John Cochrane is an economist, specializing in financial economics and macroeconomics. He is the Rose-Marie and Jack Anderson Senior Fellow at the Hoover Institution. He has previously been a Professor of finance at the University of Chicago Booth School of Business and before that, at the Department of Economics. He also writes the Grumpy Economist blog.
Welcome to our limited edition crypto series. In this episode, we welcome back Professor John Cochrane, who was a guest on the Rational Reminder series, to talk everything money. Professor Cochrane has immense experience on the topic and is a Senior Fellow at the Hoover Institution at Stanford, as well as Stanford Institute for Economic Policy Research. He is also a Research Associate of the National Bureau of Economic Research, an adjunct scholar at the Cato Institute, and was a professor of finance at the University of Chicago Booth School of Business. He is also the author of several books and writes a popular blog called The Grumpy Economist. In this episode, we take a deep dive into the concept of money. We learn what numeraire is, how a numeraire is defined, and explore some of the intricacies of money. We also discuss and unpack the differences between fiscal theory and monetary theory, along with other ideas regarding the value of money. We then delve into how all this relates to cryptocurrencies, what future he sees for crypto, and much more. Tuning into this episode, listeners will challenge their thinking about the economy and how economic relations work.
Key Points From This Episode:
Professor John Cochrane explains to us the short version of fiscal theory. [0:04:35]
Find out the definition of numeraire and how it is determined within an economy. [0:05:21]
Learn whether government backing is required to define a numeraire. [0:07:05]
What Professor John Cochrane thinks is the primary function of money. [0:08:55]
Whether money needs to be a medium of exchange that stores value. [0:09:45]
He explains why money is valuable according to fiscal theory. [0:11:22]
The role of taxes in adding to the value of money according to fiscal theory. [0:12:59]
How fiscal theory’s explanation for why money is valuable differs from the monetarist explanation. [0:13:33]
Find out whether the term ‘fiat’ is still a good adjective to describe money in a fiscal world. [0:17:24]
We learn if ‘fiat’ is an appropriate term to describe money according to the monetarist view. [0:19:10]
What the government debt valuation equations suggest about the stability of the price level. [0:20:21]
An outline of what happens when discount rates become volatile. [0:23:29]
Ways in which sticky prices affect the stability of the price level. [0:27:24]
Whether the supply of money is still a useful perspective today. [0:31:01]
Why monetarism theory has gained so much traction. [0:33:51]
He unpacks the purpose of monetarism theory. [0:35:21]
How fiscal and monetary actions set expected and unexpected inflation regarding fiscal theory. [0:37:10]
The level of fiscal and monetary coordination required for price stability. [0:39:58]
Whether the level of coordination needed is realistic considering the independence of the central bank. [0:42:10]
Ways in which monetary policy debt sales and fiscal policy debt sales differ. [0:45:02]
What effect the size of the central bank's balance sheet has on the price level. [0:49:52]
Repercussions of inside money issued by private banks on the price level. [0:53:06]
Statistical tests available that can be used to prove fiscal theory. [0:58:55]
Find out why COVID-related effects on the economy lead to inflation. [1:04:17]
Breakdown of the fiscal explanation for the US inflation of the 1970s. [1:11:24]
Reasons why inflation targets have been successful in some countries and not in others. [1:16:14]
A discussion about whether we have always lived in a fiscal-based economy. [1:19:24]
Whether citizens should behave differently living in a fiscal world. [1:27:51]
How the value of the dollar will be affected if more people buy cryptocurrencies. [1:28:49]
Professor John Cochrane shares if he thinks anonymous digital cash is a good thing. [1:30:51]
We discuss what the future has in store with regard to fiscal theory. [1:39:31]
Read the Transcript:
Ben Felix: This is a limited series of The Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision making focused on cryptocurrencies. We're hosted by me, Benjamin Felix, and Cameron Passmore, portfolio managers at PWL Capital.
Cameron Passmore: Welcome to episode 14 of this limited series, and we're super pleased to welcome back professor John Cochrane, who is a guest on episode 169 of the main Rational Reminder channel. And kudos to you, Ben, for pulling together the information and the thinking, and also convincing John to join us again.
Ben Felix: I just asked. This is another one of those instances of, are we doing a disservice by putting this under our crypto limited series? Because we barely talked about cryptocurrencies. We did at the end of our conversation, but we talked about money, what money is, what a numeraire is, how a numeraire is defined. And if anyone's listening and doesn't know what a numeraire is, I didn't until I started really researching the intricacies of money. Then, you'll learn about it in a minute from John. But we talked about a ton of other related topics, like why is money valuable? And we talked about multiple theories of why money is valuable, not just John's fiscal theory of the price level. We also talked about monetarism. We talked a little bit about commodity theories of money. And then we spent a lot of time talking about John's theory, which he's just published a book on and he's got a bunch of papers on. He just told us the end of our conversation. He's been working on this since the 1980s. But fiscal theory, in my mind at least, which I don't know how much that says because I'm not an economist, but fiscal theory is the cleanest view or theory model of that relationship between fiscal-monetary relations and the price level. Why is money valuable and what defines the value of money relative to goods over time? Until I read John's stuff on this, it was very muddy in my mind. Fiscal theory made it a lot clearer. Anyway, in our series on crypto, as I said a second ago, we're really realizing that it's just making us rethink a lot of basics about the economy and how economic relations work and all that kind of stuff.
Cameron Passmore: That is the point.
Ben Felix: And then that's really what we talked about here, about the nature of money, what sets the price level. We did talk at the end about freedom, economic freedom and political freedom and all that kind of stuff as it relates to money. Because of course, as a means of payment and a unit of account, money ends up being very political. There's no way around that. It's the basis of how people have economic relations with each other. That's about as political as it gets as a medium. So we did talk about that a little bit.
Cameron Passmore: Maybe do a quick bio, of course. So John C Rosemary and Jack Anderson senior fellow at the Hoover Institution at Stanford. He's senior fellow at the Stanford Institute for Economic Policy Research and he's also a research associate of the National Bureau of Economic Research and adjunct scholar at the Cato Institute. He was a professor of finance at University of Chicago Booth School of Business, and he writes The Grumpy Economist Blog. Worth mentioning currently, when he was on the first time, episode 169, that as of right now is number one downloaded episode.
Ben Felix: Yeah, that's right. Yep. I think it's a heavy conversation. It's a lot, as is John's... It's like a 600 page book where he goes through all these ideas. It's a lot and it is different from the typical views of money that most people are used to. As John mentions during the conversation, most people learn about monetarism. And I think at the surface, monetarism is almost taken as fact by the general population. If you ask somebody about money printing, they'll say, "Oh, that's going to lead to inflation." And fiscal theory says, "Well, not necessarily." But we've been stuck thinking from a monetarism perspective for a long time, or at least a lot of people have. And this is a whole new way of thinking, which can be a little uncomfortable maybe, but it's a worthwhile conversation to listen to.
Cameron Passmore: All right. So let's go to our conversation with Professor John Cochrane.
John Cochrane, welcome back to the Rational Reminder Podcast.
It's a pleasure to be here.
John, as a warmup, can you give us a short version of fiscal theory?
Yeah. So just finished a book. I think it's like 560 pages so that's quite a challenge. Bottom line. Where does inflation come from? Inflation comes when there is more government debt than people think the government is able or willing to repay. They try to get rid of that government debt, but we can individually sell it, but collectively we can't. So we end up then trying to spend it and driving up the price of stuff.
Nice. That's pretty good.
Hey, you wanted brief, you got brief.
All right. Now, to jump into more of the meat of it.
I would think that's sounds like a very simple statement, but what's interesting about the fiscal theory is all the things that isn't, which is what I'm sure you're going to ask me next. But yes, go ahead.
Okay. What is a numeraire?
Oh, that's a great deep question in economics. Fancy words, huh? But in this case, a useful one. So dollars are numeraire in our economy. It is the thing that we use to express all other prices. So if you look at economics, there's always one degree of uncertainty in prices. We got to choose one thing to say the price of... Rather than saying, "I'll give you three beers for four tomatoes and then I'll give you four tomatoes for a bunch of kale," we agree on one good to be, let's express all prices relative to that one good in our economy that good is dollars. In other economies, that's been pieces of gold or cigarettes or things like that. The numeraire is the one thing we all agree to quote prices relative to that good.
How is the numeraire in an economy determined?
Aha. Well, there's two questions here really. One is how do we pick a numeraire? And second, which is what the fiscal theory's all about, once you've picked it, what determines the value of that numeraire? How many dollars does it cost to get those tomatoes or whatever it is? So numeraire is, in some sense, a social convention. In our economy, it's also legal convention that we will use. Dollars, it says right on there, it's legal tender for all transactions public and private. Now, we could all agree to quote things in another currency, but we've decided on dollars. And there's an interesting anthropological quest for other possibilities. But let's not go there. And then how's the value of the numeraire determined? Well, in our economy, since our numeraire is dollars, they are part of government debt. And therefore, the government's willingness to stand behind its debt is what determines the value of the numeraire.
Is government backing required to define a numeraire?
No. The numeraire, again, is the thing we all agree on to quote prices in. So for example, after World War II in Europe with horrendous monetary problems, people were using cigarettes. And so the numeraire was cigarettes. How many cigarettes does it take to buy a piece of meat or something of the sort? So what gave the numeraire its value, in that case, part of the value was people like to smoke. They're willing to give up stuff for something that's needed. So there's an example of a numeraire, that it is also a medium of exchange and a store of value, all the functions of the money that is backed by a value different than the government. Our numeraire is a form of government debt. So it's backing, at least in my view, does come from the government's fiscal policy.
There's other theories of money. There's a theory of money that says it's intrinsically worthless, but we just all agree on this one thing and therefore it gains value by its convenience. We're willing to put up with a low rate of return because it's convenient to use money to buy things, so it doesn't need to be backed at all. So that's another possible theory of money. I'm here to talk about the fiscal theory in which it's not always everywhere. We have agreed to use this particular kind of government debt, cash, as our numeraire and as one of many mediums of exchange. Given that choice, what determines the value of our money? Well, our government doesn't limit its supply, which is one thing needed for our intrinsically worthless story to work. You need a limited supplier. Our governmental will print up as much as you want. They target interest rates. Therefore, the value of our money comes down to the government's fiscal policy.
You mentioned medium of exchange and a couple of other functions of money. What do you think the primary function of is?
