it, and interest rates are going up and they're probably going to stay up. So that great that great bailout by the financial markets isn't going to happen. 

So, there's three of, I think, five reasons. But, you know, and the last one is, I think, interesting. They did in 2008, they borrowed money and then what do they do with it? Mostly they gave it to state and local governments who just kept their employees going. They tried to do shovel ready infrastructure projects like the California high speed train, of which not a single mile of track has yet been laid. So, warning on this infrastructure bill will probably go about the same the same way. This time they printed money, three trillion of brand new printed money and sent people checks. Now, that is much more powerful stimulus than just borrowed government spending. I think in the mechanics of it, that that's more inflationary. OK, I'll stop there. You can see I'm an economist. I can cook up plausible stories to the theory until the day, until the end of time.

Liam Julian:

Well, so talking about the inflation that we're seeing now, you know, the story that we that we read, that we heard was that, you know, covid had sort of a lot of factors kind of hit at one time. All of a sudden there was this unprecedented shift, you know, a demand. We couldn't have services. So now everybody wants goods, but at the same time, we're in lockdown, so we can't produce the goods that everybody wants. So, these sort of real world on the ground kind of factors, how do they play into fiscal theory? How does fiscal theory sort of take those into account?

John Cochrane:

And I want to add the great the great progressive demon, the monopolies. Remember that Elizabeth Warren and the great chicken, the chicken monopoly, that's all right, the price of chicken, supply shocks, relative demand shocks, chicken monopoly, the great chicken monopolist, the dog ate my homework, the speculators, greed, middlemen, hoarders, all of the you know, this is since Diocletian's inflation in the sixth century. This gets trotted out every time inflation comes along. And I'm going to push back on real world versus theory. Fiscal theory is real world, too. No, no, but people keep saying this and you gave me a lovely chance to see.

Now, this is all true. These things happen. But the important thing conceptually is to understand the difference between relative prices and the overall price level. So, when there's a supply shock, suppose you can't get the TVs in through the port, everyone wants a TV and you can't get them through the ports because there's COVID. What happens? The price of TVs has to go up relative to your wages. You're just not going to be able to buy that many TVs, right? So, the relative price of TVs has to go up relative to the wages. But that could be because prices of TVs go up and wages stay the same. It could be because wages go down and the price of TVs stay the same or we get all both go up, you know, one more than the other. That's a relative price, similarly monopolies. If there was and for some reason, the minute Biden gets elected, there's an outpouring of greed and monopolies raise prices, OK, that's a relative price. That's higher prices of one thing relative to the other ones, higher prices relative to the wages. Inflation is when everything goes up and it's that component of where everything's going up together.

And in fact, that's what we saw. Prices, wages went up too. There was a labor shortage. There wasn't just a TV shortage, there was a labor shortage. Prices go up. Now, some things go up more than others. That's why it's so confusing. And that's why inflation is, in fact, damaging, because there's relative price movements and there's this change in the overall price level. So, what I'm focusing on, when I mean it, say inflation, I want it to mean exactly what I mean it to mean. You know, the inflation that we're talking about here is the lower value of the currency, the lower value of government debt, the component of all this noise in prices that is common to everything. And you can't reason from economic forces that change one price relative to another to say, why are all prices going up together?

Now, both are happening. So, both are important. And in the short run, to people, of course, what matters most is prices that go up faster than wages. And, you know, and then wages slowly catch up. But that's unpleasant. And prices of one thing, you know, the goods versus services, well, fine. That means the price of goods goes up. Price of services go down. Why are they both going up? That's inflation. So fiscal theory talks about the part that's common to everything. And then all the other parts of economics are still operating. And those are all about relative prices. The world is confusing because it's all happening at the same time.

Liam Julian:

I see. I see. No, thank you. That's helpful. So, you sort of referenced this earlier. You know, we're at a point right now politically where we don't know if the government is going to pay its debts. And whether or not we actually cross this threshold, and I guess my question is, fiscal theory rests on the expectations, as we've been talking about. People expect the government to meet its obligations. We've had recently several of these episodes where there are negotiations about whether or not the government will meet its obligations. How is this going to affect inflation? I mean, there's no way, right, that people's expectations about the government's willingness or ability to meet its debts isn't affected by this.

