Dropping Money from Helicopters: Economist John Cochrane on Inflation

the inflation rate last year eight percent that meant we paid more at the gas pump and that we paid more at the grocery store it 808 our savings and inflation is still with us now running at about six between six and seven percent as we shoot this show where does inflation come from and what can we do about it economist John Cochran on uncommon knowledge now [Music] thank you welcome to uncommon knowledge I'm Peter Robinson with an undergraduate degree in physics from MIT and a doctorate in economics from the University of California at Berkeley John Cochran served on the staff of the Council of economic advisors in the Reagan White House Dr Cochran then began his academic career proper joining the storied economics department at the University of Chicago and then the faculty of the booth business school also at Chicago for some seven years now Dr Cochran has been a fellow here at the Hoover institution at Stanford now John Cochran has published his magnum opus the fiscal theory of the price level the fiscal Theory contains a lot of equations fear not John writes in the introduction one really doesn't need any more economics or math than is covered in a good undergraduate economics course to understand this to understand it all we're about to put that to the test John welcome thank you it's a pleasure to be here all right your new book a couple of quotations Milton Friedman in 1963. inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than an output closed quote John Cochran in the fiscal theory of the price level quote in this book I argue that the fiscal theory is a genuinely new theory that unseats its predecessors at the foundation of monetary economics it's pretty bold John and you you you started your career in the economics department at the University of Chicago where Milton Friedman made his career George Stigler Gary Becker all these great economists who gave us the monetary school this enormous burst of creativity within the discipline of economics in the middle of the last century and now you're coming along and saying they were mistaken what are you saying what's your contention boy I I get excited when I'm behind the keyboard don't I uh they were 90 right and um you can see actually the wonders of academic uh cross fertilization uh because I am a lot Chicago and I'm so lucky to be there because my instincts are so Chicago but I also picked up a lot while I was at Berkeley and a certain skepticism of monetarism so let's get right to it where where are they right and what am I saying that's a little bit different um I would agree fiscal Theory agrees with standard monetary theory in Milton's famous words if you drop money from helicopters you're going to get inflation in fact our government did just drop money essentially from helicopters and lo and behold we get inflation now on this experiment we agree entirely that is going to cause inflation good thing because we observe things like that in the world physical Theory however emphasizes overall government debt relative to the amount that our people believe our government will repay so if you drop government debt from helicopters you will get inflation and money is just another form of government debt so now we're agreeing money is a special case of some okay all right I think I'm actually following you money is if I may be technical for a minute it is a very short-term non-interest paying government debt all right and actually most money right now Reserves at the FED are interest paying overnight government debt there is no big difference between money and government debt so where might Milton and I disagree if only we could bring him back and have him here it would be an even better show the central question is an exchange of money for bonds so if we dump money people will spend it and you'll get inflation if we dump bonds people will spend it and we'll get inflation but the central monetized idea is suppose that I give you money but I take back the same amount of government bonds now are you going to go around on spin I can give you 10 grand you'd quit the show and go spend it but if I give you 10 grand and take back 10 grand of government bonds you have more money but you don't have any more wealth now are you going to run out and spend it aha that is the crucial decisive conceptual experiment I would say to first order absent all the frictions and second order stuff that matter in the real world that would have no effect on inflation whereas the true monitorist says yes giving you the money but taking back the bonds is exactly the same as giving you the money is exactly okay keep going keep going so the monitor I was trying to be short for once a month no no no but no because no I'm a little surprised because I think I'm actually following this I was I was prepared in this in this conversation to let a certain amount just go over my head John never but so Milton would say there is a distinction is it it must be you can't write a book as weighty as this on a mere question of semantics there has to be something more going on than defining money in slightly different ways oh yes tremendously it's okay the underlying economics is very different in one case it's what we call a composition effect problem is you have too much money and not enough bonds and so you go to try to fix that and and that's what that's what that's standard monetary theory in my case what matters is the total amount of money plus bonds overall so a wealth effect versus a portfolio composition effect it's fundamentally different economics it's not semantics not semantics Okay so I'll give you another example please no no keep going keep going no no no uh do Bank deposits matter so and the fiscal Theory uh says we look at money and government debt they are like stock in the federal government and so what matters is the amount that they've issued relative to the taxes minus spending that the government can use to pay back that money in debt now in that view all that matters is the government money if uh if the government has issued money and people believe in it whether uh I lend you I write an ioe I owe you Peter I give that to you that's what's called inside money the government has nothing to do with it I've just lent it to you I've created a liquid asset does that cause inflation so monetarist would say yes it should shouldn't it all right I'm well uh it is not if I write you and I I'm just going to write you and Iota yes I owe you uh one dollar right all right I have just in the standard view I have created money and and you can go give that to someone else and that helps you to make transactions right that's inflationary in the standard you know Milton Friedman view whereas in the physical Theory view again in the simplest possible view of things uh that's like an option that's like a private contract on something else but the government doesn't have to take that for taxes that is not a liability of the government that's a liability of me that's not backed by the government surpluses so it doesn't have any effect on the price level so there's another big distinction does the government have to stop and monitor the quantity of these inside liquid assets that we all see hanging around do those cause inflation and I would just add quick before you add another question this is what makes fiscal Theory appropriate for today and monitors and may well have have been just right for 1935 or even 1964. but we have a financial system that is Awash in stuff like this overnight repurchase agreements liquid assets of All Sorts is this where crypto fits in crypto is in prime example uh the government our fed makes no effort to control the quantity of inside money there's no reserve requirements anymore M2 is whatever people want it to be so the idea it's fortunate that we don't count on limiting this stuff to limit inflation because the FED isn't do isn't limiting it we need a theory that corresponds to today's institutional reality one of them interest rate targets our government does not limit the quantity of money it sets an interest rate target Milton Friedman says an interest rate target will fall apart you can't do it got to limit the quantity money they don't limit the quantity money and they don't limit the amount of inside money so we don't live in the preconditions where monetarism could work and they don't try to monitor this so-called inside money they don't try to monitor the amount and so forth because they can't or because they're not please no no I I don't even want to I'll just leave it in other words is it a technical problem they just can't do it so they're not going to expend resources trying uh I think they could at tremendous cost to