I hope I'm not giving everyone nightmares from their first econ class. Sorry, go ahead.
What do you think the primary function of money is?
Oh, well, it's got all those functions. Let's jump to in our economy. The primary function is it's the thing that we quote prices in. Now, it used to be, there's a problem in monetary theory is that we tell stories to undergraduates that come back to old economies, not ours. So it used to be the quote medium of exchange. When I was young actually, if you didn't go down to the bank, write a check and get cash on Friday, you could not go out to a restaurant on Saturday. You had to give them cash. But now we use credit cards for that. So then in fact, most transactions in the US are handled electronically and we're not really sending cash around.
Does money need to be a medium of exchange, a store of value?
Monetary history is fascinating. So what are the functions? A store of value, medium of exchange, numeraire, that I can think of. There's 15 other ones. And you can find instances through history where they have all been separate and some have had them and some haven't had them. There's a great case, my colleague Francois Valle at the Chicago Fed wrote a beautiful article about a case in 18th century France where the numeraire was the Livre, a big unit that nobody had ever seen. So prices were quoted in Livre, but you actually went to the store and you used these little coins called ECU.
So the medium of exchange was ECU, yet the numeraire was Livre, and nobody had ever seen the Livre. So stuff like that happens. Let's not do too much deep... There's so much great stuff like this. Apparently some island, I'll get this one wrong, it was an island in South Pacific where they had these huge stone circles. That was their numeraire. But the stone circles were buried. They had been buried under the ocean. But they had ownership rights, the stone circles. I'll give you a 10th of my stone circle for some mangoes or something, and rights to these stone circles. Even though the stone circles, they weigh tons and they're underwater. Anyway, let's get back to the US. We're having too much fun here.
No, that's a cool story though. That's the rise stones in the island of Yap I think is what it was.
Thank you. I should never say things without getting the facts right, but we're on a podcast, so what the heck?
All good. You've touched on this a couple of times. Why is money valuable in fiscal theory?
Money is just part of government debt. And in fact, most money these days, what banks hold is money is reserves at the Fed, which are interest paying accounts at the Fed. That's the main money that counts because the way a bank pays another bank is by transferring reserves. So money is part of government debt. The cash you handle doesn't pay any interest. That's a minor inconvenience. But cash, treasury bills, reserves are all part of government debt. And so a fiscal theory says, well, why is government debt valuable? Because people think these guys will pay it back. And when does government debt stop being valuable? When people lose the faith that sooner or later, the government will be able to pay back its debt by sufficient tax revenues in excess of spending. So then money and government debt, they're all one big thing.
Government debt's just a promise to give you more money. Money and promises to print more money tomorrow, that's what government debt is, together are a claim on the government's willingness to pay repay that debt surplus. So money and government debt are valued the same way a stock is valued. The value of a stock is the present value of the future dividends. The value of the bond is the present value of the future coupon and principle payments. The value of government debt is the present value of the fiscal surpluses, which is what the government uses to repay the government debt. That's at least where we start. And then as always in economics, you start with the simple supply demand and then you sprinkle on complications as needed, but we'll start there.
How do taxes fit into that equation of why is money valuable?
If there's too much money floating around chasing too few goods, fundamentally, what can the government do about it? The government's got to soak up that money with taxes, less spending. So it's easy to run to raise tax rates, but actually one of the most effective ways is to spend less. So the net of amount of money the government is soaking up is tax revenue, less spending.
Okay.
Soak up money with taxes. That's the answer why taxes matter.
Got it. You also touched on this very briefly earlier. How is the fiscal theory explanation for why money is viable different from the monetarist explanation?
Yeah, yeah, yeah. So this is the most popular theory of money, the one you're probably taught if you take an economics class is inflation comes from too much money chasing too few goods. Inflation comes when the government prints up too much money. Does that all sound familiar?
Oh yeah.
Milton Friedman had MV=PY on his license plates, which was the basic idea, the quantity of money is what determines the price level. Now, in some sense, money is part of government debt. So fiscal theory and monetarists would agree if you drop money from helicopters, as roughly speaking, our government did in 2021, you're going to get inflation. But is that because you're dropping money per se? Suppose they dropped government debt from helicopters. Rather than giving you money, which is what the government did, suppose the government had given everybody a share of a mutual fund that was backed by government debt and said, "Here, 5,000 bucks in a mutual fund." Wouldn't that have caused a lot of inflation too?
And more deeply, the monetarist position is that it's not the amount of government debt. It's the composition. So the fundamental... If we print money and give it to people, bang, you're going to get inflation. We agree on that. Because that's printing government debt and giving it to people. The central question is suppose that the government gives you money, but takes back the same amount of your treasury bills or your retirement account. So you're no change in your wealth, but just you have money where you used to have savings. Is that going to cause inflation? Obviously if they give you 5,000 bucks, you're going to go try to spend it. But suppose they give you 5,000 bucks in your checking account and take away 5,000 bucks from your retirement account.
Does that make you go spend? Now, the monetarist says yes. The monetarist says all that matters is the quantity of this very special thing that we call money. But government debt's something totally different. It's a savings thing. It's not a transactions thing. So the giving you the money and taking away the government debt will cause inflation. Whereas fiscal theory says, well, there might be some second order fractions and stuff like that we'll talk about. But to first order, what counts is the wealth effect, not the composition effect, the overall amount of government debt, not whether it's in overnight reserves at the Fed or one month Treasury bills held through money market funds. Come on. What difference is there between those two things?
Literally, so monetary policy is when the Fed gives banks more reserves and takes back Treasury bills from the financial system. Treasury bills are held largely through money market funds. So do you really care whether you hold a money market fund that holds treasury bills or do you hold a bank account? The bank hold reserves and the Fed holds the Treasury bills, which the Fed is just another big money market fund. So a fiscal theory says to first order that split between money and bonds, doesn't really matter. It's the overall quantity that matters, where the monetarist's position is the split between money and bonds is everything and the quantity of debt is nothing.
Now, that might have been more true once upon a time. The two reasons why that monetarist view is, I think, wrong now, well, you don't need money anymore. As Marie Antoinette said, "They have no cash. Let them use credit card." Sorry. Bad French accent. And most importantly, the government doesn't limit the supply of money. Our Fed targets interest rates. For the quantity of money to determine the price level, you need the Fed to limit the quantity of money. They don't even pretend to limit the quantity of money. They set interest rates, and you can have as much money as you want at those interest rates. That theory, it's a beautiful theory, logically correct. It just does not apply to today's economy.
Is fiat still a good adjective to describe money in a fiscal world?
Sort of. I'll give you half on the fiat. We got to unpack for our listeners all this economic mumbo jumbo. Fiat money is money that is not explicitly backed. So in the good old days, that weren't so good after all, there was gold coins. That was the basic money, which is in some sense backed by itself. It's gold. Then there were notes, pieces of paper, and the pieces of paper used to say on them, "The bearer may bring this paper in to the bank of whatever or to the US Treasury and receive 1/20th of an ounce of gold." So that's backed money. It's an explicit promise that this paper money, you can have something of real value. So our money is unbacked technically in the sense that it no longer carries an explicit promise. It says this note good for all debts, private and public. It does not say you can get some gold for this or a bushel of wheat or a beer. There's no explicit promise that that money...
But it is backed in fact by the government's taxes. And in that statement, "This note, good for all debts, public and private," includes public. You may pay your taxes with money. You must pay your taxes with money. So effectively, that's what fiscal theory is about. Our money says it's fiat, but it really is backed by the need to get some by taxes, by the need to get some to pay taxes, by the government's willingness to raise taxes on other people to soak it up if you need. That's why I give you half so not de jure, but yes, in facto.
And is that different from, if we go back to the monetarist view, it's fiat a better description of money in that case?
Yes. So the pure monetarist view would say money is intrinsically worthless. It's just a piece of paper. Why is it worth something? Well, the government restricts its supply and we need to carry some of this stuff around, even though it's not paying interest, because the restaurant won't take a treasury bill. The restaurant takes cash. So it's intrinsically worthless, but we agree this piece of paper, only this piece of paper and the government limits its supply, that gives its value. So that's the purest description of pure fiat money. And of course, monetarists were really smart and they understood that most inflations came from governments printing up money when they couldn't pay their bills otherwise. So the link between fiscal and monetary policy was very strong in the monetarist tradition. And my description of a pure fiat money only holds, and monetarists are very careful about this, if the government is very healthy in its fiscal affairs and never faces the temptation to print up money in order to pay its deficits. Well, we're sliding down that slippery slope to fiscal theory right now.
Interesting. What does the government debt valuation equation suggest about the stability of the price level?
Okay. So let me unpack for our listeners government debt valuation equation. I said to you earlier, inflation comes when there is more debt relative to what the people think the government will repay in taxes less spending. Now, that's a future repayment, so we have to take an expected present value. So the value of the debt has to equal the expected present value of the real primary surpluses that retire that debt. I was supposed to be making this simpler. I don't know if I succeeded. But that is the government debt valuation equation. Fancy word. It's the same as stock pricing is present value of future dividends. That's the stock valuation equation. That's what makes the price level what it is. Now, the question, stocks jump all over the place, and so you would worry if your basis is this valuation equation, that who knows? I don't know what the government's going to pay back 30 years from now.
There's a source for instability in this, but there's also sources for stability, and that's why governments make a lot of promises. They say, "We're going to be good guys and we're not going to let inflation come out." That's a promise that says, "We're going to adjust this present value of surpluses so that the value of our debt doesn't change a lot," in the same way that bond prices are much more stable than stock prices. Well, there, a corporation doesn't just say, "Well, the bond price is the present value coupons. What are the coupons? I don't know. We'll see if we feel like paying you back tomorrow." No, no, no, no. They make a promise. Okay. You're going to get a dollar every six months and so forth. That makes bond prices more stable than stock prices.
So whereas in principle, the idea of a present value leads you to think of volatility, in fact, we have this centuries, old institutions, reputations, commitments that are designed to communicate to people, "Don't worry about it. We're good for it." And in fact, that's what the gold standard was. No government ever had a Scrooge McDuck vault full of gold to back all its currency. So what did the governments do when people say, "Hey, I want some gold for my currency." They had to raise taxes in order to get the gold to redeem the currency. Even under the gold standard, the currency was backed by the government's willingness to...
