Latest / The Capitalism and Freedom in the Twenty-First Century Podcast / On The Fiscal Theory of the Price Level and Economic Growth

Transcript

On The Fiscal Theory of the Price Level and Economic Growth · The Capitalism and Freedom in the Twenty-First Century Podcast

0:00
It's that time of the year.
0:02
Your vacation is coming up.
0:04
You can already hear the beach waves, feel the warm breeze.
0:09
Relax and think about work.
0:13
You really, really want it all to work out while you're away.
0:16
Monday.com gives you and the team that peace of mind.
0:19
When all work is on one platform and everyone's in sync,
0:22
things just flow, wherever you are.
0:24
Tap the banner to go to monday.com.
0:26
[MUSIC]
0:44
>> Jon Hartley: Welcome to the Capitalism and Freedom in the 21st Century podcast,
0:48
where we talk about economics, markets, and public policy.
0:51
I'm Jon Hartley, your host.
0:53
Today I'm joined by John Cochrane, who is an economist and
0:57
senior fellow at the Hoover Institution at Stanford University.
1:01
Previously, he was a professor of finance at the Chicago Booth School of Business.
1:06
John has just published his new book, the Fiscal Theory of the Price Level, which
1:11
is a fascinating theory about how the phenomenon of inflation, that is, the rise
1:16
in nominal prices in the economy, can be explained by fiscal and monetary policy.
1:21
Welcome, John.
1:22
>> John Cochrane: Thanks, Jon. It's a pleasure to be here.
1:24
>> Jon Hartley: So I wanna start by getting into how you got into economics.
1:32
First, you grew up in Hyde Park.
1:35
Your father was a history professor,
1:37
a renaissance history professor at the University of Chicago.
1:41
You were very interested in science, mathematic,
1:45
a lot of topics from a very young age.
1:47
You studied physics as an undergrad at MIT.
1:51
Then you applied to physics PhD programs and
1:55
then switched into economics later,
1:59
partway through your physics PhD program.
2:03
What got you interested in economics?
2:07
And I'm curious,
2:08
what was it being an economics PhD student at Berkeley in the 1980s?
2:13
>> John Cochrane: Yeah, it's a fun story.
2:15
And I worry that young people today can't do what I do,
2:21
that that flexibility is hard.
2:24
I was in the Major of the Month club for a while.
2:27
I went to MIT in physics.
2:29
[COUGH] And there were some experiences along there that
2:34
kind of said where I was headed.
2:36
I remember one, I was a young kid, and I was reading a story while we were in Italy
2:42
about the Italian government, they have poisonous snakes called vipers.
2:47
They wanted to get rid of the vipers.
2:48
So what they did was they offered a bounty of about $2 a viper.
2:53
And if you know any economics, you can guess what happened next.
2:56
The enterprising farmers of Tuscany figured out that they could raise vipers
3:00
at $2 a viper and send them truckloads of vipers.
3:03
So that kinda story stuck with me, anyway, as a physics majority.
3:07
And I took economics as my humanities distribution requirement, and then
3:13
decided the summer after I graduated that I didn't wanna do physics as a profession.
3:20
I knew I wasn't smart enough to be a theorist, and I had no talent at running
3:24
a lab, so I should find something else to do with my life.
3:26
I had loved my economics classes.
3:28
There was a couple of other sorta conversion moments in there as well,
3:33
where I understood that economics offered a way of analyzing
3:38
important problems without the claptrap of politics and
3:42
values and judgments and morality and so forth.
3:46
Once, one of the things that got me,
3:48
I saw the budget constraint facing a woman on welfare at the time,
3:52
where basically you earn 15,000 in $1 and they take away your apartment.
3:56
And I go, well, but that's me.
4:00
It's not about values and
4:01
morals, and it's just faced with that budget constraint, I do the same thing.
4:06
So that was really an eye opener, and I decided I liked it and
4:10
let's go change majors.
4:11
So get this.
4:12
Imagine you tried this today.
4:15
I'm into graduate school for physics in a bunch of places, and I wrote them.
4:20
We used to write letters on a hand typewriter, and I wrote them and
4:23
said, how about I change my major to economics?
4:26
Now, most of them, [COUGH] MIT, Harvard, Stanford, just laughed.
4:30
But Chicago and Berkeley said, sure, why don't you come join us?
4:34
This was August.
4:35
Come join us in September to an economics PhD program.
4:38
No pre-doc, no letters of recommendation from famous people.
4:41
Just here's a guy with a physics degree, pretty good grades.
4:45
Yeah, why not?
4:46
And so I went to Berkeley.
4:48
>> Jon Hartley: But you turned down Chicago for Berkeley.
4:50
>> John Cochrane: Yeah, I knew it snowed in Chicago, and
4:52
I knew it didn't snow in Berkeley.
4:54
And that's about the extent of my graduate school- And
4:58
you literally grew up in Hyde Park, too, so a bit of change of scenery.
5:01
Yes, it's an interesting question.
5:05
Turns out Berkeley was right for me.
5:07
As I look at Chicago's PhD program, I needed, as a physicist,
5:12
not knowing much economics, I loved my first year, micro and macro,
5:17
because it was supply, demand, equilibrium, optimum, welfare, just boom.
5:23
This was like a sophomore year physics problem set.
5:27
I was in California.
5:28
I had a hang glider.
5:29
It was a wonderful time.
5:31
[LAUGH] Whereas I know if I'd gone to Chicago, I've heard of Gary Becker's class
5:36
where the class is like, instead of, we're gonna the Slutsky equation today,
5:41
it was like, okay, why are McDonald's lines longer in the suburbs than the city?
5:46
And I would have gone, what the hell is this class about?