the economy so our economy is it's tremendously beneficial that we are Awash in liquid assets that help us to make transactions that there's all this financial Innovation that that's making our economy great they they could try to clamp down on this stuff if they had to I think they've discovered they don't have to uh and that the cost of the economy would be so large if they did okay one more question of the theoretical look it's not at the theoretical level it's a question about your theory I'm quoting you from the book John economists too often give a clever name to a puzzle Proclaim that no standard economic model can explain it and invent a new Theory but fiscal theory is much in the Chicago tradition we're trying to get a a bead on you John half of you is this sandal wearing Berkeley kid who got his Doctorate and they wasn't the late 70s mid 80s mid 80s oh so you went to the Reagan White House you were a child when you went to the I was a research assistant okay all right and then we've got the then we've got the button-down Chicago man economists do often give a clever name to a puzzle to Proclaim that no standard economic model can explain it and invent a new Theory but fiscal theory is much in the Chicago tradition it allows a less is more approach in which a little bit of hard supply and demand work takes you further than you might have thought close quote what do you mean get that through my skull takes you further a little bit of hard supply and demand work so I am a very much a Chicago style economics I want to advertise the theory does not require that approach you could take this to Cambridge and it would work just fine and add all the Cambridge style bells and whistles but it also fits a Chicago approach and uh I hope again if we could bring back Milton's ghost and say Melton we loved your monetary Theory I loved it for years but we live in a world Awash in liquid Financial assets and the Federal Reserve is setting interest rates and not controlling the money supply what are you going to do and I I hope I could sell a young Milton on this that this would be the Chicago of Chicago's the monetarism of today because it is so simple it doesn't have the bells and whistles and epicycles of every macroeconomic model that you've ever seen it's very easy it's Chicago supply and demand and that of course is the Hallmark of Chicago economics everybody looks at something that doesn't make sense and they say oh people are irrational oh there's a monopoly oh there's some complicated sociological explanation and then the Gary Becker the Milton Friedman the gene fava they they just count a little harder they go home they work harder they got their simple supply and demand curves and they say aha this actually makes sense in a very simple model so fiscal Theory allows that approach I take it in that direction whereas otherwise monetary Theory or even in Milton's monetary Theory you got this big thing that money is different from bonds this big something's wrong with the financial system right we remove all that you don't need money at all it's uh it it it it it works in a in a completely frictionless Chicago supply and demand view of the world you can add the frictions if you want if you need to so how would you rewrite Milton's famous line in is always an everywhere monetary phenomenon and you would say inflation is always an everywhere a phenomenon of government obligations yes it's as simple as that a fiscal well it is the fiscal theory of the price level a fiscal phenomenon there are situations uh in which the FED cannot control inflation um so it's not always an everywhere monetary phenomenon and there are um at at bottom it is not about money as a special asset distinct from bonds it is about the value of government liabilities it is what is this stuff worth in terms of Something Real uh not just there's something very special about special stuff that we use to make transactions and so it's no I think I'm I'm achieving a little intuitive breakthrough here the argument then moves in this direction if the government takes on more and more debt and people begin to develop a certain skepticism or certain realism you could put it use either word about the government's willingness and or ability over time to repay all of that debt then that debt becomes not worthless but worth less and you get what this book used to cost five chunks of debt and as people become more skeptical about the government's willingness to repay debt it begins to cost seven chunks of debt is this the intuitive uh uh am I grasping something real here you got it exactly okay it is it is total amount of time tempted to say stop here thank you John well now Brian can expand a little bit Central amount is the total we start with the simple version the Chicago version the undergraduate version we start with the total amount of debt relative to what how much the government you think the government will be willing to willing and able to repay and how does that work suppose that we look at the debt we see this is getting kind of chancy here uh what do you do if you're sitting on government bonds and you start to think you know this is not going to get repaid dump them you dump them now you might try to dump them to me but then I dump them we can't collectively dump them so you might dump them in return for I don't know some stocks but eventually we're going to dump them in return for trying to buy goods and services so as opposed to too much money chasing too few goods it's too much debt choosing too few goods but how much debt is too much relative to what we think the government will repay now this is what makes it hard because people jump to oh deficits matter and you could our government can borrow an enormous amount of money if people are convinced that over 20 30 years it will repay that money you know World War II if there's a plan for repayment solid long-term finances you can have big deficits so it's not about this year's deficit and curing this year's deficit won't do it it's about that long-term Faith just money is like stock one of my early papers I thought the title was great money is stock it's stock in the government and for the same reason it's the same mechanism if you think a stock isn't going to pay dividends 20 years from now you dump it the price goes down so let me just finish on that and this is very important because people jump to uh well there's countries with lots of debts but no inflation yes if people think those debts can be repaid there's no inflation so that makes it harder too there isn't you know Milton Friedman had MV equals py on his license plate right right and a whole book where he just looked at the quantity of money and said inflation um well it's since you have to do debt and deficits relative to this expected long repayment it's hard the same way valuing a stock is hard right it is nothing new about being hard if you know if you sit down with the books of Tesla and you say well Peter where do you think this is worth and it's awfully hard to make sense of Market values well unfortunately that's where we are but that's the idea just regard debt like stock in the government okay so let's let's let's let's take you back in time to you're starting your career in the Reagan White House let's go through inflation in the Reagan years January 1981 Ronald Reagan succeeds Jimmy Carter and inflation is running at about 12 percent not quite 12 percent and where were you in 1981 were you still at MIT probably uh no I was let's say I was a graduate student in uh at Berkeley okay so you were up the road about uh I need a year off and uh what might be a fun thing to do okay all right by 1985 inflation has fallen to under four percent and it would remain low for many many years the fiscal theory of the price level the conventional story of this episode focuses on monetary policy monetary policy you argue was too this this conventional story argues is too loose during the 1970s in part to accommodate the oil price shocks then I'm quoting you again inflation was conquered in the early 1980s by persistently High real interest rates in other words Paul volcker fed chairman slams down on the money supply drives up interest rates and Rings inflation out of the economy and that is indeed the conventional story if we go to the financial district of Manhattan and tap anybody over 50 on the shoulder that's the story they'll tell us and John Cochran says oh no no no no no inflation was not conquered in the 1980s by monetary policy alone okay so I know the conventional story now I'm about to hear your story um so I um this is story okay so let me emphasize what I'm going to be scholarly for a minute this is a book of theory all right uh I have told a number of stories which