And so what the gold standard amounted to was, look, this much, no more, no less. We will raise enough taxes to pay you back at $20 ounce. We won't raise taxes to pay you back at $30 an ounce. So yes, there's an incentive to volatility, and yes, where we have been for centuries and where I think we need to go in the future is better and better institutions to commit the government to avoid that kind of volatility and then to avoid it in fact. You're asking good questions.
That's good. Glad to hear it.
Hard questions may I add.
Well, you're answering them very well, which is no surprise. That's why you're here. To follow up on that last one, last time we talked to you, we talked a lot about discount rates and how that explains changes in relative prices for stocks. Your description just now sounded like a cash flow explanation for stability. What happens when discount rates start bouncing around?
Oh, thank you so much. I bit my tongue because I was going to go off on a half an hour lecture about discount rates, and I promised you guys I wouldn't give half an hour lectures this time. And in fact, I'm uniquely lucky in that I spent the first half of my career doing finance. And you may recognize, in fiscal theory, I call it finance imperialism, we're taking present value equations and applying them to money. Well, that's finance imperialism. I guess that's a bad word these days. Sorry. When you think about a stock, let's start with a bond. What determines the value of a bond? Almost all of the value of a bond is the interest rate. Most bonds, there's two components to the value of the bond. Are they going to default on the payments? And what's the interest rate?
Most triple AAA bonds and treasuries, you're not really that worried about default, so the bond loses value when the interest rate goes up. Why? Because the opportunity cost of money has gone up and so the bond loses value. So how does US debt lose value? Let's think about short term debt. Even if there's no change in fiscal policy itself, if interest rates go up, then government debt has to become less valuable. And the only way for it to become less valuable, especially short term government debt, is for the price level to go up. So you see right there, another way of seeing the mechanism, if interest rates go up, then interest costs on the debt go up. America is about to discover this sad fact. We used to not have so much debt. We now have 100% debt to GDP ratio.
So if interest rates go up one percentage point, then our government has to pay 1% of debt to GDP every year as interest costs on the debt. That's a lot of money. That's $250 billion. That's a lot of money. So that higher interest cost is exactly like a deficit. It has the same inflationary effect as having a deficit. So those are two ways of seeing the effect. Higher interest rates are inflationary exactly in the same way as lower surpluses are inflationary, because they lower the value of debt. They raise interest costs. When you look at stocks, one of the great discoveries of the last 30 years, when you look at the stock market as a whole, a lot of the fluctuations in the stock price is not changes in cash flow expectations. It's changes in the discount rate, changes in expected return, changes in what return you have to offer to get people to hold your money.
That's what's going on now. Why is the stock market going down? Because people see interest rates are going to go up, not so much because of cash flow. So it turns out the same thing is true of inflation. So if you want to understand inflation, especially over the business cycle in the US, most of the variation is not in fact about changing expectations of surpluses and deficits. That catastrophe sits out there, but it doesn't change a lot over time. We all know sooner or later, it's going to hit the fan, see the fan, about social security, Medicare and potential deficits.
But there's not news about that on a regular basis. What does change on a regular basis is interest rates. As you go into recession, why is there deflation as you go into a recession? Well, interest rates fall like a stone. And so the discount rate, they're running huge deficits in a recession. So you want to account for why there's less inflation in a recession. It's because the interest rates are falling like a stone. 2008, why did those deficits not result in huge inflation? Well, the interest rates fell to -2% and stayed there for a decade. The interest costs on the debt became so much that nobody was worried about debts anymore. Understanding why there wasn't inflation, 2008 to 2020, you got to look at extremely low interest rates. So discount rates, all the same ways modern finance bursts thinks about discount rates, expected returns, required returns that force in changing asset market values also applies to inflation.
How do sticky prices affect the stability of the price level?
Oh boy. Oh boy. Prices are sticky. That's just a fact. Now just how sticky they are is I think how and when they are and are not sticky is the great unsolved question of macroeconomics. Not to say there hasn't been immense amounts of work on this over the last 50 years. I'm going in fact, this year is the 50th anniversary of Bob Lucas's Nobel Prize-winning paper about how inflation and output are related which kind of kicked off the modern work on this stuff. So there's plenty of Nobel Prizes left in here though.
Sometimes prices are slow to move and sometimes they move overnight. That's the problem. When countries in Europe changed to the Euro people say prices are sticky, prices are sticky, yet on January 1st of the day of the inauguration of the Euro, everybody in Italy cut three zeros off of their price levels. They change the prices in 10 seconds with no cost whatsoever. So where are the sticky prices? Go to an airline website and find these sticky prices. Anyway, prices are, however somewhat sticky. Wages are somewhat sticky, especially salaries of academics. Let me tell you, there's some moaning around the faculty lunchroom these days because academic wages move very slowly and inflation moves a lot faster than that. That was just a background. Prices are slow to move sometimes. Now what that does, if you want to match and understand the dynamics of inflation, you have to include some description of how prices are sticky.
And so that fiscal theory easily adapts to any model. So what I've done is I've put standard models of sticky prices in with fiscal theory. And so you get kind of the smooth or smooth versions of the extreme responses that our simple stories would tell us. So let me give you this. The simplest example is if you don't have sticky prices, what happens? News comes, government drops $5 trillion. Everybody gets a check. What happens in an economic model if there are not sticky prices is the price level goes up 30% the next morning. That was 30% of additional government debt of 5 trillion. If you're working through the economics of this, well, people got a big check. They go out the next morning to spend the check. There's only so much in the stores, prices go up, Bing 9:05 AM, price levels gone up 30%. Well that's not in the data, is it?
Why not? Well, prices are sort of sticky and so what you see instead is people get the extra money, they slowly start spending it, prices slowly go up in the meantime, what do you get? Stores when people show up, they try to meet the current customers without raising prices for all the reasons that are kind of perfectly obvious in real life and perfectly difficult to put down to mathematical models. So you get supply chain snafus and labor shortages, and a kind of boom and output.
And then slowly over time, over a year or two, you get a delayed inflation. That's perfectly reasonable verbally. It just takes some equations to throw it. So what does sticky prices do? They take all the stuff that your simple intuition says happens overnight and they spread it out over a year or two. And that's very important if you want. This is not modern monetary theory where you just spend stories. Well, you need a proper modern economic theory written down with equations and those equations better have sticky prices in them if you want to try to match data where inflation builds up slowly and then goes waste work.
Yeah. Okay. That makes a lot of sense. Do you think the supply of money matters at all or another way of asking the question is MV equals PY or Friedman's license plate, as you said, still a useful model?
It's a useful model of the demand for money. There's this problem of, here's the problem with MV equals PY, rich guys drive Mercedes, I should say rich guys drive Teslas, I live in Palo Alto. Rich guys drive Teslas so will driving a Tesla and make you rich? You look at the correlation in the data and Tesla ownership is very correlated with income. So that's just as money as correlated with income, you could easily conclude. "Well, great. The key to rich is to go by myself a Tesla." Don't work that way. So there is a strong correlation of money and inflation, why? Because when the price doubles, you need twice as much money. So that's certainly true, but that doesn't mean that changing the amount of money is going to change the price level in today's economy. Now we still do. There's a center to simple version where we just abstract from all of this stuff and say, "Well, money doesn't matter."
That's not really true, but people are... So my bank account is still paying 0.01% interest rate, even though they're getting higher interest rate from the fed. What's up with these guys? So there still are what we call frictions. I haven't used cash in about six months but I still have a couple bit dollars of it left. Not to make jokes about it people who study the nuts and bolts of the financial system, a treasury debt is very important as collateral and a lot of financial decisions. So managing liquidity, managing cash. The understanding differences of interest rates between different kinds of securities. Some securities pay lower interest than others, why? Because they're more liquid. That's kind of like money. But here we're understanding money demand. Given the government's going to provide you whatever you want. So how much do people want to hold as opposed to those things determining the price level in the sense that in an idealized economy, if you don't have enough cash, you might have stuff in the bank, but you don't have enough cash that you can't spend.
You can't go out to dinner and so the price level goes down. Well, that just isn't true. There still is money demand. But if the ATM machines are open, let's go back to my example of let's take 1972 going out to dinner on a Sunday, no cash, no dinner. And if nobody has enough cash, price level goes down. Dinners on weekends are cheaper. Let's open the ATM machines. What happens? People go out and ops no cash. They run to an ATM machine and they get the cash. So you'll still have a correlation between the amount of cash and the amount of dinners but the amount of cash is supplied freely by the government. And so it's not affecting. It's very interesting how much is money demand, how much cash do people need to go out to dinner on Saturday night? The people who run the ATM machines need to understand that, but it's no longer it's interesting and money demand but it's no longer crucial for the price level.
Why do you think monetarism gains so much? I mean, you said earlier that's in every economics textbook, why did it gain so much traction?
Oh, it's a beautiful theory. It may well have been right in a simpler time. Goes back to the quantity theory in the 1910s. So in the economy up to 1960s, indeed money supply under the gold standard is limited. So you needed a lot of more cash and the economy was less able to provide cash when needed. They also, they didn't have fiscal theory. It's hard. Take some equations that they didn't have at the time, expect the present values and discount rates, looks easy now. Milton Friedman didn't have it.
And what was the alternative at the time? The quantity theory in the early monitors had started before Keynes, but was raining at the time in the 1950s and 1960s was sort of simple-mind Keynesian stuff fairy tales about fiscal policy and inflation was just kind of the wage-price spiral. And the solution to inflation was to talk unions and to not raising wages and pressure businesses and to not raising prices. There's kind of like wage price spiral that wasn't really anchored by anything. And people had forgotten what people knew for centuries about where inflation funneling came from. So that combination of it being true, truer of the economies of that period, and being a incredibly useful alternative to simple-minded Keynesianism I think made it incredibly popular.
Was there anything in there in your book, you mentioned something about almost a political purpose that it would've served at the time?
Well, an intellectual purpose.
Okay.
Suppose you think that simple mind Keynesianism is kind of empty and you're sitting at the University of Chicago and it's 1955, what are your alternatives? Well, the quantity theory is a great alternative provided Milton Friedman and Arnold Schwartz wrote this great book, the Monetary History of the United States. So it provided a narrative account of what went right and what went wrong. That was very good, very persuasive. And I would even still rate it largely true in a way that the Keynesians couldn't really do. Well, animals' spirits led to less investment. Monetarists said no, the fed let the quantity of money fall apart. What are you talking about? And an intellectual alternative to the Keynesianism had turned in that time to sort of an excuse for general macroeconomic planning. We the buzz in Washington will run the economy for you under Keynesian spirit. So it was useful. It was much more true.
