26 July 2023

The Fiscal Theory of the Price Level

John H Cochrane
2023, Princeton University Press, 584 pages,
ISBN 9780691242248

Reviewer: Melissa Davies, Redburn

If high inflation and elevated interest rates threaten that sovereign debt sustainability will be the defining issue of this economic cycle, then the ‘Fiscal Theory of the Price Level’ is the defining theory and this, the defining book.

The last economic cycle upended many theoretical received wisdoms – that printing money would inevitably lead to high inflation, that interest rates approaching the lower bound could lead to a deflationary spiral, and that there was some level of government debt-to-GDP beyond which catastrophe would ensue. This arguably led to a false sense of security in the later years of the last decade and contributed to the vigour with which governments embraced coordinated monetary and fiscal policy during the pandemic, and their eagerness to continue with major stimulus programmes in its aftermath.

Cochrane’s ‘Fiscal Theory of the Price Level’(FTPL) provides an elegant theoretical framework for both explaining the experiences of the 2010s and why the change in policy regime in the 2020s has led to high inflation and interest rates – and what will be required to return inflation to ‘normal’.

At the beginning of Chapter 21, Cochrane neatly summarises how we got here and the profound risks posed by higher interest rates and inflation – and the difficulties we may face in steadying the ship:

“Inflation returned suddenly starting in February 2021. It looks like a classic fiscal helicopter drop. Government debt increased 30%. Three-fifths of the new debt consisted of new reserves. Much of the new debt was sent directly to people as checks. That mechanism suggests why people this time thought the debt would not be repaid but thought the 2008 and following deficits would be. Whether inflation will continue depends on monetary and fiscal policy going forward. Fiscal inflation will continue if people start to believe all debt will not be repaid. From the conventional point of view, monetary policy looks set to replay the 1970s. The fiscal theory point of view suggests that even apparently loose and slow monetary policy may not lead to galloping inflation on its own. Eventual stabilisation will have to include fiscal, monetary, and microeconomic stabilization. The shadow of debt will make that effort harder than it was in 1980s.”

At its heart, FTPL hinges on a simple relationship, based on an equation familiar to equity analysts – that the valuation of a company is linked to the discounted stream of its dividends. But, in the case of government, the real value of government debt is equal to the discounted value of future surpluses. FTPL gives fiscal policy an active role in the model of the economy which is missing from New Keynesian and monetarist approaches – both of which assume ‘passive’ fiscal policy which adjusts for the impact of monetary policy on the budget deficit.

The FTPL’s most eye-catching conclusion is that higher interest rates can lead to higher inflation – via the mechanism of deteriorating future surpluses and a decreasing value of real government debt (a higher denominator). But the insights do not end there. The book is a thoroughly worked-through technical tome, examining the implications and conclusions of the model. It is a book which I will revisit many times and I was greatly helped in understanding the arguments by reading Cochrane’s more accessible research papers on his website (which I would recommend).

Another important insight is that there is no difference, from an inflationary perspective, between ‘money’ and ‘bonds’. Monetarism hinges on such a difference and so FTPL necessarily draws quite different conclusions about the effects of QE and QT on the economy, and the significance of central bank balance sheet size in general. FTPL is also relaxed about the implications of cryptocurrency for inflation and the demand for money – in fact, as long as taxes continue to be settled in the domestic currency, there is no need for any transactional demand for money in Cochrane’s model. Individuals can pay however they choose – in fractions of share portfolios, in Ethereum – and the economy can still have a stable inflation equilibrium, as long as it has a credible fiscal framework.

Reliance on New Keynesian-type models in part explains the slow response of central banks to surging inflation in 2021 – without a fiscal explanation, the response to the shocks experienced at that time suggested by those models would have been to do very little and let the shocks pass. They were analytically incapable of capturing a fiscal regime shift and its implications. Now, simply trying to use interest rates to calm inflation through the cycle will not work if expectations of persistently looser fiscal policy have become entrenched.

Cochrane makes classic observations about the implications of unsustainable fiscal policy – that the resolution has to involve either growth, inflation, default or larger government surpluses. Governments will ‘default’ on entitlements long before they default on sovereign bonds, but selective government defaults are a common historical occurrence. Ignoring the threat of unsustainable government debt leads to currency risk, high inflation and rising risk premia. Should the worst happen, we may need new institutional structures, rules and the real asset backing of the central bank balance sheet.

We should not take for granted the period of calm in sovereign debt markets experienced over the last forty years – the unthinkable could happen if de-anchored fiscal expectations, inflation and higher interest rates act in a self-reinforcing spiral, colliding with ageing populations and rising entitlements. Crucially, this is not a fight that central banks can win by themselves, and trying to revolve these issues solely by monetary means could make the situation even worse.