An Important View on Inflation and Policy

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John Cochrane’s Unpleasant Fiscal Arithmetic
Mar. 15 2011 - 4:47 pm | 1,914 views | 0 recommendations | 1 comment

U. Chicago Booth School professor John Cochrane.
Today’s big economic questions are paradoxical and confusing. Deflation? Or wild inflation? A dearth of demand? Or way too much spending? The proposed answers don’t differ by shades of gray. They are binary opposites.

University of Chicago economist John Cochrane sees through the fog. Value the nation’s fiscal picture like a stock, and then integrate it with monetary policy. The result – which says the real value of nominal government debt equals the present value of future primary surpluses – is a new lens on an unprecedented combination of unorthodox Federal Reserve action and Treasury expansion.

Referring to the successful hedge fund that sponsors his Booth School academic post and his eager MBA students seeking work there, Cochrane playfully amends his title to “The (I-can’t-get-you-a-job-at) AQR Capital Management Professor of Finance.” The irony is that if Washington spent a little more time listening to him, many more Americans would have jobs.

Cochrane’s new model, published in the January European Economic Review, explains why the booming monetary base has not yet, to the consternation of many hawks, produced a proportional measured inflation. Yet Cochrane also shows how the inflationary “tipping point . . . can come quickly and unpredictably . . . without strong ‘demand’ and small ‘gaps’.” In other words, inflation has little to do with fully utilized industrial capacity or tight labor markets. Inflation is a change in the value of money based on the expected interplay of government finance, central bank credibility, and economic growth. And $100-oil and $1,400-gold could of course be the first rumblings.

Milton Friedman taught us that “inflation is always and everywhere a monetary phenomenon.” But what if fiscal policy is driving the monetary bus? Budget crises in the states, $10 trillion in new U.S. debt over the next 10 years, and another $80 trillion (or so) in unfunded liabilities create enormous incentives to inflate.

Beyond its management of the panic, however, many of the Fed’s extraordinary actions have had seemingly modest effect. More than $1 trillion in excess bank reserves sit idly on its balance sheet. QE2 and its exotic monetary siblings are causing wild swings in commodities and international markets, but the Fed’s preferred measures of domestic inflation remain tame – too tame, even, for its own liking. When will Washington figure out the chief limiter on employment and growth is not a too-shy monetary policy?

Cochrane’s bigger concern with QE2 is term structure. The Fed is shortening the maturity of U.S. debt when just the opposite is called for. The financial crisis should have reminded us about the dangers of short term debt. You may think you are solvent, but if you can’t roll over your debt, you are not. Long term debt, on the other hand, acts as a shock absorber. You may pay a bit extra, but you will not go bust. With rates so low, why not lock them in for 30 years?

Cochrane is the author of a bible of finance called Asset Pricing but in recent times has been piercing the pieties of macroeconomics.

When everyone else complains of China’s supposed currency manipulation and its big purchases of U.S. debt, Cochrane retorts: “The right policy is flowers and chocolates, or at least a polite thank you note.”

On the Dodd-Frank financial reform: “This law isn’t really law. It’s just a piece of paper that tells people to write regulations.” There’s “no definition of what is not systemic.” By contrast, “I have a view of what ‘systemic’ means: run-prone contracts with externalities.”

When John Cassidy of the New Yorker asked, “If you were hired as head of the White House Council of Economic Advisers, what would you tell the President?” Cochrane didn’t hesitate: “I’d get fired in about five minutes. I’d start with a broad deregulatory approach to health care reform. There, I just got fired.”

Surely, Cochrane must agree with the conventional wisdom on the euro, that more central harmonization is key. Wrong again. “A currency union,” he wrote in The Wall Street Journal, “is strongest without a fiscal union.”

This is fundamental. A currency union prevents individual members from devaluing to gain (illusory) advantage. With devaluation off the table, they must abide fiscal reality. A true fiscal federation, likewise, prevents a central authority from harmful taxation and profligate spending and thus reduces its incentive to inflate. The fiscally decentralized United States, under the common dollar of Alexander Hamilton, operated under these classic checks and balances for many prosperous decades. More recently, Washington’s fiscal and monetary activism, beyond its own shortcomings, loosened fiscal restraints on the states. Hello, Illinois and California.

Today’s Europe has big problems, and the euro currency takes much of the heat. But among other virtues, the euro has exposed unsustainable anti-growth fiscal and regulatory practices of its member nations. If Europe can manage its way through the immediate trouble, the euro could prove the turning point for a new, more economically vibrant continent.

And this is the ultimate lesson distilled from Cochrane’s equations. It is the rate of economic growth – indeed, the expected rate – that is paramount. “The present value of future tax revenues is what matters,” Cochrane writes. And although the exact shape of the Laffer Curve can never be known, Cochrane takes it seriously. A “high marginal tax and interventionist policy which stunts growth can be particularly dangerous for setting off a fiscal inflation.” Government actions that reduce the prospective growth rate by just 0.3%, he estimates, would put us at the “fiscal limit” of monetary policy today.

Perhaps not coincidentally, Cochrane’s new work in finance confirms the centrality of expected growth. Once upon a time, we thought dividends drove the market. But Cochrane finds that cash flow variation accounts for approximately zero percent of market variation. In fact, changes in discount rate expectations account for about 100% of variation across most securities and markets.

Inflation is a government’s attempt to bail out itself. Former Obama CEA chairwoman Christina Romer, writing in the New York Times, now advises an even larger and more explicit dollar devaluation. Governments would be wiser to bail out themselves – and everyone else – through private growth.