And it was the theory available at the time as an alter and many of its... Stop trying to fiddle around with fiscal policy to micromanage the economy that still remains true. And it gives a coherent reason why you should do that. It just didn't nobody at the time had fiscal theory has taken 30 years to develop on the foundations of the tremendous progress in economics in the 1970s of learning how to write down proper general equilibrium models that evolve over time of learning how to put rational expectations in, of learning how government debt really works in a context where people think over time and it just wasn't, there's no way to do that in 1950.
Wow. In fiscal theory, how do fiscal and monetary action set expected and unexpected inflation?
Okay. Simplest version of the theory, the fed by setting interest rates still has fed is very powerful and I'm glad you brought this up. So a fiscal theory does not mean throw out the whole fed and it all matters debts and inflation. In fact, the central bank remains incredibly important. And in the simple model, the one with the no sticky prices which is the easiest to understand when the fed sets a nominal interest rate that determines expected inflation, why? The simplest fact in the economy is that if we have a lot of inflation, we have to have higher interest rates because if inflation's 10% and your interest rate is 1%, that's effectively a negative 10% real interest rate. And eventually, the real interest rate is tied down by real things, not by money things, by the productivity of capital for primarily the productivity of capital. People's willingness to save and invest and so forth.
So eventually in the real interest rate can't move that much so that the interest rate moves with expected inflation. So the fed by setting the interest rate determines where expected inflation is. But then what does fiscal policy do? When there's a fiscal shock, the government says, "We're going to blow $5 trillion. We have no plans. We're not going to raise taxes for $5 trillion and we're not going to raise future taxes by $5 trillion to pay off any debt. So here goes $5 trillion." That economics is it always comes out of someone's pocket. It does not grow on magical monetary trees. Whose pocket does it come from? Well, it's got to come out of the pocket of existing bondholders. If we're going to give you 5 trillion bucks, we're not going to raise current taxes, we're not going to raise future taxes. It's got to come out of the pockets of bondholders. We could default. We could confiscate default on $5 trillion worth of debt.
We don't do that. What we do instead is we inflate away $5 trillion of debt. So by that mechanism, fiscal shocks, but people won't hold the debt if they know that's coming. If I tell you, "Next year we're going to inflate away the debt." You say, "Thank you. I'm selling it today." That's the central mechanism that the present value matters. So people can't expect to get fleeced. So a fiscal shock gives you unexpected inflation which is essentially a default on the existing bondholders. So summary in the simplest version, inflation interest rates and the feds that expected inflation, fiscal shocks give unexpected inflation, which devalues government debt to equal that fiscal shock. Now add sticky prices, all this takes place over time. And so there's some complexities that it's hard to talk to verbally without charts and graphs, but just take that story and spread it out for over three to five years and you get the sticky price version of it.
Yeah, it makes sense. Now, what level of fiscal and monetary coordination are required for price stability?
Yes. Lots. So I think one of the lessons here is call it actually, I didn't call it fiscal theory, the price level, it's really a fiscal theory of inflation. And I like to call it the fiscal theory of monetary policy because both are required. And let's think of the story we just told it. Suppose interest rates that's expected inflation and fiscal shocks set unexpected inflation. What does it take for us to have steady inflation? Well, it takes steady interest rates and it takes no fiscal shocks. When the government borrows money it credibly promises to pay that money back with future taxes. So we need coordinated fiscal and monetary policy to have inflation. Let's take another story I told. Suppose the fed wants to raise interest rates. This is an important story for right now. The fed wants to raise interest rates in order to fight inflation, which it can do even in fiscal theory.
There's a short-run effect we're raising interest rates will lower inflation for a while. And the fed wants to do that as our fed wants to do. But raising real interest rates is going to raise the interest costs on the debt. And if the fiscal policy just says, "Well, screw that we're not raising taxes to raise interest costs and to pay higher interest costs on the debt." Then the whole thing falls apart. Then you have the monetary disinflation creates a fiscal inflation. Suppose the monetary disinflation raising interest rates, how does that lower inflation? Well by causing a bit of a recession, that's the whole point. They won't tell you, you have a fiscal boom and you're trying to offset it with a monetary recession just enough.
It's kind of like we drank too much at the party so we're going to have three cappuccinos to try to offset it. That's or maybe the other way around. Well, so the fed causes a recession. What happens next? Stimulus, bailout, right? Fiscal policy to the rescue. Wait a minute, the whole point was to offset a fiscal policy is going to respond to monetary policy by creating even more inflation, then you've just lost all points. So fiscal monetary policy need to work together in all cases in order to have the sweet outcome.
Is the level of coordination needed realistic because of the whole central bank independence thing?
No, I think the independence can be useful. In fact, so we should be careful. Monetary fiscal coordination is a bad word to many people because to many people that just means the fed agrees to print whatever money the treasury wants to finance its deficits which is that's the road to big inflation, which is so... I was thinking of coordination in the other direction, we're going to work together to fight inflation, not coordination on we do whatever you want in order to create inflation, but we definitely need. I do think an independent fed is a great thing. Somewhat independent, not you don't want technocrats off on their own doing crazy stuff like they have in Europe. But there is a point to having the fed independently create monetary policy and fiscal policy really is much longer run. So the monetary policy is kind of guiding the short-run path. The point of fiscal coordination... Remember, so we started with value of debt equals price level is the value of debt relative to expectations the government will pay it off. Now, the government pays off debt over 30, 40 years. We paid off the World War II debt very slowly over decades. What people need is the confidence that sooner or later when America borrows money, she will pay it back. That's a long, long run. That's not business cycles. You got social security and Medicare under control. That is just a general confidence that if you borrow 5 trillion bucks for whatever this emergency is, sooner or later you're going to make it up with greater tax revenue, not necessarily greater tax rates or higher economic growth, or restraint and spending. And you don't need a specific plan on it. So fiscal policies kind of the foundations it's this long run yes, the government's good for it whereas monetary policy is more direct adjusting the path of inflation.
So they don't need to work hand in glove on a daily basis. And they also, they shouldn't work hand in glove because fiscal policy is much more political, and here's the great puzzle. The one thing that can cause inflation reliably is to drop money from helicopters. The fed is legally not allowed to drop money from helicopters. The fed can only buy something from you, thereby getting rid of most of the effect. If the fed comes instead of dropping money from helicopters, the fed knocks on your door and says, sell me some of your treasury bills. That's not going to work anywhere near as well and vice versa. What's the easiest way to stop inflation? Well, the opposite of dropping money from helicopters coming and taking your money, the federal reserve can't come and take voters' money. It's a democracy. The treasury has to do that. So fiscal policies is inherently much more political and therefore needs to be much more politically accountable. So we need an independent treasury fed.
Well, how are monetary policy debt sales and fiscal policy debt sales different?
You guys have read the book. I'm just tremendously impressed. As you start thinking about these operations and how things could work in the fiscal theory. Let's just go back to I'm just okay. I'll admit it. I'm just a guy who knew a little bit of finance and is out there like a two-year-old where everything looks like a nail and I've got a hammer. One particular hammer is let's think of the corporate analogy. There are share splits. So what happens in a share split? A company says, give me each of your shares. I'll give you two shares. By the way, this is just accounting thing. Basically, we're not changing investment. We're not changing dividends. So what happens? We double the number of shares, but the price per share goes down and we're not changing dividends. The other thing. So what happens? The stock price halves and that's it.
The other thing companies might do is they might issue new shares. So a public offering or a secondary offering, I'm going to double the quantity of shares but this time the company says, wait, "I'm going to use that money to invest in the company and I'm going to pay you higher dividends in the future." Now, what happens? No change in the stock price, right? And the company gains a lot of revenue by issuing the shares. How is those different?" You just look at the data, you see a doubling in the number of shares. One of them, the price of the stock dropped in half and the company got no money out of it. The other of them, the stock price stayed the same and the company got a lot of money. Well, expected dividends must have gone up. Why did expected dividends go up?
Well, the company made a lot of promises and the accountants said saying, right? We understand how that works. There's a set of institutions that guides expectations. If they say we're doubling the quantity of shares and it's a secondary offering, people understand, "Aha, we're going to give them new money. The dividends will be higher. Their company is worth twice as much." If they say this is just a two-for-one split, they understand, "Okay, there's no change in expected dividends. The company is worth anymore. We're just going to devalue it." So the same thing can happen with the government. If the government can issue debt and say, "This is new debt, and guys we're going to pay for this with future taxes." Then what happens? The government gets the money and it can finance the deficit. You don't get any inflation and the government then pays off the debt.
If the government says, we're going to double the quantities here but there's no change in future deficits, then what happens? Well, the price level jumps, doubles, the value the debt goes down by half and the government doesn't get any money. And that's exactly what happened as you changed the Euro. When we changed the Euro, think of it, the quantity of debt in Italy, where the Lira it was like, I don't know, a thousand liro per Euro, something like that. We've lopped three zeros off. Well, it's just like a two-for-one split. There was 1000th the amount of debt, the price level changed by a factor of a thousand, but no change in future deficits or must. Now I think we can apply these parables. I think what central banks do is largely the former. They buy and sell government debt and they're legally not allowed to change taxes and spending that in the theory is very reminiscent of the two-for-one split.
And that's the mechanics of how is it that a central bank by setting nominal interest rates or by doing quantitative easing operations can affect the price level? Well, a central bank is in charge of two-for-one splits a treasury this is why we separate. You ask central bank why is it useful to separate central banks and treasuries. The treasury has actually gained a pretty darn good reputation. Unlike say the treasury of Venezuela or Argentina. When our treasury sells debt, it raises money by selling the debt and doesn't instantly cause inflation, why?
Well, people understand that our treasury has been pretty darn good about paying off its debts. They expect that sooner or later, there's no explicit promises, sooner or later that's going to get repaid not inflated away. People thought it would all get inflated away next year. Then they would just do all you do is drive up nominal interest rates, drive down the price of debt and the government wouldn't get any more money out of it. So that's the treasury is doing something like public offerings and credibly communicating that it's going to raise surplus to pay off the debt. And when the fed does QE sorts of things to the extent that works or sets interest rate targets, when the fed sets an interest rate target. Nobody thinks the fed can control the amount of revenue that goes to pay the debt. I've silenced you guys. That's amazing.
That's a lot. We have a lot-
Yeah. Yeah. You asked a question that's deep in the theory of sort of how does an interest rate target work.