I think at least let's get to the range of this applausible story and then the next step of course is to make plausible stories concrete with numbers and so forth and that's so where we are is I'm going to tell you a plausible story but not not the be-all and end-all test at least let's get to there's a plausible thing when everybody else thinks it isn't all right now also the theory here does not say the FED is completely unimportant and it's all in the treasury Department there is in fact a very strong role for monetary policy in the fiscal theory of the price level by setting interest rates the FED has a very strong impact on where inflation goes so inflation is a if you want to call that monetary the FED setting interest rates really doesn't have anything to do with money anymore but we call it monetary policy maybe a better word would be interest rate policy still matters a lot for where does inflation go so that the FED raised interest rates is the model in about page 372 here which will show you that the fed by raising interest rates can help to reduce inflation all right that's important the FED remains important but fiscal policy is a central part of the story I can't get away from the equations that say that too and I can make that real for you when the FED raises interest rates that raises interest costs on the debt who's going to pay for those when the FED brings down inflation uh what the that is going to be a boon to bondholders you bought if you bought bonds you're a little older than me so you probably bought some Bonds in 1980 at 15 percent and you got 15 interest in an environment of three or four percent inflation you made a killing courtesy of the American taxpayer somebody paid for that so there's there's fiscal requirements for the FED to be able to help and in fact when we look at the debts and deficits that followed the 1980s by the mid-1990s the U.S government was Awash in surpluses right right so at least with X post wisdom it was exactly right for inflation to go down uh for fiscal reasons now what happened in the 1980s I'll tell you my story um in the 82 and 86 tax reforms they cut marginal rates from 70 to 28 percent uh you want to talk about incentives to work save and invest they also closed up a bunch of loopholes capital gains tax receipts went up immediately they deregulated they did a big Social Security reform which is very good on the you know we're talking about long run expectations uh the economy took off well maybe the economy took off for other reasons tax revenues start pouring in when the economy takes off so this was a joint monetary fiscal stabilization if there ever was one and the fiscal part is import the physical part is important as a matter of accounting when we look around the world central banks can do that and do that often they did that twice in the 70s they can tighten the monetary screws bring inflation down for a while but especially go hang out in Latin America wait six months or a year boom off we go again because they haven't solved the underlying fiscal problem the underlying long-term fiscal problem and so what I think was really important in the early 1980s was the Schultz memo the stay the course memo the idea that America was on a better long-run trajectory it's not about people you know people in their kitchens didn't say aha I've worked out the numbers honey in 1997 the deficit is going to be down to only two percent no that's not how it works what you need is Faith is that this is a serious country that will repay its debts that's growing strongly the government isn't going to be in trouble those government bonds are a good investment and I think they're the the the the I the that Faith came back in the 1980s for good reason so I'm telling that's the story part the fact part is if you take monetary policy and you don't type and you don't fix the fiscal problem inflation comes back we've seen that over and over again when you fix monetary and fiscal policies together inflation goes away and often painlessly so Tom Sargent has this wonderful famous patient I'm Sergeant is our colleague here at the Hoover institution all right Nobel Prize winner wonderful Economist uh he showed that the ends of the hyperinflations in World War One that's the worst inflation you can imagine I mean we're talking you know 10 to the X right inflations how did they end did they end by monetary tightening no they solved the fiscal problem the reparations do the Allies the massive deficits the inflation stopped immediately with no recession no high interest rates no reduction of money supply so fiscal and monetary policy working together is always what ends big inflations and I think that's also true of the US in the 1980s okay from Reagan to George W bush I'm going to put this a little bit crudely but it's not entirely unfair during the administration of George W bush the president or those advising him persuade they basically they make a decision we've got a Congress that wants to spend and we've got a war to pursue against terrorism it's expensive to go into Afghanistan and it's expensive to go into Iraq we'll let Congress spend what it wants to domestically as long as they fund this imperative of pursuing these wars Prosecuting these wars Dick Cheney says to treasury secretary Paul O'Neill in 2002 this is a quotation Reagan proved deficits don't matter quote Reagan proved deficits don't matter and indeed federal debt Rose during the Reagan years from 31 to 49 percent of GDP so how where does that fit into the fiscal your fiscal Theory deficits don't matter indeed if people have the confidence of the economy's ability to pay it back the government's ability to pay it back over the long run so that's right and I think what Cheney got the wrong impression the deficit don't matter at all and in fact the whole economy uh everyone gets so wrong so can I I'm trying this I just don't remember I didn't pull this together because this thought is occurring to me now I didn't pull the numbers together in time to get them in the script this increase in the federal debt from 31 to 49 of GDP during the Reagan years as I recall that represented an increase of some single digit trillions and during the Reagan years the total asset value in the United States everything houses other forms of real properties stocks bonds the total asset value increased by some double-digit trillions so the argument there would be that was a reasonable or at least an acceptable debt to take on because we got something for it the economy grew it grew it it grew more than enough to justify the debt is that kind of the argument we're making here well yes especially because a growing economy The Government Can tax all that asset value right right the economic growth is the way out of all debt problems really if you try to if you try to to raise tax rates that's like going up a sand dune every time you raise the tax rate the base shrinks and you come back a little bit economic growth is what sends the surpluses rolling in I would say also the Reagan deficits um uh most there's an analysis of the Reagan deficits in here when we look at the Reagan deficits they look tiny certainly by current standards what were we worrying about right uh they were largely not um let me make a distinction between primary deficits and total deficits which include interest payments on the debt uh the primary deficit is taxes minus spending and then total deficits add the interest payments on the debt what happened to Reagan is first of all there's a huge recession so we always go into it we we get less taxes and more spending in a recession right but the primary deficits in the Reagan years were not at all unusual for that stage of recession they were smaller than 1975. what happened to Reagan was of course if interest rates go to 20 right the interest costs of the debt is what explodes and that actually is a secondary that doesn't really matter so much uh relative to so it was not a case of spending enormous amounts and indeed military spending is we're proud of two to three percent of GDP um the government takes in 20 percent of GDP government overall spends 40 percent of GDP so what the issue is is really entitlement spending and social programs uh everything else is is really small but you are right 2000 is where you should start that's where our our next story comes up because my story of wonderful surpluses ends abruptly uh in the year 2000. okay so let me let me set that up this takes a moment to set up but I think that this will be this is a this is this was this will be time well spent I'll go into debt here on the time but you'll repay it up to the financial crisis of 2000 I'm just dude the fed's balance sheet stands at less than one trillion then comes the