5:51
Now, it's been beautiful training for
5:53
a generation of economists to learn to think like an economist models.
5:57
And maybe I needed that in my life, but at that point, it was just right for me.
6:01
It turned out Berkeley was wonderful for general equilibrium.
6:06
Debreu was still kind of king there.
6:08
And it mounted a sustained critique on monetarism for
6:12
reasons I think had nothing to do with sort of their Keynesian proclivities.
6:18
But a lot of that stuck and became the heart of fiscal theory.
6:24
First off, I wanted a Chicago theory that survived all the very potent
6:29
critiques of monetarism that I had learned at Berkeley.
6:33
So [COUGH] mixing around is always good.
6:36
>> Jon Hartley: And so, I mean, there were a lot of others that were there
6:40
in Berkeley or at Berkeley in the early 1980s.
6:44
You had, I know James Stock was a classmate of yours,
6:49
and I think to some degree who you credit in giving
6:54
some good thinking toward fiscal theory.
6:58
And George Akerlof was your advisor.
7:02
I'm curious, it's a very interesting set of people
7:07
who were there at that time who were guiding your thinking.
7:12
Then you were hired from there to the University of Chicago.
7:17
And I'm curious, this is at the same time,
7:20
you're on the market the same year that Greg Mankiw was on the market.
7:24
And it's an interesting year for
7:27
macroeconomists on the market, to say the least.
7:32
When you got to Chicago as an assistant professor,
7:36
what was it like at that time in the 1980s?
7:39
Milton Friedman, I'm guessing, had already won his Nobel in the mid-70s and
7:44
sort of had left to Hoover, but probably still had some influence.
7:47
But I'm sure many were still there,
7:50
like Harry Johnson running his international seminar.
7:54
I think maybe Art Laffer had left by this point, along with Mondell.
7:58
But many, like Becker, Lucas and others, were there.
8:06
What was the department culture like when you joined?
8:08
>> John Cochrane: So it was wonderful for me to go to Chicago, and
8:11
I'm immensely lucky.
8:13
I've been immensely lucky my whole life, and it was immensely lucky.
8:16
I think I got my job because Lars Hanson found an interesting mistake in appendix C
8:21
of my thesis.
8:22
Imagine you're a job market candidate.
8:24
You walk in to Lars Hansen's office, and he kind of looks up and he says, now,
8:28
John, there's this interesting question in appendix C, if you're these.
8:33
I knew I had fudged Appendix C, but I did it.
8:37
>> Jon Hartley: Nobody was supposed to read that.
8:39
>> John Cochrane: Exactly.
8:41
It in many ways, intellectually, was a coming home.
8:43
I, of course, was already developing as a free marketer.
8:47
From my outside readings, I had discovered real business cycles only by browsing.
8:53
There was one rainy day when I couldn't go hang gliding, so
8:56
I went to read articles in the library and tracing down some unit root stuff,
9:00
ran across Kidland and Prescott, long and placer.
9:03
And I go, my gosh, this is wonderful stuff.
9:07
And so going to Chicago was home.
9:11
Now everybody always thinks the good old days are just over.
9:14
So everybody thought, well, you got here too late.
9:17
You missed the great rational expectations revolution.
9:20
But it turned out that it was the dynamic programming revolution.
9:26
Real business cycles were in full swing.
9:28
But the macro workshop run by Bob Lucas was the Bellman
9:32
equation takes on one more thing this week.
9:35
And it was very wide ranging from development to growth to optimal dynamic
9:40
public taxation.
9:42
I'm sorry, I got the optimal public apple.
9:45
Dynamic public finance.
9:46
That's the word I was trying to say.
9:48
>> Jon Hartley: I think people just call optimal taxation these days, I don't know.
9:51
>> John Cochrane: Well, it was dynamic and sarcastic at the time.
9:54
Of course, Lars was working out the.
9:57
Not the post GMM stuff, and he had just turned to finance.
10:00
I turned to finance.
10:02
So it was an incredibly exciting time.
10:05
And now I look back on that.
10:07
Yeah, that was the good old days.
10:08
Bob Lucas by the way, once said, people look back at Chicago and say,
10:11
it must have been the good old days.
10:13
No, we always thought that all the action was happening in Cambridge, and
10:17
we were just stuck in some cow town.
10:19
But turns out that Chicago, the 60s, was the good old days too.
10:23
And I've just learned a tremendous amount.
10:27
It's wonderful to go to a new place and meet new people and
10:31
be thrown into the deep end and learn to swim.
10:34
And what's great about Chicago is partly where again,
10:37
I worry about our profession these days.
10:40
You know, I went straight there from grad school.
10:41
No postdoctoral stuff threw me in the deep end.
10:45
I taught three different PhD classes every year where I had just tool up and
10:51
they really cared that those were taught right.
10:54
>> Jon Hartley: And you've taught, like micro, macro and metrics.
10:59
>> John Cochrane: Yep.
11:01
>> Jon Hartley: I can't say that I've met anyone else that can claim that feed.
11:05
>> John Cochrane: Well, that's where you only learn things by having to teach them.
11:08
And I learned, I learned.
11:11
I learned a lot by being there.
11:13
It was a very.
11:15
Now I'm told that I was different by being so brash, but
11:20
I experienced it as place that wasn't very rank conscious.
11:25
People were in their offices.
11:27
So I just walked into Lars Hansen's office or Bob Lucas's office or Gene Fama's
11:32
office and talked to them like colleagues, and they talked to me like colleagues.
11:37
I gave them comments on their papers and they gave me comments on mine, and
11:41
nobody told me, you weren't supposed to do that.
11:44
But it's just a tremendous learning experience.
11:49
We need to flatten our institutional cultures.
11:53
I don't see that now.
