MePlease try to imagine Late 2024. Inflation in rich countries has fallen from its peak, but remains high. At about 4%, well above the comfort level of most central banks. Governments plagued with huge debts must use their precious revenues to pay interest on their debts. The debt itself is growing due to high interest rates. The energy transition and increased state spending due to an aging population will add to the financial giants. More money will be printed because tax increases have political problems. Inflation will remain high and government credibility will suffer. Central bankers are puzzled as to why their mighty weapon, interest rates, has failed so utterly.
A strange theory, brilliantly detailed in a new book by John Cochrane of the Hoover Institution at Stanford University, would offer a potential explanation. or the “Monetary History” of Milton Friedman and Anna Schwartz. Cochrane, whose own research on the subject spans 40 years, spends nearly 600 pages chatting about how to rework the mathematics of past economic models to incorporate fiscal theory and explain past episodes of inflation. are discussing. “[E]Milton Friedman may change his mind in the face of new facts and experiences,” he speculates.
At the heart of Cochrane’s theory is the idea that government debt can be valued like a company’s stock based on returns to the pocket of the owner. The price level is adjusted so that the real value of the debt equals the government’s total future budget surplus, discounted appropriately, thus promoting inflation or deflation. So the real driver of inflation is government debt, not monetary policy. In this theory, money has value because it can be used to pay taxes or generate a surplus. The setup is not much different than the gold standard, except that the money is backed by taxes instead of gold.
Cochrane notes that price level adjustments are not instantaneous. When it comes to paying off debt, people can’t make judgments about the credibility of government. As with stocks, prices can deviate from fundamentals. But in the long run they will adapt. A government that hands out money without ending up in the black can never avoid inflation.
History seems to back it up. Brad DeLong of the University of California, Berkeley, in his recent book Leaning Towards Utopia, uses fiscal theory to explain post-World War I European inflation. In France, high debt interest payments have caused inflation to average 20% per year over seven years. Things got even worse in Germany. The public has lost confidence that the state can pay its debts without inflation. Hyperinflation soon set in.
Cochrane also applies fiscal theory to US inflation in the 1970s and 80s. In the mid-1970s price increases he exceeded 12%. The Federal Reserve has raised interest rates. Inflation he dropped to 5% by 1977. But Cochrane notes that inflation had risen to over 14% by 1980, when he again. Fiscal and regulatory reforms that raised expectations of future surpluses were needed to overcome inflation.
What is the state of fiscal theory today? In his decade after the global financial crisis of 2007-2009, prices remained stubbornly low even as the money supply surged for many of the wealthy and interest rates remained below zero. . “Oil monetarism” predicted a surge in inflation, but it did not materialize. Other revamped “New Keynesian” models have also failed. When governments spent heavily during the COVID-19 pandemic, many economists, reasoning from recent history, were optimistic about the likelihood of inflation. It was a target.
Cochrane argues that fiscal theory can explain both the period of low inflation and the rapid rise in prices after the pandemic. Inflation was low in the 2010s despite soaring government debt. This was because politicians promised debt consolidation and low interest rates meant consumers and bondholders were willing to wait. But during the pandemic, the government took a different approach. They dropped huge checks in consumers’ pockets. The Federal Reserve Board purchased Treasury bonds shortly after they were issued. There was little talk of sustainability. Cochrane claims that the direct nature of these “helicopter drops” let people know that their newly fat pockets would not be depleted by future taxes. is now used.
Front I win, back you lose
This story may be too convenient. Indeed, Mr. Cochrane admits that the shortcoming of fiscal theory is that it provides a way to explain nearly any sequence of historical events in an unfalsifiable way. there is. But if fiscal theory is so hard to prove wrong, are they really playing a fair fight? Mr. Cochrane’s story of how inflation ended in the 1980s , complicated by the fact that America did cut taxes, suggesting that politicians were less concerned with a balanced budget. Deregulation may have boosted growth, but many economists believe the 1990s fiscal surplus was largely due to globalization and the economic crisis. that Few consumers expected the boom in the 1980s.
Fiscal theory also provides limited guidance to policy makers beyond what is already well known. Monetary policy remains important under that approach. Interest rates can spread the rise in price levels over a period of time. Additionally, the theory suggests that governments must remain credible in paying down their debts, which is not a radical idea.
Fast forward again to late 2024. Now imagine that the inflation rate he has dropped to 2%. Interest rates are gradually falling. The central bank is running a victory lap. Fiscal theory? Its proponents could also win, just as if inflation had remained high. ■
Read more about our column on economics, Free Exchange.
Could Europe face a worse inflation problem than America? (January 19th)
A warning from history for a new era of industrial policy (January 11th)
The Federal Reserve’s great antihero deserves a second look (December 20th)
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https://www.economist.com/finance-and-economics/2023/01/26/have-economists-misunderstood-inflation Are Economists Misunderstanding Inflation? | | The Economist