John Cochrane:

Absolutely. No, what I think we saw in 2020, we saw $5 trillion in new debt. People said, look, there's no plan for paying it back. So, what has to happen, inflation has to rise. The price level has to go up until we inflate away that new debt and we get back to where we were, about 100% of GDP, the amount that people thought the government would repay. And then it kind of ends. So, you get a one-time boost of inflation, and that devalues the debt back down to what people think the government will repay. We had something similar in 1947 after World War II. Price controls got lifted, a bout of inflation that then goes away because the price level goes up. But still, in essence, we just defaulted on about 20% of the government bonds. The people who bought government bonds in 2019 are getting repaid in dollars that are going to be worth 20% less than they thought when they bought those bonds.

So that has already happened. But that is in some sense over. That was a huge bout of spending, and it's over. The inflation can go away on its own if we go back to fiscal sanity. The problem is, are we back at fiscal sanity, and how does this look going forward? Now there's this big brouhaha over the debt limit. That is actually not the issue. The question is, so if there is a debt, even a technical default in debt limit, this is not the failing to repay debts that we're worrying about. This is a technical default that lasts until they raise the debt limit or cut the spending and get over with it. The US government has the capacity to pay that back and will do so over the long run. So, the debt crisis we're really worried about is the bigger one, when nobody believes that the US has the ability or will to actually repay the debt. I mean, this could turn into a big default, but it looks like it's the usual debt ceiling thing. Even if it's a default, it's just a delay in payment rather than an actual, you're never going to get your money back. 

So, I do think the negotiations are important. Some of Washington, most of Washington still lives in 2016, the view common then among many people, not me, that there's unlimited amount of government debt and all we need to do to solve any problem is throw rivers of money at it and some sort of exorbitant privilege, something or other means we can borrow as much as we want and never worry about paying it back. And some of Washington is waking up to know, you know, that's not the way it works. We got to solve this. 

So, we are seeing, I think, the beginnings of how is the US going to sooner or later stop spending so much more than the government takes in in tax revenue. That's the central question. And you know, I think for the moment, you know, why is inflation easing? People have some sort of faith that, you know, after all the noise is over, that there will be something. We're not going to spend the next 20, 30 years spending 7% of GDP more than we take in in taxes. That's simply not going to happen. And people, I think, are still holding government bonds. We're not in Argentinian hyperinflation yet because people haven't lost faith that that will work out. But, you know, I think there's reason to worry about that. You know, it's not technically hard to close a 7% of GDP gap of more spending than taxes. Maybe it needs more economic growth, really, than anything about taxes and spending.

But I think there's reason to worry. And, you know, that's the problem is not really the current debt. The current problem is Social Security, Medicare promises that we don't have the money to keep. And I think where it may cause, you know, what I worry about is the next crisis. Things are, you know, we're actually kind of at the, the economy is doing quite well. It's kind of weird that, it's not weird, it's ridiculous that the government is borrowing a trillion dollars a year when the unemployment rate is 3.6%. And we're at the peak of a business cycle and we are not in a shooting war. I mean, what are you borrowing a trillion bucks a year for? And that has to end. And we're beginning to see, I think, you know, that's what what's making these negotiations in Washington so hard.

But, you know, the worry is the next crisis. China invades Taiwan, massive financial crisis, massive recession. The Uncle Sam comes to bond markets and says, I need about 10 trillion bucks. We need to bail out the financial system again. Oh, by the way, you know, here come the bank bailouts. We just found out the Fed didn't know about it, doesn't understand interest rate risk. So, bank bailouts here. We're about to see commercial real estate collapse, more bailouts there. And then, of course, when foreign trade collapses, we're going to bank bailout like crazy, stimulus like crazy. And this time we have to borrow a ton of money to actually fight a shooting war. And bond markets say, 10 trillion bucks, you got to be kidding. You know, they weren't willing to absorb 5 trillion bucks in 2020. That's when, you know, that's when the real crisis hits. So, I'm speculating about the future is hard, but it's clear. 