11:54
People, at booth, young people, stopped giving me comments on my papers and
12:00
just said I should give comments on their papers,
12:03
and I kind of missed that, that flat.
12:06
We're all rowing the boat together ethic that I experienced at the Chicago
12:10
department.
12:10
>> Jon Hartley: Well, I think there's also just fewer comments, maybe in seminars in
12:14
general now, like there's always these famous Chicago seminar things where you
12:19
can't even get three minutes and you can't get through your first slide.
12:24
I feel like that's a very Chicago kind of thing where now I feel like people
12:29
wanna be nice and understandably,
12:31
you wanna maybe allow somebody to get to the more important parts of their slides.
12:36
>> John Cochrane: I don't know what talks you're going to.
12:39
I haven't seen anybody.
12:41
In fact, I think.
12:42
>> Jon Hartley: Or maybe nicer relative to there's the.
12:44
Some places have the.
12:45
You can interrupt 10 minutes in or something like that.
12:50
I think Chicago does not have any rules of that nature.
12:54
>> John Cochrane: No, in the 80s,
12:55
my experience of the culture was that it was productive.
12:58
In the 80s that, well, first of all, people didn't go on for
13:01
three quarters of an hour on introduction and motivation and literature.
13:05
They just got to the point.
13:07
And then there was a.
13:10
It wasn't the Milton Friedman era, where you would do the paper page by page and
13:14
everyone had to read it ahead of time.
13:16
But it was sharp discussion.
13:19
Bob Lucas was wonderful.
13:21
He ran the macro workshop.
13:23
There was always sort of a king of a workshop,
13:26
and he wouldn't allow long speeches, the kind of things you see now where,
13:29
like you said, on the introduction, people are giving long speeches.
13:33
That didn't happen because Bob wouldn't let it happen.
13:36
And Gene Fama and Mert Miller ran the finance workshop similarly.
13:40
And there was incisive discussion, but
13:43
not the kind of grandstanding that tends to happen these days.
13:49
>> Jon Hartley: Very fascinating.
13:50
And I'm curious, you moved over to the booth school
13:53
from the Department of economics at the University of Chicago.
13:56
How did you get interested in finance in particular?
13:59
Because it's interesting how you've come back to sort of
14:04
macroeconomics with fiscal theory, the price level, and
14:09
all your work sort of is actually both macro and finance, but
14:14
certainly the consumption c CAPM, consumption asset price,
14:19
asset pricing models are sort of very finance sort of topics.
14:24
I'm curious, what led to your interest in finance in your earlier work,
14:30
what led you to meeting your co authors who were indispensable
14:35
in that part of your career, and also not only studying asset pricing,
14:41
but things like health insurance, where you've had a lot of influence?
14:48
What got you interested in that sort of financing side of your work?
14:52
>> John Cochrane: One of the wonderful things of our profession, if you let
14:56
it be, is our tools are simple and you can range pretty widely if you want to.
15:01
I feel sorry for scientists who at the age of 22 specialize in the 32nd spectral
15:05
line of chromium, and that's what they're gonna do for the rest of their lives.
15:10
Hope I didn't get that one wrong.
15:11
And we can range widely now, there's some cost in that sort of number
15:17
of papers goes down if you're playing a strategic game of careerist game.
15:24
There's some cost of not just being the expert on some specific thing, but
15:28
I've always loved the ability to range widely.
15:32
And also life, there's lots of little.
15:35
Life is full of little chances that move you around in unpredictable ways.
15:39
So the idea of when we're interviewing job candidates,
15:42
I never listen to the what are your research plans?
15:45
Because I know, just throw that out.
15:47
Your research plan should be what interesting thing takes you and
15:51
I've never known where I was going.
15:53
So my story is I started with money and interest rates.
15:57
My thesis was money and
15:58
interest rates heavily colored by time series econometrics.
16:02
Tom Rothenberg at Berkeley was a god.
16:05
So Roger Crane, Tom Rothenberg, and
16:07
George Akerlofs were the holy trinity of where I started from.
16:11
And I learned a lot of time series by reading Tom Sargent's books.
16:14
So I had started on money, interest rates with spectral analysis,
16:19
moved kind of into time series macro,
16:21
hanging out mostly with Lars Hanson at the time he was moving into finance.
16:26
That really sparked my interest in finance.
16:30
One big part of my interest in finance was my wife took the finance PhD
16:35
classes at the Booth School and asked me for help on the problem sets.
16:41
So every Monday night, [LAUGH] we were working those problem sets together.
16:46
And so I kinda secretly took George Constantini's PhD class.
16:50
Also, back in Chicago, we used to take each other's classes.
16:54
So as an assistant professor, I took Lars Hanson's time series finance class.
16:59
I took other classes in asset pricing, I took Jim Hepburn's econometrics class.
17:04
I took Rob Townsend's design class.
17:09
>> Jon Hartley: As a faculty member.
17:10
>> John Cochrane: As a faculty member.
17:10
>> Jon Hartley: This is something that Sargent talks about a lot, right,
17:13
in his sort of words of wisdom.
17:15
He suggests even faculty members should at least take one class a year or
17:18
something like that.
17:19
>> John Cochrane: Yeah, and I keep meaning to do it and haven't gone back to that,
17:23
but I'm sure.
17:23
So that was a formative experience.
17:26
So I just got interested and started doing financy stuff for those reasons.
17:31
And my interest in finance coincided with not getting tenure at the department and
17:36
being offered a tenure job at Booth.
17:38
So it kind of looked like the fates were aligning that
17:43
I should go over to Booth, which was a great experience.
17:49
Booth and the Eugene Fama aura is very fact-based.
17:54
And so you have to learn the facts of finance, which really helped.
17:59
And teaching, again, very important for me to teach the PhD classes and
18:03
MBA classes in finance, right, where I learned what finance was all about.