Right. Oh no. We have another question about that later too, but we'll take a break from interest rate targets for a minute.
Well, I'll give you longer answers. That'll settle it.
What effect does the size of central bank's balance sheet have on the price level?
Good question. I'm torn about that. So let's start with the evidence. As I look at the QE operations, I see essentially nothing. You look at a plot of inflation versus quantitative easing. These were enormous. The fed used to have 10 billion of reserves in tiny amounts of assets. They went up to 3 trillion. So just for background, quantitative easing has been times when the fed buys up literally trillion dollars of treasury bills and gives banks in return trillions of dollars of interest-paying reserves. Now my first instinct is nothing. My first instinct is those are open change operations, not open market operations. The fed essentially took your $20 bills and gave you two 5s and a 10. I don't care if you have a $20 bill, you're a bank you're Goldman Sachs. Do you really care if you have treasury bills or overnight reserves and you understand perfectly well, your Goldman Sachs, you understand that the overnight reserves are a money market fund that is backed by the same treasury bills that you used to have.
So that looks like two 5s and a 10. Do you care suppose in your retirement account, you might have some individual treasury bills or you might have a money market fund that hold treasury bills? Do you really care? It looks like the same thing. So option one QE looks like now there are ways in which QE can work under fiscal theory. And primarily there, if you think that the fiscal promises underlying money are different than the fiscal promises underlying treasury debt, which might be true. I like to have it both ways. I think the answer is essentially nothing, but if you find empirically the answer is a lot, I'm ready with a theory that'll explain that. And the theory is that people think of reserves as something that are going to be left outstanding and not backed by future taxes whereas people think of treasury debt as bearing the full imprimatur of the treasury and that is backed by future taxes.
So I'm ready with the theory to explain the wrong facts. If facts come out the way I don't like, but so far, as far as I can see, QE is just a massive done. QE has been wonderful marketing for central banks. Interest rates hit zero. They didn't want to say we've done what we can. We'll be on vacation. Call us in when you need to raise interest rates. Instead, want to say, "Oh, we're the great, wonderful central bank still stimulating the economy. So we'll do something." And QE gave them something to do and to trumpet. But if QE was so wonderful, if 3 trillion of QE was just that great stimulus that helped the economy, why did we suffer year after year of tremendously high unemployment and slow growth? If 3 trillion was so wonderful to get unemployment down to 6%, why didn't you do 6 trillion and get unemployment down to 2%? That question looks to me that there's no theory that says 3 trillion was exactly the right amount at all we could do at anymore would've been worse. Not quite so sure about that. So, sorry to unload on you.
Yeah. So what effect does inside money issued by private banks have on the price level?
Yeah, that's a great one. That lets me contrast back to monetarism versus fiscal theory. So let's just unpack that in case, sorry, I've been teaching so long I always want to...
No, that's good. That's good.
We unpack that into what the heck inside money. But the paradigm inside money would be if we were out drinking and I didn't have any money, I said, "Look, I'll write you an IOU. Could you buy my beer and I'll pay you back on Friday?" And I write the IOU and then you guys go out drinking the next day without me and you run out of money but you give someone else my IOU and he's going to come get it collect from me on Friday, right? We have just created inside money. It's not provided by the government. It's not backed by the governments. The government doesn't care about this IOU.
It's something that can circulate and facilitate transactions and it's a temporary store of value and a medium of exchange and so on and so forth. And we call it inside because it's inside the private sector. It's not provided by the government. So checking accounts are inside money in the same way. A bank simply creates, you go borrow money from a bank and they simply create the money. They flip a switch say, "Yeah, here comes $10,000." And then you can go spend that and we have increased the money supplied by $10,000. Now, in traditional fiat money theory, that's very dangerous because if there wasn't any government here, the value of money, intrinsically worthless money, depends on us having a demand. We need to hold some of the stuff to get dinner on Saturday night, but also limit its supply. And if the banks can freely print up all the money they want effectively, print up all the IOUs they want, they're going to cause inflation. And so the government needs to limit private money, money backed by private assets. That money was backed. IOU is backed by my wealth, my willingness to pay it. So it's a backed private asset, but it threatens the price level even of the government's money, because it contributes to the money supply. And the simplest version of fiscal theory, who cares?
The value of the government's money, if I welch on the IOU, you show up at the Treasury department and say, "Hey, I got this bond here. You want to pay off this bond?" The Treasury looks, "That's not my bond. I don't give a damn about that." So in a fiscal theory, the value of the government's money is determined by the government's willing to pay taxes. But the existence of private money, so long as the government isn't going to bail it out, the existence of inside private money makes no difference, in the same way that if options on a stock are inside shares, but they always net to zero so they have, in principle, no effect on the stocks value, they increase the liquidity of the stock maybe. But me writing you an option shouldn't change the stock value because the company doesn't pay dividends on that option, doesn't care about that option.
So the same way in the simplest version of the fiscal theory, who cares if there's inside money. Who cares if there's competing money? Who cares if there's Bitcoin? We don't need to force you to only use the government's money. Use whatever you want. The government's money is just a claim to the government's surpluses, whether you use it for transactions or not. That's one of the biggest... Does the government need to limit the amount of inside money, of financial innovation, of payment systems to make sure that inside money doesn't create inflation? Monetarists, yes. Fiscal theory, no. Real world. We don't have reserve requirements anymore. The Fed doesn't even monitor M1, M2, and M3, let alone try to control it. There's another case in which today's financial system just has no relationship to this story we tell where the government severely limits the amount of inside monies by reserve requirements and regulations and not letting people issue it. Fiscal barrier, you want Bitcoin? Good luck to you.
Yeah, it's big because a lot of people still worry about that. I still get questions on the internet from internet strangers about, aren't you worried about the M2 money supply and stuff like that?
Yeah. Well, the answer to that is why. So let's go back to reality. It is a fact that there have been many... Inside money can get overdone. If I write 10, 000 IOUs because I have a drinking problem, come Friday I might not have $10,000 to pay back those IOUs. And if you figure that out before somebody else, there might be a run on my IOUs. So inside, whereas I'm schizophrenic on this one. In my fiscal theory, the price level hat, I don't care about inside money. You show all the inside money you want. In my financial stability hat inside money typically is of a very dangerous form.
I don't give you equity in Cochrane, Inc. I give you a money. I give you a short term debt, first come first serve, run prone security that over history has led to all sorts of financial credit expansions and crises and booms and busts and depressions and so forth. So inside money is very, very dangerous from a financial stability perspective. I would actually be for really limiting run prone inside assets, lots of equity financing, no short term debt financing all over the place, but on financial stability grounds, not on price level grounds. That's another show.
Yeah, seriously. Geez.
I call it equity financed banking and a government monopoly on run prone liabilities. We did this in the 19th century. The 19th century, all money used to be inside money. There was no cash. There was coins. And the cash that existed was all inside money issued by banks. Banks issued notes payable at the first bank of Nowheresville, Nebraska. And they issued too many of those notes and there was runs and crashes and crises. And then the government said, "We're done with this, guys." We're going to have a government monopoly on money notes. And we haven't had a run on notes since. It was a great success. Well, I think we should do the same thing. But this is about financial stability. It's not about the price level.
Right. Back to fiscal theory, are there statistical tests that can be used to prove it?
Yeah. You can't prove anything in economics. And I think there's been a huge effort to prove or to disprove. You can only disprove anything. You could reject hypotheses. You can't accept them. And there's some deep theoretical problems with that. But let me just appeal to history first. Grand tests of one whole class of theory versus another have never been successful. What is fiscal theory? Fiscal theory is an emphasis on one equation that's part of a larger model. This idea, if I say the inflation comes from the government debt valuation equation, well a proper economic model has 18 equations, not just one. So it's predictions depend on what all those other 18 equations look like, and how do you write down what people are expecting for surplus and discount rates are so forth. Technically, as in other places of economics, this identification is hard and there are observational equivalent theorem that say, as a class, you can't tell theories apart without assumptions, not just fiscal theory.
So let's think about the monetarists versus Keynesian debate, which we talked about. Did anybody come up with a grand statistical test prove monetarism is false and Keynesianism is right or the other way around? No, it's not how it worked. They fought about it for 20 years. And they fought about the way we fight about all... Read your Thomas Kuhn, how do we fight about all science? There was no grand test of the logistic hit theory of heat versus the caloric theory of heat. People put together the facts and one got more useful and the other got less useful. But the idea of this theory will never be able to explain it, that happens occasionally. There's great stories like general relativity and the bending of light around the sun, which turns out to be they faked the date on that one, but that's how most science works.
So monetarists versus Keynesians, real business cycles versus rational expectations versus new Keynesians. You've never had a grand statistical tests settle this once and forever, and that's not going to happen with fiscal theory either. You could try. People have tried. Good luck to them. I don't spend my time on that, because I think it's very difficult. That's the point of my book, the point of what I'm trying to do talking to you. Theories prosper when you can figure out how to use them to productively understand events in the simplest possible way. Part of this rejection is I'll say things like, "Oh, monetarism is rejected because the zero bound era or the quantitative easing didn't show hyperinflation." Well, those guys are very good. They're smart. There's always an apple cycle you can add. You can always save a theory. There's always an ex-post assumption that makes a theory work.
But when a theory provides the simplest possible explanation and becomes useful for policy, then it gradually takes... And I think that's the way it works in science. That's the way it works in economics in the past. That's the way it works in life. My previous in finance where you guys understand too, nobody ever tested behavioral versus rational finance. They tried. Over and over again, we filled the pages of journals with test of behavioral versus rational finance. Did that shut up either Fama or Thaler? Nope. They're still at it. Because there, the theorem is the existence of a discount factor theorem. In the absence of arbitrage, there always exists the discount factor, such the price present value of dividends. That's theorem. You can never reject either one right. Now, what do you do? You need a plausible theory of expectations. It's possible that if stocks were high Monday, Wednesday, and Friday and low Tuesday and Thursday, you could come up with a rational theory, but boy, would that be strained? And the behaviorists would have a good shot at that. Well, that doesn't happen. Good thing. So trying for big formal tests, I think it's useful for straightening things out in your mind. I spent a lot of my time on the big formal tests. And tracing down where the assumptions went and why those assumptions might not be right and how you might save a theory versus another theory on the auxiliary assumptions, that's very useful for the whole math of this thing, but I don't look forward to, for the first time in history, telling capitalism versus socialism, a test. Nah, it's not going to happen.