crisis of 2008 fed injects vast amounts of liquidity into the economy balance she goes to 4 trillion 2020 we get the covet crisis once again the FED floods the economy with liquidity now the fed's balance sheet Rises to 7 trillion instead of leveling or reducing the balance sheet as the economy reopens the FED adds even more in part to accommodate the Biden administration's 2021 American Rescue plan which cost almost 2 trillion so we now have by early last year the fed's balance sheet stands at just under 9 trillion one trillion to 9 trillion federal debt from I'm not going back to 2000 I'm not going back far enough for you John but you can correct me the general vectors here are what's important before the financial crisis of 2008 federal debt stands at 64 percent of GDP today it's a hundred and twenty percent of GDP inflation and this is the first question inflation doesn't really appear until about 20 late 2020 or early 2021. so before we get to the inflation that has taken place tell me about the inflation that didn't take place and let me let me give you a quotation from Alan Meltzer Alan Meltzer the late Alan Meltzer esteemed economist spent some time here at the Hoover Institution he was a monetarist monetarist and he wrote in 2014 a long time ago never in history has a country that financed big budget deficits with large amounts of central bank money avoided inflation yet the U.S has been printing money and in a reckless fashion for years close quote Alan melter went to his grave without seeing the inflation that he predicted Why didn't it take place so you asked two great questions here brace yourself here and stay awake okay the first question that I want to get at is this balance sheet question uh the fed and and maybe we'll ex can I explain a little bit um so here's how the FED operates uh it has assets and typically let's make it simple treasury Wheels they have a little more mortgage-backed Securities but let's just think mostly in terms of Treasury assets so they buy treasuries they print up money and they create money in return for treasuries except now the money that they print up is interest paying reserves uh cash is there's some cash out there that doesn't really matter for our our discussion especially since interest rates are close to zero so cash cash is the same as bonds really so the FED holds a bunch of treasuries and issues interest paying reserves which are overnight debt the FED is nothing but a gigantic mutual fund money market fund really it's a money market fund because they're uh they're fixed uh fixed fixed assets it holds treasuries and it gives you a bank an account that pays interest on those treasuries you can't do that but you can hold vanguard's money market fund that holds treasuries and is an account that pays interest that's all this massive balance sheet is instead of you holding treasuries directly the FED buys them from you and now you hold a money market fund that holds treasuries how much do you really care whether you have a brokerage account actually you personally might already have a money market account through say Vanguard or Fidelity that holds treasuries do you really care if that money market account sells those to the fed and instead holds interest paying Reserves at the FED I care about the interest rate on my statement and about nothing else okay then in that case it makes no difference whatsoever the FED buying those treasuries and giving you overnight reserves is just like you holding the private sector instead of holding treasuries directly holds a money market fund that holds the treasuries so so what's the limiting principle then why shouldn't it run up its balance sheet to Infinity as much as people want why not it's pretty good pretty good system in fact Milton Friedman let's bring back the ghost Milton once said that the ideal monetary system that he had this paper called the optimum quantity of money where he said the interest rate should always be zero so cash and bonds would be perfect substitutes why didn't he argue for that because he he believed that would be unstable and blow up but physical Theory actually allows that or by extension that money should pay the same interest as bonds why should you artificially have to go to the bank every often to keep money just use your bonds so we live in with a big balance sheet I think the big balance Sheet's a wonderful thing from an economics perspective there's some political problems with the big balance sheets but the idea of having lots of short-term government debt that we can use to make transactions is just wonderful so this huge run-up in the balance sheet of the FED doesn't bother you at all to first order now it bothers me for political reasons uh because Congress doesn't seem to understand that this is not a kitty that they can go raid and I I think it would be better it says there's a big problem the treasury should be issuing uh fixed value overnight interest rate electronically transferable debt because that's what we want instead what happens is the treasury issues debt the FED buys that and then biped gives you what you want in exchange but no to to first order on the issues of inflation recession and so forth fiscal Theory says don't worry about it buying U.S treasuries and giving you in return overnight U.S treasuries that's what reserves are doesn't make any difference at all on the way up or on the way down okay now you ask the second question why didn't we have inflation this is what is harder now I I have to remind you I had a long cup of coffee with Alan Meltzer about 2014. and he had me scared stiff that inflation was going to come back the the day after tomorrow and it just never happened yes now um and he knew a lot this is this we're not talking about a foolish man he was a distinguished Economist I view the period from 2010 to 2021 and actually for another reason the period since then as remarkable confirmation the fiscal Theory the price level in view of the other theories so um if the interest rate just stays pegged at zero right the traditional Keynesian view says you get deflation spirals remember all the worries about deflation spirals it's going to happen never happened interest rates stuck at zero inflation went nowhere that's exactly what what physical Theory says it would do no deflation spiral similarly the monitorists say reserves used to be 10 billion that's the basic quantity of money they are now what 9 000 trillion right right that is an atom bomb of money if you ever wanted an experiment monitor monitors Doctrine says fed buys treasuries gives you money that's inflationary we did that from 10 to 9 000. that should have set off you know we leave Zimbabwe and Argentina back in yeah yes it didn't happen well good thing wouldn't it be nice to have a theory that is perfectly consistent with inflation is constant no matter no matter how much the FED does of this stuff so that one I'll chalk up as a victory the harder question is there were big deficits in 2008 and those did not cause inflation and there were big deficits in 2021 and those did cause inflation so we've got to come up with a story for how those are different uh I'll try to give you the short version of the story I think there are stories so so what you're what we're addressing now is you've told me why inflation didn't take place now we're in 2021 inflation suddenly appears and climbs to quite a high level not Reagan level or Jimmy Carter level to be a little fair about it but pretty high eight percent after a couple of Decades of very low inflation is a very big shock and you're now going to tell us what you've told us why it didn't happen then and you're now going to tell us why it did happen last year correct okay let's take a deep breath okay so what have we talked about we're talking why with interest rates stuck at zero did we not have a spiral of deflation the way Keynesian said it would well because there was of all the things you look at fiscal policy in in the United States running huge surpluses does not look like fiscal policy in the United States so uh we're perfectly consistent with the absence of the deflation spiral money was printed on an enormous scale why did that not cause inflation because suppose money in return for bots so we're doing great on the Zero bound era now the next puzzle deficits do deficits cause inflation and they didn't in 2008 and they did in 2021 in fact can I tell a little story of course we need to lighten this up a little bit I turned in the the draft of this man I've been working on this question since 1980 and I turned in the draft of the manuscript to Princeton University press and the introduction said this is before inflation it said you know I don't you know we haven't seen inflation in 40 