18:08
And so the combination of time series, macro real business cycles, and
18:13
then my increasing interest in sort of the beauty of late 80s,
18:17
early 90s macro-finance models produced what I was doing in finance at the time.
18:23
>> Jon Hartley: So how did you meet John Campbell?
18:26
And can you explain, in simple words, what consumption-based asset pricing is and
18:33
how that was sort of built on what had come before with sort of basics of CAPM,
18:39
and Bill Sharp, and Harry Markowitz, and sort of that 1960s period?
18:44
>> John Cochrane: Yeah, all economics, like good science works backwards.
18:48
And we start with the complicated thing, and we end up with the simple thing.
18:51
And consumption-based asset pricing is asset pricing.
18:56
It just took us 30 years to figure that out.
18:58
So if you read my book, Asset Pricing, we do not build up from the older,
19:03
simpler ones and consumption-based is the queen of it.
19:06
That's the history of thought.
19:08
The fact is this is the simplest model.
19:11
And it basically says, how can I say this in one sentence,
19:17
that why are people scared of holding stocks?
19:23
Why don't they hold more stocks, given the great returns of stocks?
19:26
And the answer is because stocks tend to do badly in recessions when you're cutting
19:31
back on your consumption.
19:32
So when you're particularly hungry and wish you could look to your stock
19:36
portfolio and sell some stocks, is exactly when the stocks are doing badly.
19:39
The question of all asset pricing is why do people fear stocks and
19:43
not hold more of them?
19:44
And that's the answer of consumption-based asset pricing.
19:47
So it's a natural.
19:48
And it also, technically, if you come from a real
19:53
business cycle,1990s macro context,
19:57
it just theory of asset pricing just falls out of that naturally.
20:03
So it's intellectually very clean way of doing things.
20:07
And it fits in with this huge empirical fact-base of facts,
20:12
which is what's wonderful about asset pricing.
20:15
>> Jon Hartley: I know your Campbell Cochrane can [INAUDIBLE] assets pricing.
20:22
>> John Cochrane: Yeah, again my theme is don't try to plan your life cuz you
20:26
never know how to work out.
20:27
Just go lots of places, meet lots of people, and
20:30
little billiard balls will strike and something interesting will happen.
20:33
So I got to know John Campbell, he like Greg Menke was the star of our generation.
20:39
And I met John first at a NBER asset pricing conference,
20:43
where we had kind of dueling papers on unit routes and random walks.
20:47
So we got to know each other there and saw each other at other conferences.
20:50
And we were at a conference in an NBR asset pricing conference in Wharton.
20:55
And I had been working on production-based asset pricing, and
20:58
I kinda had some ideas of what I wanted to do next.
21:01
And John thought that this was about how to track risk
21:05
premiums varying over the business cycle.
21:08
And that was kinda the technology end, and John sort of had the production end.
21:12
And we said, well, why don't we work together on this?
21:15
That's how that started.
21:16
And that actually was a collaboration entirely by Internet or
21:21
the nascent Internet at the time.
21:24
I would work on it for a couple months, dump it in his lap.
21:26
He would work on it for a couple months, dump it in my lap.
21:29
We actually were together only for a couple of days at a vacation house in
21:33
Massachusetts that my family used to go to.
21:36
And I regret not working more with John.
21:40
We both have kept meaning to go back and finish that project.
21:43
That project was supposed to end with a theory of business cycles,
21:47
a theory of general equilibrium, and this was just the first of many.
21:51
But then he got busy in household finance and I got busy on other things.
21:54
It never happened, which is too bad.
21:56
>> Jon Hartley: Amazing Cambridge Chicago collaboration.
22:01
And so interesting to that it was probably fairly early Internet days.
22:06
So fast forward here, you're now at the Hoover institution in a good
22:12
part of the 2010s and you spent on top of starting the grumpy economist blog,
22:18
which is a fantastic blog that I'm sure many of our listeners read.
22:23
And if they are not reading it, they should.
22:26
You have spent a good chunk of recent years, the late 2010s and
22:31
early 2020s, working on fiscal theory of the price.
22:35
Going back to your dissertation and getting back to this question of money and
22:41
prices, not just asset prices, but prices of everyday goods.
22:46
And thinking about inflation, this is a project that you've been
22:50
working on perhaps longer than anything else, which I think is fascinating.
22:55
Can you explain just to a layman, what the fiscal theory, the price level says?
23:00
>> John Cochrane: Yeah, it says that inflation fundamentally comes from more
23:05
government debt than people will think the government
23:09
will repay by the excess of tax overspending.
23:12
So it's the same theory as prices present value
23:16
of dividends applied to government debt.
23:18
The value of government debt is what people think the government will be able
23:23
to pay back.
23:23
And if they don't think there's enough value there,
23:26
they try to dump the government debt.
23:27
And the only way to dump the government debt is to buy other stuff, and
23:31
that drives up the price level.
23:32
So that's the basic theory.
23:33
Now, it comes from a 40-year search.
23:37
As he mentioned, I started really getting interested in money and
23:41
inflation in graduate school and trying to find a theory that had sort of
23:46
Chicago [COUGH] analysis, but fit the critique of monetarism that I learned and
23:51
I think was correct at Berkeley.
23:53
I was looking at it for a long time, wrote my thesis on money and inflation.
23:56
[COUGH] Ran into just a comment on the way to a seminar by Mike Woodford,
24:01
who pointed me to some of the important early work.
24:05
>> Jon Hartley: This is at Chicago, probably in the 80s.
24:08
>> John Cochrane: Early 90s, actually.
24:09
>> Jon Hartley: Okay, he didn't leave for
24:11
Princeton until- >> John Cochrane: Yeah,
24:12
we were in Chicago together.
