In this interview, John Cochrane discusses the relationship between government debt, inflation, and monetary policy, the risks facing the US economy, and whether policymakers have made another financial crisis more likely. We also explore the limits of central bank independence, the consequences of rising public debt, and the importance of economic growth.
About the Guest
John Cochrane is a Senior Fellow at the Hoover Institution and a Professor of Finance and Economics (by courtesy) at Stanford Graduate School of Business. He is also a Research Associate at the National Bureau of Economic Research and an Adjunct Scholar at the Cato Institute. His books include The Fiscal Theory of the Price Level and Crisis Cycle, and he authors the Grumpy Economist Substack.
Interview
Simon Sarevski: The Federal Reserve is supposed to be independent of politics, yet its decisions have enormous political consequences. Is greater independence always desirable, or can a central bank become too independent?
John Cochrane: The Fed has limited independence, granted by Congress for Congress’ purposes. It is a precommitment mechanism against intemperate policy. Like the rest of checks and balances, it should move slowly in response to politics. But it should move. Our democracy does not appoint completely independent czars to print money and hand it out as they see fit! The Fed’s independence is strictly limited by mandate – prices and employment means “and not anything else” like climate and inequality – by instruments – the Fed can move interest rates, borrow and lend, but may not hand out money or take it away, no matter how useful to controlling inflation and employment that might be – and by its accountability to Congress. So yes, central banks can be too independent. They can grab powers that should be reserved to politically accountable parts of the government. I think our Fed is about the right amount of independent. More on the Fed’s independence.
Governments responded to the pandemic with enormous spending, while central banks kept monetary policy unusually loose. What did policymakers get wrong about the inflation that followed, and have they done enough to prevent a repeat?
John Cochrane: Well, they got wrong that following spending and financing policies like we do in wars – spend like crazy, borrow and print money to finance it, no particular plan for repayment – was not going to produce the same inflation that occurs in and after most wars. The key fault, in my mind, was not having a clear plan for repaying all the extra debt and soaking up the money. They also mistook the pandemic for a “demand” shock that needed “stimulus” rather than just a minimal level of insurance. And the spending binge and zero interest rates continued for a full year after the pandemic and its economic dislocations ended. A crisis was too good to waste, I guess, on large-scale spending unrelated to the pandemic. (Europe did the same thing). The Fed made the mistake of believing its forecasts – that inflation would quickly go away – rather than reacting to the dumpster fire in front of it.
I think we are perfectly set up for a repeat. Neither government nor the Fed admits that the huge spending, accommodated by zero rates and huge Fed purchases, was behind the inflation. No, the Fed says it bought Treasuries because of some market dysfunction, and that inflation was due to some nebulous “shocks” beyond its control. A new crisis will come; the government will want trillions of money for bailouts, stimulus, and more; long rates will start to rise, the Fed will lower short rates and hold down long rates, and people scarred by what happened last time will start demanding higher long rates and raising prices even faster than before. Nobody is even attempting to confront what happened and set up a different response for next time: spend more wisely, have a plan for repaying the new debt, Fed allow rates to rise and not accommodate. More on inflation.
Inflation is always and everywhere a monetary phenomenon, or so Friedman claimed. But what if the problem is also that people increasingly doubt whether governments can manage their debts? Doesn’t a loss of confidence in a government’s long-term finances erode the value of its currency even without a comparable increase in the money supply?
John Cochrane: Well, you’re singing in my fiscal theory of the price level choir there. Inflation is always and everywhere a fiscal and monetary problem. Even Friedman recognized that most money printing occurs to finance out-of-control deficits, and won’t stop until the fiscal house is in order. Your last sentence expresses the central proposition of the fiscal theory of the price level beautifully. More on the fiscal theory of the price level.
When the Fed raises interest rates to fight inflation while the government runs large deficits, can the two policies end up working against each other? How much can the Fed accomplish without greater fiscal discipline?