So it sounds like what you're talking about there is the joint hypothesis problem is the equivalent in testing efficient markets, right?
Thank you. The joint hypothesis problem, that was Fama's word for it. That was the early version and then that became the Harrison Creps existence of a discount factor theorem, which formalized the joint hypothesis problem even more formally. Now, that doesn't mean it's pointless. That means you're forced into rather than the fruitless, I'm going to prove you can never be right, you're forced into the fruitful. What are expectations like? How do people form expectations? What is the evidence on how plausible is one theory or another? That's where we belong.
Yeah, right. Thinking back to the asset pricing side, that's like that basically how the additional factors were added, the Fama/French five factor model, right?
Yeah.
They needed a better model-
... about those irrational irrational factors.
Right. Yes.
A plug for the rational side. How easily could your theory be adapted to explain everything if the signs came out the other way? The sense of some rejectable content to your theory, as well as simplicity and plausibility, is important, but don't look for that grand F test.
Interesting. So why did the COVID QE, which looked like you called it the Freedman helicopter drop, lead to inflation?
Yeah. Well, now I'm going to start spinning some stories. Here's the problem. So COVID QE, I think 5 trillion bucks inflation, helicopter drop. Why? I'm Mr. fiscal theory. There's more debt than people think the government will repay. So now we're forced into, well, why do people think the government won't repay that debt? And why in 2008 when we had a huge stimulus and bailout that people think they would repay that debt? That's where we're going to go. And that's a tough question, but I want to contrast this to the Larry Summers's view. Larry Summers was also right on calling it for inflation, but I want to point out a very different mechanism for thinking about fiscal policy, the flow versus stock question. How did Larry call inflation right? He said $5 trillion worth of deficit multiplied by the multiplier of 1.5. That's $7.5 trillion of stimulus. That's larger than anybody's guess of the GDP gap. That's going to cause inflation.
Now, notice the difference. He's thinking entirely about the flow deficit relative to the GDP gap, not the amount of debt. And people's long term expectations of will the government pay this back are just absent. If the flow deficit of 5 trillion, everybody understood that's going to get paid back, in my view, that would not cause inflation, because it's fundamentally different view. So back to the question, why did people think this debt, they should spend it quickly and it caused inflation, whereas the World War II debt, they held onto as a good investment or the 2008 debt did not cause inflation, they thought the government was good for it? Well, let's make up some stories. As I look at this, the first obvious thing is we joke about politician promises, but let's first look at the politician promises. The Obama Administration did make a song and dance about, we're stimulating now, but deficit reduction will follow.
Now, I laughed at that and everybody laughed at that because every administration says, "Yes, yes, deficit reduction's going to come exactly one year after we leave office." But at least they went through the song and dance about saying that, whereas this time no one was saying that. And Washington was a wash in modern monetary theory in debt doesn't matter. Academia was a wash in debt doesn't matter. R is less than G. Nobody was even talking about this is borrowing to finance a crisis. We're going to borrow to finance a crisis and we're going to raise taxes to pay it back when we're done. No one was talking about that. So number one, why didn't people think they'd pay back debt? Because nobody's promising. Nobody's even said they'd pay back debt. Number two, in fact, what happened after 2008 was not a big rise in taxes to pay back the debt, but that interest rates stayed -2% for a decade. That was great. That essentially is what paid off the debt, low interest rates.
If you borrow a ton at the bank and all of a sudden, rather than having to pay back 5%, you got to pay back negative 2%, you're in great shape. But the chances that this time interest rates can go down from -2% to -5%, that's not happening. So we're not going to get bailed out by low interest rates this time. People thought about that. And I do think... Now, here, we have to add, I've been too frictionless in my fiscal theory. It does matter who gets the debt and what kind of get debt they get. The government in 2008 borrowed money in treasury markets from people who are investors, who are used to thinking about the debt as, this is an investment that I'm going to hold onto because I'm a pension fund or a mutual fund or a Chinese central bank. I'm going to hold onto this. It's an investment.
And they used that money. They threw it down rat holes, but it was government spending. A lot of it went to state and local government salaries. A lot of it went to studies for the high speed train that's never getting built, but that kind of thing. This time around, they did not borrow money. They literally printed up a lot of the money. They sent it as checks to people, and that's why M2 went up. It went straight into bank accounts of people, and people in trouble, kind of people really likely to spend it. So it doesn't take much adding friction to fiscal theory to think that is going to be more quickly spent than money borrowed from traditional investors and then spent in traditional ways. So there's three excuses. We can make up a lot more. I got to be honest, and I'm telling stories that are maybe plausible, but this is not rigorously done quantitative research yet. That needs to be done.
What about sudden shifts in spending, like house improvements or pools and backyards, shift in travel plans, things like that?
We have to distinguish people do that, and that was a lot... So we were into the question of where did inflation come from? And I said obviously they dropped $5 trillion from helicopters, and everyone else is saying different things, supply shocks or demand shocks. People decided that they want to have backyard swimming pools not go out to restaurants, so all of a sudden that backyard swimming pool price has to go up. A lot of that confuses relative prices and inflation. So let's be clear about the phenomenon of inflation. This really is helpful. I'm going to say a classic economist thing. Inflation isn't about prices going up. Don't you love economists? Suppose there's a supply shock and we just can't get enough TVs to the ports. What's going to happen? The price of TVs has to go up because we have to not buy so many TVs.
So the price of TVs has to go up relative to the price of other things and relative to wages. But that doesn't tell you whether the price of TVs goes up and everything else stays the same, or whether the price of TV stays the same and everything else goes down. So that supply chain tells you about a relative price. It doesn't tell you about the overall level. Inflation is when everything is going up and wages are going up too. True inflation is a decline in the value of money, not about individual price. Now, the reality combines both, which just why it's so confusing. Same with the demand trucks. You asked about the swimming pools. And Janet Yellen said this early on, that what we're seeing is just people are not going out to dinner and spending their money on TVs instead. Well, that should raise the price of TVs, but lower the price of restaurant food. The only way it leaves the price of restaurant food alone is if monetary and fiscal policy allow the overall price level to go up.
It could just as well have been restaurant prices go down, price of the TV stays the same. So what often happens is the oil price is the same way? Oil prices go up. We all got to drive less. The price of oil has to go up relative to everything else. Doesn't tell us whether the price of oil goes up or the price of everything else goes down. Because like what happened in the 1970s? Well, then the government chooses. If this relative price changes, do we want the price of oil to go up and everything else stays the same or the price of oil to stay the same and everything else to go down? No, we don't want that.
And in fact, what they choose is the price of oil goes up a lot and the price of everything else goes up a little bit. So the overall price level is monetary and fiscal policy. On top of that are all these relative price changes and it's very easy to confuse it. We're getting late, but here's a takeaway point. You can see my teaching history. Takeaway point, don't confuse relative prices with the overall price level. The overall price level, the value of money is inflation. Relative prices are relative prices.
What do you think the fiscal explanation is for the US inflation of the 1970s and its swift end in the early 1980s, which is often positioned as a monetary story?
Yeah. Thank you. And here let me plug, I have a article coming out called Fiscal Histories. You can get it on my website. It'll be in the Journal of Economic Perspectives. Obviously you read it as well as the 500 page books, a good job there. So again, I'm spinning a story, but at least I think it's important that there is an alternative story, because the '70s and '80s are told as the triumph of the story that inflation's always and everywhere a monetary phenomenon. But there's a fiscal side to the '70s and '80s too. So we can at least tell the story. It's possible. It's plausible. Is it true? I keep telling my graduate students, here's a thesis topic for you. So the '70s inflation was certainly sparked by fiscal problems. Johnson wanted the Vietnam War in the great society and didn't want to raise taxes for it. And we had a foreign exchange crisis that led to the fall of Bretton Woods.
In part, our economy was much more fragile back then because the Bretton Woods system where exchange rates were fixed, the US promised gold for dollars abroad. And you can't do that with any inflation. And two or 3% inflation over a couple of years, well, the gold price, you can't keep the gold price constant. It's hard to remember what a closed economy we had. Foreigners couldn't buy us stocks and bonds. The only way to finance trade deficits was to send them gold, send them dollars. And when they didn't want the dollars, send them gold. So all the outlets now, when the US Government wants to deficit, they, "Yeah, come on in foreigners, buy our debt." Couldn't do it back then. Bretton Woods fell apart. Inflation came out. Wage in price controls. There was a fiscal spark. The 1970s had fiscal problems. The growth slowed down. The deficit of 1975 was the biggest since World War II. Carter's Malaise was a general sense that America was spinning out of control and might not be able to pay back our debts because we're growing slower than we used to and the economy was in terrible shape.
Now, fiscal and monetary policy matter, and monetary policy certainly played a role in amplifying it, but the fiscal policy matter too. Why did it keep coming back? Well, the Fed would raise interest rates, which would temporarily lower inflation, but fiscal policy then would go stimulate in the recession. Boom, more inflation. So there's certainly that cycle of raise interest rates. That does slow inflation down, but then it causes a fiscal blowout and then boom, you get more inflation. So the fiscal part was there too. And then 1980. 1980 is supposed to be the cap center and monetary policy did it. Volkar came in, raised interest rates three to 5%. Rio left them there for a decade, horrible recession squeezed out the inflation, but there was a fiscal side to that as well, as there must be. The 1982 and '86 tax reforms cut the top marginal rate from 70% to 28%.
Now, we can whine about incentives when we're talking about 22%, 25%. You cut the top marginal rate from 70% to 28%, you got some huge incentives to go... And they broadened the base. They cut a lot of that junk out of the tax code. The sort of thing that we haven't even approached since. There was a deregulation effort starting with Carter, also under Reagan, and at least the regulatory expansion stopped. The economy boomed. And with the boom tax revenues boomed. Now again, what matters is tax revenues, not tax rates. And the easiest way to high tax revenues is to grow the economy. So the government was just rolling in cash. By the 1990s, economists were writing papers about, how are we going to run a financial system when the US Government has paid back all of its debt? And it looked like it actually might happen. So in fact, in terms of present value of surpluses, those surpluses came rolling in.