24:14
And so, he just, he pointed me to one crucial point that got it going.
24:20
I actually wrote on it in the 90s.
24:23
I wrote a paper I thought I was gonna do for Friedman and Schwartz, fiscal theory,
24:28
in six months, that didn't work out.
24:30
But the paper taught me lots of other things and
24:33
I just kept plugging away on it until I knew in the mid 2000s that I needed
24:38
to write a book to put it all together in one place.
24:41
And I kept trying to do it and I kept not having the time to do it.
24:46
And then Hoover came along and gave me the time to finally finish it.
24:50
So here we are all these years later.
24:52
Fantastic.
24:53
>> Jon Hartley: And it's so interesting how fiscal theory, the price level,
24:57
has its roots in a lot of research that's
25:00
been done by macroeconomists like Eric Lieper and Mike Woodford.
25:06
What I think is so interesting about the fact that a lot of the early fiscal theory
25:10
papers were in part written by Woodford.
25:12
He since obviously moved on and has been arguably the leading figure in building
25:18
new Keynesian DSGE models, dynamic stochastic general equilibrium models,
25:24
which also culminates in his magnum opus, interest in prices.
25:28
I think your book fiscal theory of the price level is very similar
25:34
in that it's trying to serve a similar function in describing
25:39
a theory of inflation, but of course, one that's very different.
25:45
I'm curious, you do have some versions of fiscal theory of the price level
25:51
in your book that sort of comport with new Keynesian models.
25:56
And you have a whole chapter, a pretty substantial chapter or
26:00
set of chapters in your book that talk about integrating physical theory at
26:05
the price level into the so
26:07
called workhorse DSGE models that are used by central banks around the world.
26:12
I'm curious, why should those central bankers have your book on
26:16
their shelves right next to interest in prices, Woodford's interest in prices?
26:21
>> John Cochrane: Cuz it's right, now they are not really that much competitors.
26:27
Mike's book was sort of the once every 20 years book on monetary policy of that era.
26:32
And what was so important about Mike's work is he took seriously
26:37
the fact that central banks set interest rate targets.
26:41
And I love Milton Friedman and MV equals Py, but
26:44
central banks do not set money supplies.
26:47
>> Jon Hartley: They tried in the 80s and they failed.
26:49
>> John Cochrane: For a brief period.
26:50
>> Jon Hartley: And they sort of realized that money demand,
26:53
they couldn't really control it very well.
26:56
>> John Cochrane: You want to talk about monetary policy,
26:58
you have to start with I, not M.
27:00
Central banks set interest rates.
27:03
And Mike, the whole new Keynesian project, one of the things that I
27:07
think distinguishes it, it takes that really seriously.
27:11
And in fact, now there's some problems with it,
27:14
which go read the book if you want to see some problems with it.
27:17
But one way to view fiscal theory is that it repairs those problems, but
27:22
then imports 95% of the rest of the structure.
27:25
So one should always build on the good things of what came before.
27:31
And so it certainly builds on that.
27:33
And in particular, explicit economic modeling, dynamic modeling.
27:39
We think about the economy not as each day in isolation, but when you think about how
27:43
much you want to spend today, you think about what you got left for tomorrow.
27:48
So dynamic optimization is the fancy word for that.
27:52
And writing down equilibrium models,
27:54
all that stuff is great of the new Keynesian tradition.
27:59
And if you want to think about central bank policy mattering and
28:03
inflation mattering, you have to have some sticky prices or something.
28:08
You can import all of that.
28:10
But then there's some theoretical problems with it that you fix.
28:13
When you fix those theoretical problems, you get quite different answers, and
28:17
you start paying much more attention to the need for monetary and
28:21
fiscal policy to act, get together.
28:24
Fixing that theoretical problem then opens a window to a whole bunch of stuff that
28:28
they knew about, but kind of swept into footnotes and may not have mattered back
28:33
in an era when debts were small, but actually matters a whole lot more now.
28:37
So I view it not so much as a competitor, but I hope a worthy successor.
28:41
>> Jon Hartley: We'll see what Woodford thinks about it, certainly, or
28:44
at the very least, bringing public finance back to the fore.
28:47
Because it's so interesting, I think about the new Keynesian framework and
28:51
how, in general, we've thought about inflation or
28:54
approaching inflation over the past few decades.
28:57
Is that really it should be, we should just be focused on interest rates.
29:01
In fact, it's ISLM in many respects, without the m, right?
29:06
>> John Cochrane: Yeah, let me be specific about that.
29:08
>> Jon Hartley: But I'm saying what you're saying is sort of a deep contrast
29:11
with that.
29:12
Even those that don't aren't necessarily familiar with it technicalities of
29:16
the models.
29:17
The sort of common wisdom of the past 30 years or so, or
29:21
maybe prior to 2008, was that it was just central banks and
29:26
interest rates that should be controlling social.
29:30
Whereas you're saying public finance, rather than just being something that is
29:34
just an assumption that we make on the back end that's not very important,
29:39
has to be brought to the fore.
29:40
>> John Cochrane: So, in standard new Keynesian models,
29:43
like in monetarist thinking, the central bank is completely in charge of inflation.
29:49
So, what just happened in 2021 cannot happen,
29:52
which is something else causes inflation.
29:55
The Fed does nothing.
29:56
I mean, 2021, whatever you want to complain about,
29:59
the Fed is not because they did anything to interest rates,
30:01
because they just left interest rates absolutely alone for a year.
30:05
So, this just cannot happen in a view of the world that inflation is always and
30:09
everywhere, just the central bank.
30:11
Now, fiscal theory says, hey, a huge deficit like that can cause inflation,
30:16
that the central bank doesn't do anything.
