Iimagine it is Late 2024. Rich-world inflation has fallen from its peak but has remained stubbornly high. At around 4%, it is well above the level at which most central banks feel comfortable. Governments burdened with enormous debt must use precious revenues to pay interest on the debt, which itself is growing due to high interest rates. The energy transition and increasing government spending due to the aging population are contributing to fiscal generosity. Tax increases are politically sensitive, so more money is printed. Inflation remains high and government credibility is deteriorating. Central bankers are scratching their heads, wondering how their mighty weapon – the interest rate – failed so thoroughly.
A cloudy theory, set out in glorious detail in a new book by John Cochrane of Stanford University’s Hoover Institution, would offer a possible explanation. The Fiscal Theory of the Price Level builds a theory of inflation as ambitious as that of John Maynard Keynes’ The General Theory or Milton Friedman and Anna Schwartz’s A Monetary History. Mr. Cochrane, whose own work on the subject spans four decades, spends nearly 600 pages revising the math of previous economic models to include fiscal theory while chatty discussing how it explains past episodes of inflation. “[E]ven Milton Friedman could change his mind with new facts and experiences,” he speculates.
Central to Mr. Cochrane’s theory is the idea that government debt can be valued like a company’s equity, based on the returns from its owner’s pocket. Price levels will adjust – thereby driving inflation or deflation – to ensure that the real value of debt equals the sum of a government’s future budget surpluses, appropriately discounted. So the real driver of inflation is government debt, not monetary policy. According to this theory, money is valuable because it can be used to pay taxes and generate surpluses. The setup isn’t all that different from the gold standard, except that it’s taxes, rather than gold, that support money.
Mr Cochrane is careful to point out that the adjustment in price levels is not immediate. People have a hard time assessing a government’s credibility when it comes to paying off debt. Just like stocks, prices can deviate from fundamentals. But in the long run, they adapt. A government that distributes money without eventually running a surplus will not avoid inflation forever.
History seems to offer support. Brad DeLong of the University of California, Berkeley, uses tax theory to explain inflation in post-World War I Europe in his recent book Slouching to Utopia. In France, high debt interest payments over seven years resulted in average annual inflation of 20%. In Germany it was even worse. The public lost confidence in the state’s ability to repay its debt without inflation. Hyperinflation soon set in.
Mr. Cochrane also brings tax theory to American inflation in the 1970’s and 80’s. In the mid-1970s, price increases exceeded 12%. The Federal Reserve raised interest rates; inflation fell to 5% by 1977. However, Mr. Cochrane points out that by 1980 inflation soared back above 14%, partly because America failed to get its finances in order. Defeating inflation required tax and regulatory reforms that raised expectations of future surpluses and another dose of monetary medicine.
How is the fiscal theory today? After the global financial crisis of 2007-09, prices remained stubbornly low for a decade, despite a skyrocketing money supply and interest rates hovering at or below zero in much of the rich world. A “crude monetarism” predicted a surge in inflation that did not materialize. Other revised “New Keynesian” models also proved unhelpful. As governments spent heavily during the Covid-19 pandemic, recent history has left many economists optimistic about the possibility of inflation.
Mr Cochrane argues that fiscal theory can explain both the period of low inflation and the return of rapidly rising prices after the pandemic. Inflation was low in the 2010s despite rising government debt as politicians promised to get their books in order, and low interest rates meant consumers and bondholders were willing to wait. However, during the pandemic, governments took a different approach. They dropped huge checks in consumers’ pockets. The Fed bought government bonds immediately after they were issued. There was hardly any talk of sustainability. Mr. Cochrane argues that the direct nature of these “helicopter drops” informed people that their newly fat pockets would not be emptied by future taxes. Therefore, they were more willing to spend money.
I win heads, you lose tails
This story is perhaps too comfortable. Indeed, Mr. Cochrane admits that the flaw in fiscal theory is that it offers a way of explaining in an irrefutable way nearly every series of historical events. Yes, other inflation theories have problems. But if the fiscal theory is so hard to prove wrong, are they really in a fair fight? Mr. Cochrane’s story of how inflation ended in the 1980s is complicated by the fact that America actually cut taxes, suggesting politicians weren’t all that keen on balanced budgets. Although deregulation may have boosted growth, many economists believe that the budget surpluses of the 1990s were mainly caused by globalization it Boom few consumers saw coming in the 1980s.
Fiscal theory also offers policymakers limited guidance beyond what is already known. In this approach, monetary policy remains important: interest rates can spread an increase in the price level over a period of time. Furthermore, the theory suggests that governments must remain credible when it comes to paying off their debts – hardly a radical idea.
Fast forward again to the end of 2024. Imagine if inflation fell to 2% this time. Interest rates are slowly falling. Central bankers are on a winning lap. What about the fiscal theory? Their supporters might also be circling in victory, as they would have been had inflation remained high. ■
Read more from Free Exchange, our column on business:
Could Europe end up with a worse inflation problem than America? (January 19)
Warnings from history of a new era in industrial policy (11th January)
The Federal Reserve’s great anti-hero deserves a second look (20th of December)
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