years nobody cares about inflation uh but I've been thinking about this my whole professional life so here it is and you know maybe someday you'll need it take it down off the bookshelf and dust it I am the luckiest Economist in the world that the Trump and Biden Administration saw fit to drop five trillion dollars of money from helicopters and uh and do exactly what this said would cause inflation uh between then and when it came out uh the 2021 inflation is very clear they dropped three they literally wrote and created new money and wrote three trillion of checks which they sent to people and borrowed another two trillion and sent people checks and I don't think if you have if I just tell you the word fiscal Theory the price level you know that's going to cause some inflation right um 2008 however we had a you know 800 billion stimulus and that seemed Not to cause inflation people are happy to hold it now uh um you know this is perhaps you'd say too easy to weasel out of but there are differences between the episodes um you can again you can borrow an immense amount if people think that there is a chance you'll pay that people think we'll pay it back that's always which we're always returning we're always returning it's not today's deficit you trust do you trust the feds itself the government got enormously Lucky in uh after 2008. the other thing that happened is interest rates went to zero now suppose you bought a too expensive house in Palo Alto but suppose interest rates your mortgage you have an adjustable rate mortgage and the adjustable rate goes down to effectively zero uh you can sit on that house for a long time yes and that's essentially how we didn't get it that's one of the most important reasons we didn't get into trouble after 2008. and here I'll give you a big picture too again I'm I am like all of us I am the sum of things that smart people have told me over the years in my time as a finance Professor I learned the great discovery of the late 80s and early 90s in finance that if you account to account for stock market values it's really not about changes in dividends it's about changes and expected returns changes in discount rates changes in in Risk premiums changes those are the things that account for stock valuations well the same is true for the government but it's not really that much about the expected surpluses it's the expected discounted surpluses and the fact that you get to have a very low interest cost on the debt for a decade that makes it very easy to sustain debt John I'm a little nervous now that circularity has is entering in expectations are unprovable unknowable unless you have some very clear objective criteria you not you personally but one can slide into the form of argument well see X happened because expectations changed and how do you know expectations change why expectations must have changed because X happened okay you see that you see that obviously you see it but when you when you put your good Lord you put this whole book on expectations and that's pretty slippery ground isn't it uh it is people have occurred to you go ahead this has occurred to me and I wish it were different I will argue only that it is uh no better or worse than anywhere else in economics uh so let's take the theory of Finance uh which has been I would say a grand success the most successful uh theory in economics of the last gosh knows how how long and where does it start price is expected discounted value of dividends what are the expectations why did people change their minds about uh Tesla's expected dividends or the discount rate they want to apply to well now it gets hard so what do you do you do the same thing we do in that horrendously you know that is the theory right you do you you find as many predictable as many predictions as you can you in try to plausibly interpret historical episodes as best as you can but if I am no worse than the entire rest of the theory of Economics which also depends on exploitation it's not bad now uh there's important lessons that we should learn here it is it has been a Fool's errand in finance to you and me go out take analyst forecast of dividends say here's what we think Tesla should be worth and try to explain Tesla's stock price that just doesn't work so trying the same approach is not going to be useful for fiscal Theory there's plenty that you can do though expectations so so you want me to be testable and scientific I'd like it yes expectations we don't know what they are on any individual case but good expectations if people are not too dumb they should be right on average so we can look and and I have if you look at periods of time with high inflation what do we see on average afterwards I can't tell you what people were expecting in a particular episode but I can say many times that look like that on average we saw either High required returns or low surpluses and so forth and that that checks out nicely so certainly the on average and we can look at historical episodes and say you know what makes sense of the zero bound era why did we not get a deflation spiral what happened in 1933 when they went off the gold standard why was Bretton Woods a difficulty at least at least you can create a plausible consistent story of these things and that's how we do what we can in all of Economics okay now that actually is very reassuring to this Layman because I was slightly concerned that you're moving in the moving off towards String Theory which is based on no physical evidence whatsoever of course it's purely theoretical as far as I understand it I was a little worried that this is all this all exists on the chalkboard but actually you go back and check known event you are moving back and forth constantly between the chalkboard and history yes got it I feel much better knowing that John but I do um everywhere simply this is many of my referees on paper say give me a give me a test is this a testable Theory and I I write back uh look we do what we can but um that's not how the history of science ever worked monotheism versus keynesianism uh that went on for 60 years it's still going on today I would say was that ever decided by someone you know did someone say to Milton Friedman show us the test of your theory well I said well there's this episode and then in the in the Great Depression look what the FED did and how terrible that was he organized history and that was persuasive no one ever tested monotheism versus cancer uh Finance efficient markets versus behavioral Finance well they've been at that one for 70 years did anyone solve that by you know writing down some formal statistical test aha the T statistic is 2.1 I win no we assemble the evidence we assemble the historical episodes we see does it work in that average sense we do the tests that we can uh is it at all plausible that things work that's how you assemble evidence on all scientific theories okay okay oh my goodness this is I wish I'd gone to booth business school I think if I'd encountered you I might have understood a few things much better than I did all right so let us now shift from John Cochran fleshing out a new theory that comports better with reality than previous theories that's the argument that's whose assumptions I'll make three the assumptions uh comport with current reality I I didn't want to jump to oh wait oh it makes predictions that are clearly better I think it does well the assumptions fit better with current reality namely that our fed sets interest rate targets and does not limit the quantity of inside money that's just a fact and if your theory says the FED is controlling the money supply I'm sorry I love that theory it's just not true of today's economy second it's a internally consistent economic theory which we actually don't have for interest rates so how does the feds set interest rates and that leads to inflation I give you a complete Theory with economics into it that answers that question and it does I think it certainly com there's a plausible answer to historical questions and I actually went out on a limb last summer in some discussion with John Taylor and others John Taylor at the Hoover Economist at Hoover's yeah uh was it necessary for the FED to raise interest rates more than inflation to bring inflation down and while inflation was still going up I for the first time in my life went out and said okay I'm going to put that on paper prediction I think the models in here say no this inflation can go away even though the FED doesn't raise interest rates more than the current inflation rate that seems to be going away so I think I'm doing good so all right on all three then let's ask you to do more of this um Jerome Powell Joe Biden new Speaker of the House Kevin McCarthy here's the pickle that