30:19
But that's an example of how you just repair a slight little theoretical
30:24
problem in the new Keynesian Woodford wave, and all of a sudden you see
30:29
something that just can't even happen in those models for concreteness.
30:34
So, I'll mention another one.
30:36
If the Fed raises interest rates today,
30:38
that's going to raise the interest costs on the debt, and today that's huge.
30:43
Every 1% that the Fed raises interest rates,
30:46
the Congress has to come up with $250 billion more interest cost on the debt.
30:52
Now that's all sort of in a footnote in Woodford.
30:55
Yeah, sure, they'll just come up with the money.
30:57
Wait a minute, maybe they won't come up with the money.
31:00
So by thinking more clearly about the fiscal part, you're led to ask,
31:03
well what happens if the Fed raises interest rates in Congress?
31:06
Does nothing, raise taxes $250 billion each time they do it?
31:11
>> Jon Hartley: So I guess this leads me to another question, and
31:14
this is something that Eric Lieper's worked a little bit on.
31:18
What do you think about fiscal policy rules?
31:20
Like, in the sense when we think about John Taylor's work, and
31:25
John Taylor was one of these great new Keynesian economists,
31:29
arguably, the Taylor rule is the one part of the whole DSGE sort of
31:34
framework that actually really works well empirically.
31:39
But I'm curious, sort of taking what you said,
31:43
that fiscal policy matters in determining inflation.
31:47
What do you think about fiscal policy rules in the sense
31:52
that if we really wanna keep inflation in a low and
31:57
stable, doesn't that suggest that there.
32:01
That there should be some sort of implicit, not necessarily written
32:05
mechanical rules, but rules in the sense that the, for example, the Eurozone,
32:11
in order to join the Euro, you need to have your destiny, GDP under control.
32:16
I'm curious if that's sort of one maybe corollary of
32:21
fiscal theory, the pricing in terms of managing.
32:26
>> John Cochrane: Yeah, I'm a little frustrated as a child of the 1980s that so
32:29
much 1980s economics is getting forgotten.
32:31
One thing that seems to be forgotten is the central insight of rational
32:36
expectations, that we think about policy as a rule, as an institution,
32:40
not as what are we going to do today.
32:43
And fiscal theory, like new Keynesian theory,
32:45
has that feature that you need to think about policy in terms of rules and
32:50
institutions and expectations for how things are gonna happen in the future.
32:54
So I'll mention both the Taylor rule and the fiscal rule, which was your question.
32:59
The Taylor rule actually,
33:00
being offices next to people is important because I love John Taylor.
33:05
And so I needed to think about, well,
33:07
what do we do about a Taylor role in this model, and it wasn't initially obvious.
33:11
The Taylor rule is a lovely example of something where the answer stays the same
33:15
when the questions just keep changing.
33:17
And in this case, that's not a criticism, that's a strong advantage of it.
33:24
In sort of traditional ISLM models, the Taylor rule, those models are unstable,
33:29
the economy just blows up if the Fed doesn't do anything and
33:33
the Taylor rule stabilizes them.
33:36
In Woodford's new Keynesian models, it's already stable on its own,
33:40
the Fed doesn't have to do that.
33:42
But the Taylor rule removes multiple equilibrium, totally different thing, but
33:46
it's good for a totally different reason.
33:48
Fiscal theory models, they're already stable and
33:51
they don't have multiple equilibrium.
33:53
But it turns out the Taylor rule works really well not to stabilize the economy,
33:59
but to lower the volatility of inflation.
34:02
So if fiscal shocks are coming along, those will cause inflation.
34:07
If the central bank follows the Taylor rule,
34:10
it smooths them out almost exactly optimally.
34:12
That's totally different economics, but again, that particular
34:16
rule turns out to work really well in lots of different kinds of models.
34:20
Fiscal rules.
34:21
Now, once now that fiscal policy is important,
34:24
fiscal rules ought to matter too.
34:26
And in fact, the key that fiscal theory points to is,
34:29
it is not a theory of debt and deficits cause inflation.
34:34
It's always a theory of debt and deficits relative to what people think
34:37
the government can repay over the long run, causes inflation.
34:41
Today's debt can be huge,
34:42
today's deficits can be huge if people think it'll get paid.
34:46
So getting people to really trust the government, you're borrowing a lot today,
34:50
but you'll pay it back tomorrow, that's the key.
34:53
So you can have huge deficits and huge debts, so
34:56
long as you persuade people you're gonna pay them back.
34:59
Well, good rules, traditions, constitutional limits,
35:03
all that's institutions,
35:04
those are the keys to getting people to believe it'll be paid back.
35:08
So number one, yes, fiscal rules, traditions,
35:12
institutions are crucial to price level stability.
35:17
In fact, the gold standard is in fiscal theory, the price level,
35:21
it's just a fiscal commitment that we're going to come up with the taxes needed to
35:26
get the gold.
35:27
Well, that's a way, it's an example of a fiscal rule that's really good,
35:31
not perfect, we don't want to go back to the gold standard.
35:35
And then there's a second level that it would be,
35:38
fiscal theory points that it would be really useful.
35:41
In times of inflation you want to commit that you're cutting back,
35:45
and if times of deflation you want to commit that you're not cutting back.
35:49
That's just as hard, for whatever reason,
35:53
our governments wanted more inflation in the 2010s.
35:57
And even Japan, which did stimulus after stimulus,
36:00
was never able to convince people that it wasn't gonna pay back the debt.
36:04
So a negative fiscal rule that says as long as there's deflation we're gonna be
36:08
spending like drunken sailors, that would help stop deflation as much as a positive
36:13
fiscal rule that says if inflation ever breaks out, trust us, it's austerity and
36:18
we can't stop it.