Everybody says fiscal policy in the U.S. is unsustainable. And if it does not get sustainable at some point, there will be inflation as well as other horrible problems at some point. When? I don't know. This is it. So, I live in California. I live on an earthquake fault. There will be a magnitude 9 quake at some point in the next 100 years. When? I don't know. But just that it hasn't happened in the last 10 years shouldn't reassure you that it's not there. You know, back to theory versus empirics. You know, our real estate agent said, we haven't seen earthquakes here since 1986. Don't worry about it. I've read some geology books. So yeah, a lot of us have been moving up. Here comes the debt crisis for about 30 years now, and it hasn't happened. But that doesn't mean it can't happen.

Liam Julian:

Yeah. So, you kind of alluded to this earlier, John. What do you think are some areas of, you know, you wrote this book, 500 Pages, It's Wonderful, where you really set down fiscal theory and sort of combined a lot of, but where do you think are the areas that could use more research that are still open questions, things that you would like to investigate or others? 

John Cochrane:

Oh, thank you. So, this is a foundation. This is, you know, Milton Friedman and Anna Schwartz started with, oh, it was on Milton Friedman's license plate, MV equals PY, you know, the quantity of money equals that determines the price level on which you build a tremendous amount. So, this effort, this book is really just the simplest possible foundation. You know, start by thinking about money and bonds as an asset. But back to your real world, you know, in economics, we always, good economics starts with very simple supply and demand.

And then there's what we call frictions. There's all sorts of little problems in markets. There's real world complications. There's how do expectations really get formed? What about prices? Prices are somewhat sticky. You know, how does inflation really feed through a financial system, all the parts that should be connected to each other and aren't connected in the short run?

So that's really, this is really just the beginning. And I hope, you know, my great hope for it is that it is, you know, one one-fiftieth of the job that needs to get done, which is reconstructing the edifice of macroeconomic theory on top of fiscal foundations, as opposed to the current New Keynesian foundations, which I won't tell you too much about. But that's sort of the current basic theory. Now that is only just begun. And there's some big puzzles here. You know, when you take the simplest supply and demand and it says when the government spends too much money, there's a jump. Price level jumps up overnight. Well, no, it took two to three years.

So, what's the nature of that sticky process? One of the biggest puzzles, so I'll advertise another paper, it's Expectations and the Neutrality of Interest Rates, which tries to put together what we as an entire economics profession don't know. Everybody believes that if the Fed raises interest rates, that's going to lower inflation. Really? Why? Because if you look hard at the equations of everybody's models, that's not there. It's there only if fiscal policy helps. And I'll tell you why. When the Fed raises interest, this is important for policy, so I get to go on for right now. When the Fed raises interest rates to combat inflation, that means interest costs on the debt rise.

You see it happening right now, right? And we have like 100 percent debt to GDP ratio. So back of the envelope, one percent higher interest rates. That's one percent of GDP, more deficit to pay the interest costs on the debt. Where's that coming from? You know, imagine Powell raises interest rates, you know, another two percent, goes down to Congress and says, hey, two percent interest rates. So, we need to see something like six hundred billion dollars, if I got the math right, tighter fiscal policy to pay the interest costs on the debt. Please cut spending six hundred trillion, six hundred billion dollars.

Can you see I'm getting laughed out of Congress? So how does higher interest rates, so in the models that we have joint monetary and fiscal policy. OK, so let's ask the question, if the Fed raises interest rates and fiscal policy does not tighten to pay the higher interest costs on the debt, can that still lower inflation? There's only one model I know of which I've been working on that does it, and I don't really believe it. But so, you're the general faith that the Fed alone by raising interest rates can lower inflation without paying, without help from fiscal policy. Is that there? Is it not? I don't know, because I've worked with very simple models, but, you know, add all the smorgasbord of things people want to put in macro models that, you know, that one reason is just to understand this basic question.

