Score One for the Fiscal Theory

In an op-ed in the Wall Street Journal John Cochrane takes a victory lap:

As inflation eases, representatives of different schools of thought are taking victory laps. But who really deserves one? What have we learned about inflation?

I think the episode is a smashing confirmation of the fiscal theory of the price level. Where did inflation come from? Our government borrowed about $5 trillion and wrote people checks. Crucially, and unlike in 2008, there was no mention of how the new debt would be repaid, no promise of debt reduction later. The spending was couched as an “emergency expenditure” not going through the usual budget process or requiring offsets. Treasury Secretary Janet Yellen, argued that “with interest rates at historic lows”—they were then—debt isn’t a concern, so “the smartest thing we can do is act big.”

People could have looked at all this new debt, thought it would be repaid with interest, and therefore regarded it as a good investment. They didn’t. They chose to try to spend the new debt rather than save it. But we can’t all sell, so that drives up prices.

The “fiscal theory” of the price level is the view that government fiscal policy is the primary determinant of the price level, i.e. inflation. Therefore, for sustainable price levels the federal government must run a balance budget over the business cycle. Unlike folk Keynesianism which holds that federal spending always stimulates the economy, that is completely consistent with what Keynes taught. If fiscal theory actual explains what we have experienced over the last several years, our present structural deficit is highly problematic.

Think of currency as stock in the federal government. When the federal government runs a structural deficit, the stock loses value.

Dr. Cochrane concludes:

A fiscal point of view isn’t encouraging about the future, however. Inflation is easing but remains high. The U.S. is running a scandalous $1.5 trillion deficit with unemployment at 3.6% and no temporary crisis justifying such huge borrowing. Unfunded entitlements loom over any plan for sustainable government finances. The Congressional Budget Office projects constantly growing deficits, and even its warnings assume nothing bad happens to drive another bout of borrowing.

Do people believe that the U.S. now can raise future taxes over spending by $1.5 trillion a year to finance new debt without more inflation? When the next crisis comes and Washington wants to borrow, say, $10 trillion for more bailouts, stimulus, transfers and perhaps a real war, will markets have faith that the U.S. can repay that additional debt? If not, another cycle of inflation will surely erupt, no matter what the Fed does with interest rates.

As Dr. Cochrane notes, neither the economists he refers to as “team transitory” (inflation can be explained by supply shocks) monetarists, nor those clinging bitterly to the Phillips Curve actually explain what has transpired. Here’s his comment on the monetarist view:

But does money alone drive inflation? Suppose there had been no deficit, and the Fed had done another $5 trillion of quantitative easing, buying $5 trillion of bonds in exchange for $5 trillion in reserves. Would people with $5 trillion more cash but $5 trillion less Treasury bonds, and thus no net increase in wealth, have tried to spend money, driving up prices? We pretty much know the answer—similar QE throughout the 2010s had basically no effect on inflation. In the monetarist view, more money and less bonds has exactly the same effect as more money and more bonds. In the fiscal view, overall government debt, including reserves, matters, not its particular maturity.

I suspect that no one will learn anything from what has transpired.