it seems to this Layman that we're in what was it we have economists Reinhardt and rogoff 2008 paper which as far as I know was quite famous at least it got a lot of got mentioned in the Wall Street Journal which is what I read and they claim that economic growth decreases one to two percentage points when public debt exceeds 90 of GDP and this is not a law it's not a theory this is observed and our federal debt now stands at 120 as we mentioned 120 of GDP so we are in the zone where we are depressing our own economic growth according to what they would predict and inflation remains again at seven percent and this apart from anything else there's a political problem in that people begin to feel well no this isn't just a political problem this feeds right into your theory because your theory is what we the question we return to again and again and again is fundamentally do people trust the feds and inflation what inflation does among other things is inject mistrust and suspicion and queasiness and who's in charge and who's all right so we have inflation that's still running at a pretty high level what do we do what does what does this book tell us to do solve the long run fiscal problem get the economy Grow Again okay now I'm going to give you a longer answer you you knew I couldn't stop at that uh as much as I love reinard rogoff let's let's analyze what they actually said which is to point out a correlation and the number one problem in all of Economics is correlation is not causation right uh Rich guys smoke cigars smoking a cigar isn't going to get you rich and in fact and I've tried by the way and does it work it doesn't no um the problem with that correlation is that um of course who racks up a lot of debt if countries get into a growth problem they start borrowing and they rack up a lot of debt uh and in fact that's why in economics that's why theory is important in economics uh you need to understand a mechanism to make any correlation plausible and what we know about long-run growth long run growth comes from productivity growth which comes from work saving investing the ability to get a permit to rehab a house without too much trouble we were talking about that earlier uh you know the sand and the gears and so forth so debt itself is not a problem uh debt can if if an economy has sand in the gears the government's going to start borrowing money and you'll see debt but the fundamental mechanism for long run growth is is microeconomics and an economy that's growing should borrow um You probably if you're of an economy that's booming growth private people should be borrowing to invest in in future opportunities and it's fine for the government to borrow because it's going to be just rolling in tax revenue in the first in the place so it's always debt relative to long-run fiscal stability which is primarily long-around growth uh so I'm in the end I'm I'm a microeconomist we need to get back to Long Run supply-side growth is is the main answer okay so another couple of questions here um and now I'm doing something that makes me this is the the sort of thing that makes me more nervous than anything else which is throwing away the script and just going with a couple of questions that occurred to me here um it felt to me as though after the crisis beginning with the crisis of 2008 President Bush famously said I will now misquote him but this is a close paraphrase at least that we are departing from free market principles in this emergency to save capitalism something happened there where the government began injecting huge amounts of liquidity there were bailouts and it seemed I'm now talking about economics as a as a profession as a discipline as a field and I know a lot of economists but I'm not an economist so I may be wrong about this but it felt to me as though very quickly surprisingly quickly all the progress that had been made in the field from the middle of the last century on the understanding of the well the understanding of how to promote economic growth I mean once one asked one way of telling the story of the Reagan Administration is to look at the board of economic advisors he had to come into the White House once a quarter to talk over the economy with him Milton Friedman Arthur Burns George Schultz people you with whom you studied and they understood a version at least of what you're saying we need productivity growth that means low taxes smoke all right and it seems as though all that it seems as though within two months it was as if Milton Friedman had never been born and John Maynard Keynes never died that the economics as a profession embraced a sudden surge of big government with really an unseemly enthusiasm instead of in a manner that was intellectually rigorous am I just wrong about that well economics as a profession has always embraced big government with unseemly enthusiasm most people are not because it puts the economist in charge exactly just the power Earth and and young is it as simple as that yeah young people go into it who want to save the world uh there's the the free market Chicago Minnesota school is a small curmudgeonly Branch small and and smaller every day curmudgeonly branch of Economics as free market incentive Associated people like you and I are are a small curmudgeonly branch of our political Spectrum 2008 did um I think 2008 was very important and the lesson I took from 2008 is not that Keynes was right all along but that Financial crises matter so the financial when you blow up the financial Plumbing of the economy you're going to get a recession I mean finally in 2008 a good thing about is we know why we had a recession because there was a huge financial crisis and maybe we'll have another uncommon knowledge on on the proper lessons and the wrong ones learned about the financial crisis I don't want to get too far there you are right that many people took that as an indication of oh Keynes was all right throughout Chicago and so forth um now just to make the case what was the problem in 2008 was that people had animal spirits and didn't feel like spending enough or was it that the financial system had blown up and people were scared about risk kind of clearly the latter right so what I think we learned what the proper lesson is that risk premiums matter back to asset pricing and the financial structure matters but you're right Lots the mainstream profession who believe this all along took this as a Victory lap to say we just need more Keynesian stimulus right and we spent the 2010s hearing about secular stagnation and hysteresis and modern monetary Theory and the so-called New Normal and The New Normal but the the new problem that our economy it was true our economy grew very slowly right slow long run growth is the economic problem since 2000 our growth rate is cut in half and a lot of people said well look there's it's just not enough aggregate demand what you need to do is borrow a lot of money and throw it from helicopters and the economy will recover now the it's not so much monotheism on the other side but I'll call it supply side that the economy is is doing as well as it can but it's hobbled by all sorts of taxes and regulations and problems and so forth that was my view but it wasn't a very popular view uh in in the 2010s inflation is a wonderful slap in the face this has brought inflation that we just observed changes everything and I think it's going to be very hard for our friends on the left to recognize that fact it turns out we were pretty close to the edge of the cliff all along because what they said is all the econ all the government needs to do borrow money give it to people the magic of the multiplier and and we will start growing again we finally did it what do we get inflation it turns out that Supply limit of the economy that best we can do was write pretty darn close to where we were all along so what inflation inflation right now just throws that all out the window demand is not the problem it's increasing Supply increasing the productive capacity of the economy is where all of economic policy has to be right now and these habits 10 years of every problem you have just throw money at it I I forget who you quoted saying oh deficits don't matter boom Dick Cheney Dick Cheney Dick Cheney well he there's historic Dick Cheney I'm sure is looking out the window at inflation saying well now deficits matter right the the the program of just throw money at it it it's that and that will be stimulus and this matters everywhere I'm thinking of say the green New Deal which was uh advertised is it'll give you 20 million new jobs well maybe that's an argument with this 20 million people sitting around with nothing to do all day but there's a massive labor shortage going on we have inflation we