But also, what do people put in a macroeconomic model? What is this thing? And that includes consumers, producers. It has investment. It has banks. It has frictions where it's, you know, the banks may not be able to lend, even though people might want to lend them banks, all of this kind of interesting dynamics. Maybe the answer to that big question is in there. Maybe it's not. But certainly, to understand where recessions come from, how does the Fed influence recessions? That's the other big policy question today. Hey, the Fed is raising interest rates and nothing seems to be happening. What's going on here? How do interest rates actually affect the economy?

Well, that, so you can see tons as an academic, I always end every paper with call for future research. But this is the case where, you know, we've done the first week of the economics course. We got the supply and demand right, you know, price of apples goes up. Less people buy apples. Apple producers produce more apples. Yay, that's done. OK, great. Well, now we've got nine weeks to go. And so certainly that's my hope, in order to answer important questions like, can the Fed lower interest rates by raising inflation? If so, when, how and how much? There's a good question which we really don't know the answer to.

Liam Julian:

Yeah. I'd like to end on a personal question. Not that personal, but, you know, John, so you did your undergrad, your degree was in physics and then you became an economist. I was just curious what when you made the decision to abandon physics and move into economics or maybe abandon isn't the right word and how you came to that to that decision. It's interesting to me.

John Cochrane:

Thanks. I love physics. There's a lot of fallen physics physicists in economics because they're very similar. Physics is a great education in practical mathematical modeling. So, to see a system, reduce it down to its essentials. We used to call it the science of massless elephants going down frictionless sandpaper. But it teaches you mathematical modeling without getting too abstract like mathematicians do. And as an economist, I recognize, you know, there's an optimal matching of talents with activities. And it became clear that I wasn't smart enough to be a theoretical physicist. And I'm a terrible manager of people. So being an experimentalist would have been a disaster. I also kind of realized there weren't any jobs. I was at MIT.

So, economics had been my undergraduate humanities distribution requirement. I took two courses in economics, which I love. When I saw my first supply demand graph, when I saw the when I saw the conversion moment in undergraduate, I saw the choices. We were analyzing welfare and I saw the choices facing someone on welfare, which at the time was you get welfare up to $15,000, $15,001. You lose your check, you lose your apartment, you lose your health insurance. Well, it just, you know, there before the grace of God go, there's no no culture of something, no sociology is just, hey, you know, you're going to stay on welfare if that's the deal. And so, there is a politics free, a value free, a morality free way of analyzing important social human problems. That seems cool.

And its economics is physics and about 1811, I remember the story of Joule, who was a brewer and then went down his basement and did the theory of heat. Well, you can do it all by yourself with a computer and sort of the math that you learn in undergraduate physics and you can solve important problems. So that all attracted me. And it's certainly been a good match for my talents. You know, other people are good at running big labs. Other people are good at abstract math. This was something that both I wanted to do and was something that I could do productively. 

So, I went now I'll just I'll finish the story, which is getting long. Sorry. I'm sad that it would be very hard to do that these days. The economics profession has gotten much more bureaucratic, formalized careerist. I in August of 1979, I wrote a letter on a typewriter. Book those up, people watching on YouTube, they're interesting historical things. And I sent it to all the places that had let me in as a physics graduate student to say, how about I change my major? And Berkeley in Chicago said, sure, why not? I knew it. I knew it snowed in Chicago. I knew it didn't snow in Berkeley. And there I went. You cannot now apply to a top Ph.D. program in August and say, hey, I'd like to show up in September. So, I did two years of predoc and letters of recommendation and intern and so on and so forth. So, and in fact, most of the most of the really famous people I know have life stories like this, which are just harder and harder to do in our in our more and more careerist bureaucratic world, which is kind of sad.

Liam Julian:

Yeah. Well, John, thank you so much for taking time to talk with us and share that story, too, which was fantastic and really interesting. Really appreciate it. 

John Cochrane:

I hope the audience will as well. Thank you for listening and for asking such great questions. This has been fun. Thank you.