John Cochrane: Exactly. Indeed, it’s worse than you think. If the Fed raises interest rates, that raises interest costs on the debt. For a 100% debt-to-GDP ratio, a 1% higher interest rate means a 1% of GDP worse deficit. If Congress does not raise tax revenue or cut spending 1% of GDP, that’s additional fuel on the inflationary fire. Most economic theories of monetary policy have a footnote somewhere stating that Congress tightens fiscal policy to pay interest costs on the debt, and the Fed loses most or all power to lower inflation without that. Woodford’s Nobel Prize-winning book, Interest and Prices: Foundations of a Theory of Monetary Policy, includes that assumption.
You don’t have to be an economist — or understand a balance sheet, for that matter — to notice that America’s debt keeps rising and that interest payments on it have become enormous, exceeding defense spending. How worried should ordinary Americans be? At what point does government debt stop being a problem for future generations and start threatening the economy today?
John Cochrane: About five minutes earlier than you expect it to do so! Debt crises are always unpredictable, because if you knew it would happen tomorrow, then you sell and it happens today. The problem is the plan to repay debt, slowly, over decades. That needs decades of small primary surpluses. It means basically entitlement and tax reform. I think bond markets believe that the CBO projections won’t happen because the US is a serious country and will eventually get around to a 1980s-style Social Security, health, and tax reform. Immigration reform and economic growth would help a lot too – more people is more GDP, more growth is more GDP, and more GDP is more tax revenue. But that faith can evaporate. I worry less about the bond vigilantes showing up some quiet morning, and more that the next crisis will lead to a replay of 2020-2021 on steroids, with a big flight from the bond market and sharp inflation.
In 2015, Rand Paul dressed up as the national debt for Halloween, when it stood at roughly $18 trillion. Today, almost 11 years later, it has passed $40 trillion. Why has persistent deficit spending become so politically normal? Is balancing the budget still a realistic goal, or should we be thinking about a different way to impose fiscal discipline?
John Cochrane: I think the government acts just like average Americans. For the last 20 years, real interest rates and thus real interest costs on the debt have been zero or negative. If you and your wife are shopping for a house, you go to the bank, and the bank says, “We’ll lend you the money at a -1% real rate of interest. We pay you a monthly check.” You say, “Let’s borrow every cent we can and buy the mega-mansion!” I would hope, though, that you would get the fixed-rate loan so that if rates go up you don’t lose the house! They looked at low interest costs, borrowed like crazy, and enjoyed the low monthly payments. But alas, the Treasury borrowed short, so now that interest rates are back to normal, the payments are kicking in.
Bottom line though, I think a combination of the usual pressures to spend and not tax, combined with ultra-low interest rates, made that inevitable. Having to pay a trillion bucks a year in interest costs on the debt may wake them up a bit.
——— Related: Daniel Mitchell on Fiscal Policy ———
Suppose inflation is 10%, but my wages rise by 15% and I end up being able to afford more than before. Why should I care about inflation? If we’re getting richer in real terms, what exactly is the problem with rising prices?
John Cochrane: Good point! Economists puzzle that the peasants with pitchforks are so alarmed about inflation. There are some good reasons, though. First, wages don’t typically go up 15%. They go up 5%. Wages eventually catch up with inflation, but it takes a while. Moreover, as a dean once said to me, “inflation is the dean’s best friend.” People who switch jobs or can get outside offers get raises. People who are a bit older or can’t switch jobs usually don’t get much in the way of raises. Ask old tenured professors how they like inflation! People on fixed incomes do a lot worse. Anyone who holds government bonds lost about 15% — inflation is the same as a partial default. So inflation means a lot of churn; some gain, some lose. Also, inflation makes it harder to compare prices, and prices lose their wonderful ability to communicate information. Indexing all contracts for inflation is a pain. Notice how it broke out in the 1970s, and then vanished as inflation vanished. Inflation doesn’t hit each area equally, too.
The question economists dread the most is being asked to predict the next crisis. So let me ask it anyway. Looking beyond the AI boom, do you see vulnerabilities in the global economy that could lead to another financial crisis on the scale of 2008, or an economic shock as disruptive as the pandemic? What risks, if any, do you think we’re underestimating?