don't have 20 million people free to go put up solar panels because they're all driving trucks or you know doing something else uh the supply side constraints this is what inflation that the wonderful news of inflation is to wake us up that in fact the supply side matters okay can I ask another couple we're running a little long here but and I want to go back to uh okay but can can I I promise well my I'll I'll get you there in about three questions okay that'll be I'll save me one for because I never answered your Powell and how do things look going no no I'll get to that I'll get to that but let me get you there because now we're on now we're on basic stuff yes that a Layman like this is really all basic so don't worry about it so let me ask you a couple questions about contrasts China here's the whole question about China the whole question is have they invented some new way of achieving long-term economic growth that we didn't understand Milton would say and John Cochran his his intellectual legate would say no no here's what you need you need freedom for Innovation you need freedom to for risk taking and investment you need limited government modest but reliable regulatory bodies and the Chinese say no no no here's what you need you need a Communist party that says we're going to invest in this industry and we're going to invest in that industry we will Brook no descent and the economy will grow and grow and grow okay two quotations here Peter Thiel this is in 2014 he publishes zero to one quote the Chinese have been straightforwardly copying everything that has worked in the developed World railroads air conditioning even entire cities they might skip a few steps along the way going straight to wireless without installing landlines but they're copying all the same that's the secret to their economic growth all they're doing is trying to is copying what we have here's Eric Schmidt second quotation the former CEO of Google unless Trends change by the 2030s we will be competing with a country China we will be competing with a country that has a bigger economy more to research and development Investments better research wider deployment of new technologies and stronger Computing infrastructure close quote so who's right my little mind can almost get what an authoritarian government can do is command various persons over whom it has authority to copy what's going on over there that I can sort of see that as a way to Rapid economic growth and that could explain China to my little mind But Eric Schmidt is saying no no no no no they may have copied for a long time but now they're in the business of innovation they're leap frogging over ahead of us and I can't come up with any economic understanding under which an authoritarian regime should be able to pull that off okay the China question now tried the strategy of copy everybody go out and and make steel in your backyard that did not work out the North Koreans tried that the authoritarians is not the story of China China started incredibly poor and is still barely a middle-income country and it made me get my numbers wrong U.S GDP per capita is about 60 000 Chinese GDP per capita is about 20 000. so they are still quite a ways behind us on average what they are doing is called catch-up growth uh where and and it was clearly from the liberalization of the Deng era uh the private companies allowing a market they have a market that exists private companies Market that's that's the part of China so it's to the extent that they embraced Freedom free markets the bit of the copying that paid off for them was copying our economic system well first they allowed the copying of the economics and yes of course they copied no reminder how the US got to where we were uh the the UK had wonderful um they had wonderful Machinery in looms that they didn't want us that was their intellectual property and some smart Americans went over and remembered exactly how it worked went to Lowell Massachusetts and copied it John that's called Yankee ingenuity we want them to copy our systems the ways of doing it let's not get into the intellectual property uh debate about it but that's exactly right they to a small extent copied the free market system Chinese entrepreneurs got to set up shops got to start businesses you know who do you think is is sending you is sending you I bet these are from China I bet the coffee cups from China this isn't some Chinese Central planner who decided this is the industrial policy this is some smart uh guy who probably grew up on some miserable Farm went to a city uh figured out how to start a factory figured out how to send it on Amazon to Hoover and is sending us sending us you know great nicely done cheap cups that was all the private sector so the the this catch-up growth this join you know civilized way of doing things that can that's how China made its big growth China is now stuck at the middle income trap so the the great direction of the party that's that's only very late this is after the big growth right right they're trying and they're trying to rein in uh that you know the Jack Moz Jack ma wasn't a state-owned company Alibaba wasn't a state-owned company uh it is now and we'll see how well it does so to the extent that they reassert communist control or broaden communist control over what had been for the last two decades free-ish markets to that extent they'll get in their own way and now they are kind of stuck as many countries are and they're they're you know how do you they're they're facing the problem that you can't have a lot of innovation you can't have new companies and also maintain political control so the China of great you can't you can't there's nothing in the history of the recent history of China that persuades you otherwise uh they that's the that's the fundamental China During the period of great growth was um the China of liberalization the China of letting economics now what's going to happen in the future um they are doing research in stem we'll see if you can do a Cutting Edge research in a unfree country but we are also shooting ourselves in the foot uh it is it is harder and harder to do academic research in the United States it's harder to innovate in the United States are we are not teaching our Chinese students they teach the math we don't really teach math anymore for all sorts of reasons uh so um I think there is a definite challenge there of whether we can maintain our leadership in those fields but but Trends trans country after country remember the Japanese yes right the Japanese you watch the US GDP is here the Japanese GDP is here they grow like crazy why because they're catching up They're copying what we do and sometimes bettering at Toyota was better than GM but they didn't get the idea of how to run an assembly line on their own you know right they and they they allowed Innovation they allowed competition the trend the trend the trend and then Japan stops South Korea here's the U.S South Korea oh they they open up they allow you know they they have a vibrant economy they learn our way of doing things ketchup ketchup they don't pass us and moving from catch-up growth to leadership Innovation growth that's a whole different thing very very hard so here's the other big thing sort of question red and blue for a couple decades now we've conducting an experiment here at home the blue State model and the red State model and the blue states have enacted very high taxes and lots and lots of Regulation and they have permitted teachers unions to retain total control over public education and the red states have by and large cut taxes and there are a number of red States Texas Florida has become a red state of course blue means democratic and red means Republican but I'm trying to avoid the partisan nature here to get to the underlying economics or policy question in a number of red states don't even have an income tax and the red States tend to be where they've been making experiments in charter schools and voucher school systems and so forth and the results of this experiment are in blue states are shrinking last year for the first time in history the population of California shrank even on net even net of immigration Texas Arizona Florida the red States grow today California has a deficit of some over 20 billion dollars and Texas has a surplus of over 30 billion dollars one model works and the other model doesn't so of course what we see is the political systems responding no we don't and this is the question here in California the state the party of big government and high taxes remains in total control likewise in New York likewise in Illinois there's no adjustment taking place I mean who knows you can't run control experiments and set up an alternative