So that was what I like to call a joint monetary fiscal and microeconomic reform. And that is the sort of thing that was very- in the 1990s, they were things which were joint. There weren't just the Central Bank does something. They were, "By the way, we're going to fix our tax system and we're going to deregulate our economy and let it start growing." And those just stopped inflation on time. So I think of 1980 in the Western were the first joint, it was kind of slow. The fiscal microeconomic came later, which is why we had such bruising recessions and the inflation targeting countries now had no recessions whatsoever. They just killed inflation, boom, the day the target was announced. That can happen, but it takes joint fiscal monetary and microeconomic reform. At least there is a plausible story on the '70s and '80s that is not just monetary, that has fiscal shocks and joint fiscal monetary policy being responsible for the waves of inflation and the final disinflation.
Why have inflation targets been successful in countries like here and Canada and New Zealand, but failed in Argentina?
Yeah. So my, again, story for the inflation targets... Sorry, the usual way we say inflation target is the government tells the Central Bank, "You, pay attention to inflation." And now that's important, because when you say pay attention to inflation, it means don't pay attention to anything else. Don't worry about labor markets. Don't worry about inclusive growth. Don't worry about climate change. Just worry about inflation. That helps. But in the standard story that just gives the Central Bank the political capital to repeat a Volkar, to raise interest rates cause a horrible recession and not care, and that's not what happened. Inflation targeting countries on the day the target was announced, inflation fell like a stone and the central banks never raised interest rates. And in fact, there's an economic boom. Why? Well, something else happened along with the inflation target.
In each case, those governments put in the successful ones, fiscal reforms broadly lowering tax rates widening the base, and microeconomic forms, deregulating, getting the economy growing. The economies grew. Tax revenues grew. It's a joint agreement between central bank and government and the government is at least implicitly saying, "You hold inflation at 2%. We promise to run our fiscal affairs so that we don't borrow too much money and we will pay off our debt at 2% inflation and we won't want to inflate away our debt. We're going to be responsible about paying back our debt." That's the fiscal side of inflation target. Where does it fail? It failed many times in Latin America where you can announce an inflation target, make all sorts of speeches about the central bank, but you don't fix the deficit problem. Well, when you don't fix the deficit problem or the ham strong overregulated economy problem, the fire's still on. And sooner or later, it's all going to fall apart. That's exactly what happened. And it happens through expectations.
It is true. Where does inflation come from? Inflation equals expected inflation plus whatever pressure from real interest rates. Where does expected inflation come from? Well, central bankers would love it if expected inflation came from central banker speeches and forward guidance. We tell you that inflation will be low. You believe inflation will be low. Inflation goes away. Wouldn't it be lovely if all we needed was more speeches. In these episodes, what fiscal theory really tells you is what gets rid of expected inflation. By the way, that's the sticky price you were asking about. What gets rid of expected inflation?
When people understand we're in a new, durable, long run regime where our government is going to be able to pay back its debts, then we know there isn't going to be inflation in the future. And you just don't kill the expectations, but you going to have all the speeches and win buttons and the rest you want. When people see the government's going to be able to easily pay off its debts, then the inflation expectations fall like a stone. And the easiest way to pay off your debts is to let the economy grow. High tax austerity, everybody knows that's going to fall apart, because we need it over 20, 30 years. Paying back the debt is 20, 30 years. That only comes from long term growth. High tax austerity that kills the growth, that's like walking up a sand dun at best and then the sand dun avalanches. That doesn't work.
I've read a bunch of stuff recently from anthropologists and sociologists that look at the long histories of money, and I think a lot of it sounds fiscal. Do you think that we've always lived in a fiscal world?
No. Now, you're asking me to jump away from the US. Fiscal theory is very Chicago school. It's very hyper rational and equation centric, although I'm delighted if any anthropologist and sociologist wants to come along. But let's go back to money under gold coins. Now, is that fiscal or not? Not really. It's a monetary system that operates really independently of governments. Governments, they minted coins. They put their stamps on it, which helped the coins be easy. You didn't have to weigh it and sample it for how much gold was in it. That's a small role. It did involve... Governments made money on that business. But fundamentally, well, government's also were fairly irresponsible intended to default on their debts all the time. But governments were small. The gold coin system was international. So I would not analyze that system fundamentally. Once you get to paper money, then you start getting to money that is backed by whoever issues it's resources.
If a private bank issues paper money, then the value of that money, what is the resources of that bank to be able to repay that money? We start with John Law, who issued paper money in the 1710s, I think, in France, and it was backed by the great government revenues that the French Government was going to make from all the gold it was going to find in Louisiana. You know how much gold there is in Louisiana? Yeah. Well, now you know what happened to John Law's paper money, but that's the first time we start getting, I think, monies that are really backed by government resources. So it's not an always neverwhere theory. It's a theory about when we use as money something that the government issues, and the government stands behind with its ability to tax, then you have a fiscal theory of price.
Now, the theory of money that is bigger is the question of "Is money valued because it's backed?" Is the value of money because it is really a claim to something of real value? Or is money intrinsically worthless, but is valuable because it's a social convention and we all need to have this one thing to make our transactions? And real money's a bit of both. Gold coins often were more valuable in the market than their pure value of gold. Well, they had a little bit of that transactions liquidity value and a little bit of fundamental value. Reality actually was always a little bit between both.
And that's I think where fiscal theory will end up. Government debt is valuable as a claim to future surpluses, but government debt's also very useful in transactions. That's why it pays a lower interest rate than private debt. And so that liquidity value of government debt contributes to its value and to the price level. So we're a little bit… I think our current economy is closer to the pure, "Its valuable because of it's fundamental value," than "It's worthless, but value in trade," but a little bit of both is where we are always. And in the future, if governments inflate away our monies, we'll have to think of something else. And I'm all for thinking about… I'm a great free market libertarian. I focused on fiscal theory because that's the money we have right now, but designing private monies that are useful as stores of value, medium of exchange, numerators that don't involve governments, well, there's two routes: they're going to be backed or they're going to be intrinsically worthless and limited in supply.
Bitcoin was an effort at intrinsically worthless and limited in supply. The problem is its competitors aren't limited in supply. So that model I don't think is going to work for private monies, because it's always competing with private monies. If you want to have your libertarian fantasies, which I encourage, money is in a highly liquid competitive system. A successful private money will have to be backed by some real wealth other than the government's present value of taxes. So is that fiscal theory now? Well it's not the government's fiscal theory, but fiscal theory is part of the general theory that says, "If you want to design a good money, especially in a competitive environment, you got to design something that is credibly backed by something else." The backing theory. And if it's not backed by taxes, it's got to be backed by something else. And I think you can design backed cryptocurrencies completely independent of the government that are backed monies that will be stable in value that are not nearly so profitable to introduce as the current ones, which is why nobody's doing it. But that's, I think, the larger part of where we go.
And backed by…?
Something. Well, unfortunately backed by… So the first ones they tried were cryptocurrencies backed by other cryptocurrencies.
Yeah.
Pull yourself up by your bootstraps there. That didn't work out so well.
No.
Cryptocurrencies backed by Treasury Bills. If you want a stable coin, that's a great stable coin. Unfortunately you've just reinvented the money market mutual fund and you don't have a different… When the government deflates away the Treasury Bills, you're sunk too. So you need to design a cryptocurrency backed by real assets that are nonetheless liquid enough that you can maintain a stable price level or one-to-one. But that's for another show.
For the moment, until the great worldwide sovereign debt crisis, we're going to stick with what works and that's going to be money provided by the… And the government has a natural monopoly. There is no source of wealth as good for backing money as the taxes-less-spending of a competently run government. So there is a natural case for the government running this. If you have a portfolio of houses, we used to back money by houses. Banks would issue notes backed by loans against houses. That's a backed currency. But the houses aren't nearly as liquid or as flexible as taxes-less-spending of a government that isn't taxing at the top of the Laffer curve all it can. So let's hope that they don't screw up the current system. It's a pretty good one.
I want to follow up on the, "Did we always live in a fiscal world?" So the account that I've read of gold coins is that they varied greatly in their gold content, but always had the stamp of the issuer, which could be used to pay taxes. That sounds pretty fiscal.
Yes. Governments figured out that allowing worthless things to be surrendered and used for taxes was a way to give value to worthless things. So we've always been on the spectrum, but that wasn't always the case. So what happens? We start with gold coins that are good gold coins and full of value, and then they start trading at a little bit more than their gold value, because they're good coins and people hold them, and then governments say, "Oh, wow, here's a business to get into. Let's start burning up gold coins." And then governments discovered that if you make the coins underweight, they'll keep their value in trade, because of its liquidity value, and the government can get some of the gold. And now there's a temptation to make them less and less weight and to turn them into gradually fiat money and just profit off the value. You've discovered by gradually making less and less gold in the coins, you're on your way to paper money. But paper money to work has to be limited in supply. And of course the governments didn't want to limit its supply because they had deficits.
So Emperor Diocletian figured this one out. Well, didn't figure this one out, created one of the first big inflations in, I think, the sixth century. So, yeah, we're always on the edge between the pure backing value of a coin and the liquidity value of a coin if it's in limited supply, and then the temptation to print up more of that coin to finance your wars and art purchases and whatever else governments like to do back then, which causes inflation. The more it changes, the more it's the same thing.
Yeah. That sound like a fiscal story.
It is a fiscal story. Yes, yes, yes, yes. So it's a joint fiscal monetary story. So really any reality has some element of liquidity value of money above its backing value. Issuing money was a great business for 19th century banks too. And they tended to issue too much of it. It wasn't a fiscal deficit, it was a personal deficit for Leland Stanford's wine collection or whatever. The incentive to issue too much of the stuff is always there. The short run gain of I get it versus the long run loss of what we inflated away and then it's no good anymore. So these components are there in all of monetary history, including today.
Do you think individual citizens should behave any differently if we live in a fiscal world?
Well, I think we do live in fiscal world. Behave optimally. The big behavior question is how do you think about inflation? And we all have to think about inflation. But the most important thing for people is to understand there's a lot of risk and nobody really knows where inflation's going. But certainly as a citizen and a voter, I think if you don't like inflation you need to get a world in which we have long run, stable monetary fiscal institutions. It's not going to be fixed by Jay Powell waving a wand. And it's certainly not going to be fixed by budget shenanigans that make us look like we're reducing the deficit $5 in some reconciliation bill. You want to live in a serious country that allows long run growth, low marginal tax rates, and the kind of monetary fiscal policy that your grandmother told you'd want. So maybe that's the practical advice.
Yep, I think so. I'd like to pop back to crypto for a second. What happens to the dollar if more people start using cryptocurrencies?