36:19
That's really helpful for limiting inflation.
36:22
>> Jon Hartley: Absolutely, so just on the topic of John Taylor,
36:26
you sort of have this prediction now about the Taylor principle and
36:31
the Taylor principle, sort of part of the Taylor rule in a sense,
36:36
which says that the central bank optimally needs to raise nominal interest rates,
36:42
more than one for one with inflation, in order to get real positive interest rates.
36:48
And you don't think that's necessary in part because you
36:53
think really sort of fiscal issues are more dominant.
36:58
Is that fair to say what your prediction is?
37:01
>> John Cochrane: If you work out the standard fiscal theory models and
37:04
you have to think through models, the key of economics is don't make it up,
37:09
have a model.
37:10
So we'll just, I'll refer to the simplest possible models in fiscal day,
37:14
the price level, chapter five.
37:16
And one says if there's a fiscal shock and the Fed does nothing,
37:20
leaves interest rates alone, that inflation will come and
37:23
then it'll slowly melt away after we've inflated away the debt.
37:26
So going on that basis,
37:28
it's okay if the Fed does not move interest rates more than one for one.
37:33
In fiscal theory experiment two however,
37:36
if the Fed responds by raising interest rates one for one or less,
37:40
not more than one for one, I was a little bit glib there.
37:44
If the Fed does raise interest rates in response to inflation, it doesn't have
37:48
to go all the way up to inflation, in fact, it should be less than inflation.
37:52
That will bring down current inflation at the cost of some future inflation and
37:56
help stabilize things.
37:58
So the Taylor principle, in the fiscal theory model, it shouldn't be more than
38:04
one for one, it should be one for one or less, unless the inflation will go away.
38:09
It'll just go away faster if the Fed follows that modified Taylor principle.
38:14
>> Jon Hartley: So one last question here, John.
38:17
You spent a lot of time talking about also economic growth on top of inflation.
38:22
And I'm curious, over the past few years,
38:25
since we've seen this big inflationary jump, since I think,
38:30
may of 2021, we've seen a lot of very thoughtful people,
38:35
whether it's the Federal Reserve, other parts of the federal government,
38:41
within the Biden administration, within the media, within academia,
38:46
say this is all supply constraints and supply driven.
38:51
And it's interestingly been the first time in quite some time when we've heard this.
38:56
And I remember in my sort of textbook, first economics class in high school,
39:02
trying to explain the inflations of the 1970s and
39:06
1980s all being supply shocks and
39:09
not really talking about the role of the Fed or, say, the Arthur Burns Fed.
39:16
I'm curious, do you see a sort of parallel in that debate today where maybe
39:21
some people would say it's this recent inflationary burst?
39:25
Or it's all supply shocks and fiscal policy,
39:29
all the big recent run up of debt has nothing to do with this.
39:35
What do you say to those critics of a sort of fiscal argument of being
39:41
the cause of the recent early 2020s inflationary spiral?
39:46
>> John Cochrane: Well, two points here.
39:47
So a supply shock like you can't get TVs in through the ports,
39:50
that's gonna raise the price of TVs relative to other things.
39:53
Price of oil is in trouble, then that's the relative price of oil.
39:56
So don't confuse relative prices and the price level.
39:59
The price of TVs could go up and wages could go down.
40:02
Why is it that that makes everything go up?
40:05
So inflation always has lots of relative price changes, but
40:08
the phenomenon is the price of everything going up.
40:11
So in one sense, that kind of says prices wouldn't go up if people didn't
40:16
have the money to spend on the goods that are [LAUGH] in short supply,
40:21
then we would just have the wages go down.
40:24
So it has to be to turn into inflation.
40:26
The supply shock has to be validated by the increase in demand,
40:31
if you will, by the extra.
40:33
And really, the consensus view of the 70s is the oil shocks would
40:38
have been a relative price change.
40:40
And then it induced the Fed and the government to validate so
40:45
that the relative price change meant oil prices went up and
40:49
nothing else had to go down, and then they overdid it and everything went up.
40:54
Similarly, Europe has an energy, no question,
40:56
they have an energy supply shock.
40:58
They don't have as much energy.
40:59
What are they doing about it?
41:00
Giving people money in order to buy energy.
41:02
Well, you can tell what that's gonna do.
41:04
So a supply shock only turns into general inflation if
41:09
there's also the increase in demand.
41:12
But the word supply, the aggregate supply, inflation,
41:16
does tell us we're at the aggregate supply limit.
41:19
So in that sense of not enough supply, I wish our friends
41:22
on the left who are saying supply shock, supply shock would pay more attention,
41:27
because it just means stimulus, secular stagnation, we're done with that.
41:32
If you want growth now, you gotta get more productivity, and
41:36
so go back to growth theory.
41:38
So that sense of supply mattering is important.
41:40
And the final point, it is kind of just distressing for someone.
41:45
I was a teenager in the 70s, and young economist in the 80s.
41:50
We're seeing all the same arguments over and
41:53
over again as if we had not done this just before.
41:55
I mean, in the early 1970s, inflation came out.
41:58
What did people say?
41:59
It's just a supply shock.
42:00
It's greed, it's profiteering, it's the great chicken monopoly.
42:04
Well, not that one, but just about the other ones.
42:08
Then they said then, it's a union wage bargaining, different sources of power.
42:14
We got to 1980, and all the Keynesians saying, we can't,
42:17
we just need to raise the inflation target, because we can't possibly,
42:21
it'll take forever and too much unemployment to get rid of this.
42:24
Exactly what you're hearing right now.
42:26
The lesson of rational expectations that you can have a painless disinflation,
42:31
that central Tom Sargent lesson seems to be completely forgotten and we just seem
42:35
to be having the same arguments all over again, which is kind of sad.