California but if there's adjustment taking place it sure is subtle it's too subtle for me to detect why is that this is really a political question uh it is lovely that the U.S has to some extent uh still states that we see competition between the states so we can see experiments before our eyes of course if we were to look out a little more the rest of the world there are some some god-given experiments North Korea versus South Korea the same culture same country the north used to be the industrialized Rich one uh you know you can't ask for a controlled uh trial on how much governments can destroy an economy East versus West Germany um but we have some of that here now your question is a deep one why do local governments go into the Detroit spiral uh a a used to stay there for decades you start with something very productive the car industry because here we started with the with the Silicon Valley and then a rapacious political class takes over and even as you see it falling apart is unable to uh there's two too many people sucking at the trough to agree to stop it until you have what happened to Detroit and we see this in many other countries why can't India um why can't India start growing the way China did our our Hoover colleague Raghu Rajan has a nice book with Luigi's and gales of Chicago called saving capitalism from the capitalists telling the story of India India is perfectly clear what they need to do but the people who benefit from the current system they know they'll lose and of course the heads of the teachers union knows that if California becomes free market Paradise they will lose so and you know it we our country has a lot of taxpayer support for political activities and you know the people who will lose are able to block uh things that benefit all of us but I want to tell I want to be optimistic out of this uh because in my thinking about growth Theory um this I've gotten in some debates about my view that the US as a whole could be growing much much more than we are that that we our tragedy is that from four percent growth from the end of World War II to 2000 we are now growing at two percent and add that up over a couple decades this is an immense tragedy and I think we could be growing it for now you do John you're nuts so so so can I just this is this I'm Now setting up my last question and my last question goes from Young John to John today I did not say old John I say John today and here's what I mean in the 1970s we see stagflation the 1970s were catastrophe in all kinds of ways and then Along Comes the 1980s and one way of telling the story of the 1980s is the economics as a discipline had actually gotten some place it had it had come to understand the importance of productivity growth and the importance of limited government stable dollar cutting back regulations and Ronald Reagan listened to George to some economics economics as a discipline hated Ronald Reagan George Schultz doesn't know really so they were always a subset because I thought that I mean there was a point there was by the end of the 19 by by the early 2000s no economics Department was legitimate unless it had at least a couple of free market economists isn't that right wasn't there an intellectual Triumph of at least a limited one no uh I'll give you a limited one uh but certainly the uh it's always been more contentious and it's less the economics profession is less um you know what Ronald Reagan did was Adam Smith could have been his advisor I see okay okay so my question is really simple then I I withdraw I don't know the economics profession my question was going to be is economics is a profession capable of the same kind of usefulness as it demonstrated or as a subset of it demonstrated back during the 1980s and does this country still retain the capacity for Renewal so I think yes and I'm this is just pure optimism and patriotism uh the point I was going to make on the states um the differences between red and blue I don't like the partisan Association but let's call them economically Economic Policy focused versus distributive policy focused okay students whatever you want to call it these differences are actually quite small um because we all live under the arm of the federal government which is much larger look at your taxes right right you pay I think more to the state of California that you'd like but you pay a lot more funds correct exactly and you look at the level of Regulation yes there's the California air quality board that wants to take away my gas stove which I'm gonna have to take me from it uh violently but that's nothing compared to the EPA so these small differences in state policies are showing big effects in economic effects think what you could do if you could fix the federal policy that so that's my optimistic case that the U.S is capable of of economically capable of great growth if we can just uh get the stop Charlie Munger once said that he and Warren Buffett made a lot of money by not being stupid and it's all in other words economic renewal isn't that hard we understand yes it is not it is not that hard as a matter of Economics now it's very hard as a matter of politics right and you asked me I think the economic profession the economic profession uh it many people in the economic profession are following modern today's political fads but there are many people remaining the economic profession who are doing great work on the sources of long-term growth and so the the fact that long-term growth is the most important thing I mean I wrote a book about inflation because I have some answers about inflation and I've been thinking about it but the important thing if I if I your next book if I were to write a book about what matters I would write a book about long run growth I just don't know how it works as well you know we'll let our colleague Chad Jones here at the business school I'll write that I told a lie that wasn't the last question here's the last question your dad was a medieval historian renaissance renaissance historian and you spent a lot of time as a boy in Florence yes and in fact I know from a mutual friend of ours who knows Italian that you're Italian is not only fluent but you speak Italian like a fiorentino your Italian is specific to certain neighborhoods in Florence yes so anybody who had known you as a boy might have said art history uh Renaissance something along the lines of his father and you went into economics instead how did that happen well I must credit my my father with some fundamental values that stuck with me and in fact I've always criticized myself for not being very imaginative I kind of went into the old man's business without being an academic I see I kind of knew I was going to be an academic but if you if you met me when I was young my talents and interests don't lie there I I built model airplanes I liked math I liked science so I took that seriousness about academic Pursuits and the understanding really of what a wonderful life it is to to spend your time thinking about things like where does inflation come from so that I I got from from both of my parents um but I I went in an opposite direction just because uh I know historians that I tremendously admire I hang out with Neil Ferguson and uh Steve cotkin and the historians here I love them because they know all this stuff they know a lot my mind doesn't work that way uh I have to organize things um around a few simple ideas and so um all of my previous book asset pricing boiled all of asset pricing down to one very simple principle from which everything else follows this book boils money inflation down to there's one equation real value of nominal debt is present value of surpluses everything follows from that so that's that's the mind that's the mind of a physicist that's what I my physics training my proudest intellectual moment was my electricity and magnetism exam where I started every question with the appropriate Maxwell equation derived what I needed and went on I can organize things that way and I I am full of admiration for um you know people like my father who can basically memorize the Florentine archives and then write a beautiful book about it or or kneel or or all the others and their ability to do that I I don't have that ability so you do what you like and so so this was your humble best so far John Cochran author of the fiscal theory of the price level thank you thank you for uncommon knowledge on the Hoover institution and Fox Nation I'm Peter Robinson [Music]

Channel: Hoover Institution

Views: 198,659

Keywords: uncommon knowledge, hoover institute, hooverinstitution, peter robinson, john cochrane, inflation, economists, economics, academics

Id: 3t6a7Gj0ubc

Length: 77min 6sec (4626 seconds)

Published: Tue Feb 28 2023