Well, according to fiscal theory, nothing, because the value of the dollar is set by the present value of the government's taxes-less-spending. And if you don't want to use the dollar to make your transactions, well, I don't care. Sit on them as an investment. The value of them is not that you're using them to make transactions, the value of them is you're sitting on them. And whether you sit on them or use them is irrelevant, the first order. To a monetarist, of course, cryptocurrency transactions are a big threat because they undermine demand. That's more money supply. They undermine demand for the government's money and threat inflation.
Yeah. That's interesting.
As part of the general, monetarists were Chicago free market types. Yet if you're a monetarist, you have to be deeply suspicious of financial innovation, because financial innovation allows people to economize on the use of money and economizing on the use of money can lead to inflation or inflation instability. Well, who cares? Make transactions any way you want. Money is valued as an investment, not as a liquidity provision mechanism.
Cryptocurrencies are particularly… They're not very good for making transactions. They're called cryptocurrencies, but as a matter of fact, they're horrendously computationally expensive for buying cappuccinos. They are, for the moment, pretty good at hiding transactions from governments, anonymity. We've lost the anonymity of our money, if you don't mind a little libertarian rant. You used to have privacy in what you buy and sell. And as a result of the income tax, the great gargantuan government now more and more has the right to know every detail of your financial transactions. Now, part of that is because it's illegal, but you want to collect taxes. But crypto offers anonymity. I think that's, right now, its big sales point, plus speculation. Anyway, let's not get off on crypto. Let's get wherever we're going.
We were there, actually. I'm glad brought it up. I wanted to you, John the Libertarian, do you think that's a good thing? Anonymous, digital cash.
Yeah, I'm a good libertarian, but I'm a good "on the one hand, on the other hand" libertarian. So I'm profoundly worried about the Chinese system where the government knows every single transaction you make, even in the quest of enforcing. If we enforce every single law, which once you can afford transactions, you can afford every law you want. So instantly 11 million people living in this country without proper work authorization are out of work, living in the gutters. If we use federal surveillance of transactions to enforce every law, that's not good. If we enforce every tax law, every business in the country would go under. I really think anonymity of transactions is vital to political freedom. If you could look at every transaction any politician made, or any commentator, any blogger, and go find some dirt there, imagine. And then, of course, that'll be held by the government, right? The government will leak that promptly when the person's you know. That's crucial to your political freedom.
But we do have to have taxes. We have to enforce taxes. So to some extent you have to have some ability to check that stuff and cryptocurrencies being used by all sorts of fraud and hackers and so forth. But not every law is good. I think using cryptocurrency to evade Venezuela's and China's foreign currency laws is a wonderful thing. We want people getting money out of Russia illegally as fast as possible. It's not clear that enforcing other countries laws is a great thing. So the anonymity of transactions, I think it's very important, but there is a limit because of course you have to collect taxes and it is quite useful to fight crime by knowing where transactions are and crime is a problem. So I'll give you a 50/50 on that one. Central Bank digital currency. I think digital currency is very important. In fact, we talked a little bit about financial stability. We now have electronic money. And in the 19th century we said enough of this junk with the private bank notes, we're going to have a government monopoly on bank notes and we ended runs on bank notes. 2008 we had a run on the electronic money system basically and what we basically decided to do about it is nothing. We kept the private bank note system alive, but basically we are now in a regime that banks get to profit by issuing electronic money, banks and other financial institutions, and every time anything goes wrong, the federal government's going to bail them all out.
The unsung story of COVID is the massive financial system bailout. Our Fed bailed out the Treasury markets. The Fed bailed out the money market funds. Once again, the Fed put a Mario Draghi worthy "whatever it takes" put option on all corporate bonds. Guys, this cannot last. I'm all for a system where all short term, run prone, financial crisis prone debt, which means money, is backed by short term government debt. Until the great cyber debt crisis comes and they inflate that stuff away. But within that, we could have no private financial crises ever again if we got rid of all inside electronic money and instead… And if you want something that says it's always worth a dollar, no price volatility, and you can get your money right now if you want it, that has to flow through to either a short term Treasury Bills or reserves at the Fed. That would end financial crisis.
Now should the Central Bank directly provide that? There, I think is not such a good idea. The central debt asset exists. It's called reserves. Now, why don't we all have reserve accounts? As the Fed is in the news for its rationing of reserve accounts and letting politically favored people have it and politically unfavored people not have it, the Fed has, in fact, scandalously not allowed, it has denied, narrow banks the ability to have reserve accounts instead of giving them a gold star for financial stability. A narrow bank takes your deposits and puts them in reserves. A narrow bank cannot fail. A narrow bank cannot have a run. A narrow bank cannot go bankrupt. Why are they not getting a prize for financial stability instead of the Fed denying them illegally master accounts? I don't know. But then I think is you and me having an accountant at the Fed, we would get rid of run prone money and because the Fed can never go bankrupt, just print it up if it wants to. But forget your password, who you going to call? I don't think the Federal Reserve is particularly good at customer service at a retail level. If you talk to banks and credit card companies, they actually do a lot on fraud prevention. There is someone you can call if you forget your password. If someone screwed you out of money, there's something you can do about it. And the bank, they can implement the Fed's own "know your customer regulations." I think it'll be funny to watch the Fed try to implement Dodd-Frank regulations that apply to retail banking. Good luck to you, guys.
So all that says, direct Central Bank digital cards, I don't think it's such a great idea. Instead what's a great idea is narrow banks. Private, competitive financial institutions that take your money and handle your transactions, know how to run websites, know how to do password recovery, know how to do fraud protection, know how to do know your customer regulations. They flow that money straight into reserves, or better yet the Treasury should be offering reserves. The Treasury should offer fixed value, overnight debt electronically transferable. Why not? Why doesn't the Fed have to do that? And why does the Fed buy treasuries and then issue that stuff rather than Treasury just do it? So then we have a system of narrow bank payments companies that are competitive, service the customer well, but can never fail, 100% backed by short term Treasury debt. I think that's the answer. That's also the answer to privacy. Once the Fed watches every transaction you make, or the Treasury watches every transaction you make, you're one leak away from that embarrassing visit to whatever it is being public. But if it's held by a private company like a private bank now, well then the FBI and the Department of Justice have to get a subpoena before they can look at just how much beer you bought for a last Friday night's party. And I think that's also a good way to run that balance between privacy, political freedom, and controlling crime and taxation.
That makes sense, because I was going to follow up on privacy and ask about, what about all of the child porn and illegal drugs? With Monero, the truly anonymous cryptocurrency, being used for all that stuff and the North Korea money laundering all that kind of stuff.
Yeah, yeah. Well, there's good illegal and there's bad illegal. Yeah, we're always going to be on the end. There's a little bit of a problem of we're banishing people from the financial system, they're creating alternative financial systems as a result. So there's a sense of overusing that great ability. Maybe there's other ways to go after child pornographers other than monitoring every transaction of every citizen in the country.
Transactions are pretty good for monitoring though.
Yep. They're also very good at silencing political opponents.
Yeah, yeah. Of course. Yeah, absolutely. Last question. This has been fantastic. Other than your book being published, which I will buy the hard copy of so I can have it on my shelf back there because I've read it I don't know how many times I've read it, a lot, what's next for fiscal theory?
Well, it's nice of you to plug the book, though I will have to be honest, this is a book aimed at academics and it's full of equations because I think persuading the academics first is important. I want to advertise my article Fiscal Histories, which is a much shorter read and has no equations in it and tells some of the useful stories. I think stories come first, then equations then help you make stories precise.
So what's next? Well, I'm hoping to pass the baton. Fiscal theory has been a passion of myself and a small number of like-minded colleagues, particularly Eric Leaper, Chris Sims, Tom Sergeant, and a small number of academics. I think it's ready for prime time. The point of the book was to make this not just equations that a couple of pointy head academics play with, but a framework that central bankers can use. Now, we start with the academics. My hope with the book was to convince the thousands at central banks who run models to just change their models slightly to make them fiscal theory models, which I think will make them work a lot better and be logically more consistent. So that's part of an academic enterprise to get academics to use that approach.
The book is full of… If you're an academic listening, there's a thousand thesis topics in here. There's unanswered questions, all these stories we told about histories and policies and how do people, and all that needs analysis. This is a framework, a foundation. I wrote very, very simple models in here and it needs elaboration. We talked about effects like, "It matters who gets the money." M2 might be different from Treasury Bills. Well, we need to work that out and think about it. In the academic context, it points out some of the gaping holes in macroeconomics that we've had for 20, 30 years. And one of the biggest gaping holes is just why are prices sticky? Why does raising interest rates lower inflation in the short run? That is a gaping hole in macroeconomics. We've been working on it 40 years. And by treating it in the fiscal theory that removes some of the ways we glossed over it. That remains a gaping hole that I hope economists will get at. But really, take this on. Take this framework and use it. Everybody. That's what's I hope next. And I don't know where that'll go.
I know where I'll go, which is trying to track down some of these, especially that higher interest rates, lower inflation thing. My ambition for it is this is the framework we should be thinking about monetary policy and inflation with. I don't know all the answers, but I hope this is the framework that other people think of. So it asks a lot more questions than it answers. Once every 20 years we come up with a big book about inflation that kind of sets what's the framework for thinking about things in the future, and that's my ambition for The Fiscal Theory of the Price Level.
That's a good ambition. I'm not an economist, but I told you this by email a while ago, but your book on fiscal theory is the first time that monetary fiscal stuff made sense in my brain. At least you convinced me.
Well, thank you. And I'll say the same. You know what attracted me? I've been working on this since 1980. I found macro so confusing. In some sense, I went into it because I thought, "Oh, well this is full of," what's a polite word? You know what I'm looking for, but. "Confused theories that don't actually hold together." It's very simple. And I'm accused of some sense of that. It's the joke about the drunk who looks for his keys where the light is next to a lamppost. And that's absolutely true. This is a beautiful and simple theory. I don't know if it's right, but at least it hangs together better than everything I was taught when I was in grad school. That was attractive to me. So you give me great… If you can look at that book with its forest of equations and say you're learning from it, I'm extraordinarily happy. You don't have to understand the equations.
Yeah, I was going to say, I gloss over the equations.
You're allowed to gloss over the equations. The equations are repeat the words. To an economist, they make the words precise and they allow you to see and logically analyze the assumptions behind the words a little bit better. But I made an effort to make the words self contained so you could just ignore the equations.
Yep. I would say that was successful.
Well, thank you.
All right, John, this has been fantastic. We appreciate you coming back on the podcast.
This has been great. Thanks a lot, guys.
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