John Cochrane: As you said… And if anyone could scientifically predict a crisis, it would already have happened. Still, lots to worry about. If you think our Fed can see vulnerabilities ahead of time, ponder their inability to see an elephant in the room at SVB – plain vanilla interest rate risk in Treasuries financed by large hot money uninsured deposits. Meanwhile, the Fed was studying “climate risk to the financial system.” So… crises come from a lot of debt that nobody knows how it will be repaid, shady accounting, rolling over short-term debt, and nobody thinks it can happen. That sounds like sovereign debt to me! There are plenty of smaller vulnerabilities too. AI stocks seem pretty rich. Stock crashes aren’t too bad, but there is a lot of debt in there too, and I don’t know who is exposed. Then there are lots of fundamental shocks that could cause big economic damage. A new pandemic (plague from Russia?), China moves against Taiwan, Russia moves against NATO, the Middle East blows up, and so on. We have such a fragile financial system, all of it buttressed by the expectation that governments and central banks will always be there to flood the system with cheap money, that when people figure out the government is out of steam, things could be pretty ugly.
——— Related: Davies & Harrigan on Cooperation & Coercion ———
When Greta Thunberg condemned what she called the “fairy tales of eternal economic growth,” she gave voice to a broader criticism: that society places too much importance on producing and consuming more. What do critics of economic growth get wrong, if anything?
John Cochrane: Everything. Pre-industrial life was nasty, brutish, and short. For most of the world, living like Greta is an unimaginable luxury. Once we all attain material comfort, growth can bring us health and longevity.
———— Related: Art Carden on Prosperity ————
After the 2008 financial crisis, the US introduced sweeping reforms, including the Dodd–Frank Act, to make the financial system safer and prevent future bailouts. Nearly two decades later, have these reforms made another crisis less likely, or have they mostly shifted the risks elsewhere?
John Cochrane: They’ve made it more likely. Dodd-Frank piled on more regulation while enshrining large leverage and too-big-to-fail guarantees. SVB showed its essential failure. 2020 had more bailouts on steroids. The Fed stepped into the Treasury market and decreed that the price of corporate bonds can’t fall! Some risks moved out of big banks to fintech. The right answer was for risk to move from overnight debt to equity. Stock price crashes are not a crisis. But banks make too much profit leveraging 10:1 to let that happen. More at “Toward a Run-Free Financial System”
Trillions of dollars are being invested in AI infrastructure, much of it concentrated among a relatively small group of companies. If the AI boom turns sour, could some of these firms become so large or interconnected that the government would feel compelled to bail them out, as it did during the 2008 financial crisis?
John Cochrane: Interconnected or politically connected? Bankruptcy is not a crater; it is a reorganization in which stockholders lose everything, bondholders lose a lot, and the company keeps going. But it’s politically awkward, and said stock and bondholders will scream “systemic risk.” I think the government, having never defined what “systemic” means other than “somebody somewhere might lose money on a mark-to-market basis,” will quickly intervene. Until Treasury yields spike and inflation breaks out.
Economists often disagree sharply over inflation, government spending and monetary policy. How much of this disagreement reflects genuine uncertainty about how the economy works, and how much reflects different political values?
John Cochrane: Inflation and monetary policy differences are mostly genuine uncertainty about how the economy works. What we really understand about that is a lot less than Fed officials pretend. Taxing and spending is more political. Notice the open letters from Nobel Prize winners backing wealth taxes that their own research says don’t work.
We’ve discussed some fairly technical topics, but many of our readers are interested in these questions because they affect their everyday lives. What books would you recommend to someone who wants to better understand how the economy affects their daily lives, without having studied the subject formally?
John Cochrane: Milton Friedman, Thomas Sowell, Marginal Revolution, and the Cato Institute are great places to start.
And finally, as I always ask our guests at Strixly: How do you find freedom in an unfree world?
John Cochrane: I don’t know about finding it. I know we have to understand it, understand its precious value, fight for it, and defend it.