Iimagine it is End of 2024. Inflation in rich countries has come down from its peak but remains stubbornly high. That rate is around 4%, well above what most central banks consider appropriate. Governments weighed down by huge debts must use precious revenues to pay interest on debts that are themselves growing due to high interest rates. Fiscal generosity has increased due to an aging population, the energy transition and increased state spending. Raising taxes is politically controversial, so more money is printed. Inflation remained high and the government’s credibility deteriorated. Central bankers are scratching their heads, wondering how their powerful weapon – interest rates – could have failed so utterly.
John Cochrane of Stanford University’s Hoover Institution has elaborated a quirky theory in a new book that offers one possible explanation. The “Fiscal Theory of the Price Level” established a theory of inflation as ambitious as that proposed by John Maynard Keynes’ “General Theory” or Milton Friedman and Anna Schwartz’s “Monetary History”. Mr. Cochrane’s own work on the topic spans 40 years, and he spends nearly 600 pages revising the mathematics of past economic models to incorporate fiscal theory, while chattering about how it explains past inflationary episodes. “[E]Milton Friedman may have changed his mind with the new facts and experience at hand,” he speculated.
At the heart of Mr Cochran’s theory is that government debt can be valued, like equity in a company, based on returns to the pockets of its owners. The price level would be adjusted – thereby driving inflation or deflation – to ensure that the real value of the debt was equal to the sum of the government’s future budget surpluses, properly discounted. Therefore, the real driver of inflation is government debt rather than monetary policy. According to this theory, money has value because it can be used to pay taxes and generate a surplus. The setup is not that different from the gold standard, except that the currency is backed by taxes rather than gold.
Mr Cochrane is careful to point out that adjustments in the price level are not instantaneous. People may not be able to judge the credibility of governments when it comes to paying their debts. Just like stocks, prices can deviate from fundamentals. But in the long run, they adjust. A government that hands out money without eventually running a surplus will not avoid inflation forever.
History seems to back it up. UC Berkeley’s Brad DeLong uses fiscal theory to explain post-World War I inflation in Europe in his new book, Sloshing Towards Utopia. In France, huge debt interest payments have led to an average annual inflation rate of 20% for seven years. In Germany, the situation was even worse. The public lost confidence in the country’s ability to service its debts without inflation. Soon hyperinflation set in.
Mr. Cochran also used fiscal theory to deal with inflation in the United States in the 1970s and 1980s. In the mid-1970s, prices rose by more than 12%. The Federal Reserve raises interest rates; by 1977, inflation falls to 5%. However, Mr Cochrane noted that by 1980 inflation had surged again above 14%, partly because of the failure of the US to put its finances in order. Fiscal and regulatory reforms that raise expectations of future surpluses and another dose of monetary medicine are needed to beat inflation.
How is fiscal theory going today? In the decade following the 2007-09 global financial crisis, prices remained high even as money supplies surged and interest rates were at or below zero in most developed countries. “Primitive monetarism” predicted soaring inflation, which didn’t materialize. Other refined “New Keynesian” models have also proved unhelpful. As governments spend huge sums during the covid-19 pandemic, many economists are optimistic about the likelihood of inflation, based on recent historical reasoning.
Mr Cochran argues that fiscal theory can explain periods of low inflation and a return to rapid price increases after the pandemic. Inflation was low in the 2010s despite soaring government debt, as politicians promised to straighten the books, and low interest rates meant consumers and bondholders were willing to wait. During the pandemic, however, governments have taken different approaches. They put huge checks into the pockets of consumers. The Fed bought government bonds immediately after issuance. Sustainability is rarely talked about. Mr Cochran argues that the immediate nature of these “helicopter drops” tells people their recently fattened pockets will not be depleted by future taxes. So they are more willing to spend money.
Heads I win, tails you lose
Perhaps the story is too convenient. Indeed, Mr. Cochran admits that fiscal theory is flawed in that it provides a way of explaining almost all series of historical events in an unfalsifiable way. Yes, other inflation theories have problems too. But if it’s that hard to prove fiscal theory wrong, are they really leveling the playing field? Mr Cochrane’s story of how inflation ended in the 80s is complicated by the fact that US taxes were actually cut, suggesting that politicians are not entirely concerned with balancing the budget.While deregulation may have boosted growth, many economists argue that the budget surpluses of the 1990s were largely driven by globalization and it Boom, which few consumers saw coming in the 1980s.
Fiscal theory also provides limited guidance for policymakers beyond what is known. Depending on its approach, monetary policy still matters: interest rates can spread increases in the price level over time. Furthermore, the theory suggests that the government must remain creditworthy when it pays its debts—not a radical idea.
Fast forward again to the end of 2024. Imagine that this time the inflation rate has dropped to 2%. Interest rates are slowly coming down. Central bankers are celebrating victory. What about fiscal theory? Its supporters are also likely to celebrate victory, as they would if inflation remained high. ■
Read more from our economics column Free Exchange:
Will Europe end up with a bigger inflation problem than the US? (January 19)
Historical warning of industrial policy in the new era (January 11)
The Fed’s Great Antihero Worth Revisiting (Dec. 20)
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