42:39
>> Jon Hartley: But just on this topic of economic growth and
42:42
being at the supply limit, you have long, just over the past decade,
42:48
argued that this 2% real economic growth number that we
42:53
have sat at is something that we can get out of.
42:57
Not through more fiscal stimulus, spending more to raise aggregate demand,
43:02
but instead we can have structural microeconomic reforms together.
43:08
Has that sort of view shifted at all in this post-pandemic world that
43:12
we're now in?
43:13
Do you think that we can sort of get to a 4% sort of GDP growth sort of level,
43:21
even with population falling, or at least not growing as much?
43:27
In China, they just reported their first negative population growth number.
43:31
I think since they've been keeping track of these things,
43:35
has sort of COVID and talking about supply shocks revised
43:38
in your thinking about what is possible in terms of economic growth?
43:43
>> John Cochrane: I think has confirmed my thinking that we were at the supply
43:46
limit all along and now we've got to talk about the supply limit.
43:49
The problem is there's a branch of economists who I love, growth theorists,
43:53
but they talk about the long run growth potential of the economy, the accumulation
43:57
of innovation, and they write down economies where there are no frictions.
44:01
We are exactly at the absolute best we could possibly be.
44:06
Now, I look around the world and I'd love to do growth theory.
44:09
I'm just not smart enough to do growth theory.
44:12
[LAUGH] It's a land of its own.
44:14
It's very important.
44:15
But the big debate about growth acts as if there are no frictions,
44:20
no regulations and taxes in the US economy holding us back.
44:25
So then the question is,
44:27
well, how much before we get onto the flights of fancy of growth theory and
44:31
endogenous growth and population and stuff like that, to what extent is the US
44:36
economy held back by all the obvious Adam Smith microeconomic distortions?
44:41
And I think it's a lot, but people make fun of me of that, but
44:45
I just look around the world.
44:46
So let's look at Europe.
44:48
Europe is about 40% GDP per capita below the US.
44:52
So there's no question, if Europe just adopted us institutions,
44:56
there's 40% to go.
44:58
We don't have to go all endogenous growthy, and they promised us jet packs,
45:03
but they only gave us Twitter and all that stuff.
45:05
There's 40% lying on the table.
45:08
Just moved from Europe to UK economic institutions and
45:11
Europe's economic institutions are pretty good.
45:14
Let's go to- >> Jon Hartley: You don't
45:16
think it could be a cultural labor leisure thing?
45:19
You spent a lot of time in Florence and your earlier years.
45:24
You don't think that there could be sort of other
45:27
non-institutional reasons for- >> John Cochrane: Europeans used to work
45:30
on Saturdays.
45:31
In the 60s and 70s, they made fun of the British,
45:35
because they took the whole weekend off, whereas Europeans work on Saturdays.
45:40
Europeans work like crazy given the incentives to work.
45:44
And we are Europeans, you and me are Europeans.
45:48
What is there about moving over here that all of a sudden that culture changes?
45:52
So there was Europeans back in the 60s and 70s worked really,
45:58
really hard and they had miraculous economic growth.
46:03
Let's go to India.
46:04
Also, we're talking 40% here.
46:08
We're talking major stuff.
46:08
India, we're at 60,000 per capita GDP.
46:13
India is 2,000 per capita GDP.
46:16
Now, Indians are perfectly hard work.
46:19
They work like crazy, too.
46:21
But we don't have to get endogenous growth and theories of innovation and
46:26
technology to understand that India just needs to free up its markets a little bit.
46:31
And the amount of growth it could get by just good old microeconomic Adam Smith is
46:36
like 2,000 to 60,000.
46:38
That'll give us a 4% growth rate for a couple 100 years just to do that.
46:42
So I look at the US and I love the US, but it's not perfect either.
46:46
And so maybe war is far off of free market Nirvana as Europe is to the US.
46:54
So there's 40% of cumulative growth,
46:56
there's ten years of 4% growth right there.
46:59
If we just clean up the obvious pathologies of the US that are clearly
47:04
on the level, Europe isn't that much worse than the US.
47:09
So I think clearly you just look out the window at the difficulties of lots of over
47:14
regulated our healthcare and our banking, at what it takes to get our permit to
47:19
rehab a house in Palo Alto, and you got a sense that things could be made better.
47:24
So the argument is that 0.1% growth or a couple percent, well,
47:28
look at Europe's not that much worse than the US and there's 40% there to be had.
47:33
So I do think my policy view lies in the not very interesting.
47:39
In between everything is stimulus or inequality and the growth theorists
47:44
who are worrying about how could free market Nirvana US grow even faster?
47:50
Well, let's get rid of the sand in the gears,
47:52
I think is actually an underappreciated source of growth and
47:55
just looking across countries, I think, makes that obvious.
47:59
>> Jon Hartley: Absolutely, you think about how far Singapore has come
48:04
from being part of Malaysia 60 years ago and it's enormous.
48:09
>> John Cochrane: We can do catch up growth.
48:11
Catch up growth is supposed to be easy.
48:13
Even the US could do catch up growth.
48:14
Just catch up to yourself US.
48:16
>> Jon Hartley: Absolutely, and you think about East Germany versus West Germany,
48:21
you think about South Korea versus North Korea.
48:25
These are all kinds of fantastic natural experiments in economic growth that really
48:29
show that institutions really do matter for growth.
48:32
Well, thank you so much John for joining us today.
48:34
This has been a real, real pleasure to have you on.
48:38
It's fascinating both following your career and
48:42
your thoughts on everything from finance to inflation to economic growth.
48:49
It's a real pleasure, thank you so much, John, for joining us.
48:51
>> John Cochrane: Thank you, and good luck with the podcast.
48:53
[MUSIC]