Inflation and Debt - John Cochrane

8/2/2019 Inflation and Debt - John Cochrane

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Jo H. Cocr is the AQR Capital Management Distinguished Sevie Pess Finane at the nivesity Chiag Bth Shl Business, a eseah assiate the

Natinal Bueau Enmi Reseah, and an adjunt shla at the Cat Institute.

Copyright 2011. Al l r ight s reserved. See www.Nat ionalAf fa i rs .com for more information.

Inflation and Debt

John H. Cochrane

Fr vr r, h b h r among economistsand policymakes aout wete we ace a seious isk o ination.

Tat deate as ocused lagely on te Fedeal Resee especially onwete te Fed as een too aggessie in inceasing te money supply,wete it as kept inteest ates too low, and wete it can e elied onto eese couse i signs o ination emege.

But tese questions miss a gae dange. As a esult o te edealgoenments enomous det and defcits, sustantial ination couldeak out in Ameica in te next ew yeas. I people ecome conincedtat ou goenment will end up pinting money to coe intactale

defcits, tey will see ination in te utue and so will ty to get id odollas today diing up te pices o goods, seices, and eentually

wages acoss te entie economy. Tis would amount to a un on tedolla. As wit a ank un, we would not e ale to tell aead o time

wen suc an eent would occu. But ou economy will e pimed oit as long as ou fscal tajectoy is unsustainale.

Needless to say, suc a un would unleas fnancial caos and e-newed ecession. It would yield stagation, not te ination-ueledoomlet tat some economists ope o. And tee would e essentiallynoting te Fedeal Resee could do to stop it.

Tis concen, detailed elow, is adly conentional wisdom. Manyeconomists and commentatos do not tink it makes sense to woyaout ination igt now. Ae all, ination declined duing te f-nancial cisis and susequent ecession, and emains low y post-wastandads. Te yields on long-tem Teasuy onds, wic sould ise
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wen inestos see ination aead, ae at al-centuy low points. Andte Fedeal Resee tells us not to woy: Fo example, in a statementlast August, te Fedeal Open Maket Committee noted tat mea-

sues o undelying ination ae tended lowe in ecent quates and,wit sustantial esouce slack continuing to estain cost pessues andlonge-tem ination expectations stale, ination is likely to e suduedo some time.

But te Feds iew tat ination appens only duing ooms is toonaow, ased on just one intepetation o Ameicas exceptional post-

wa expeience. It oelooks, o instance, te stagation o te 1970s,wen ination oke out despite esouce slack and te appaent sta-

ility o expectations. In 1977, te economy was also ecoeing om aecession, and ination ad allen om 12% to 5% in just two yeas. TeFed expected ute modeation, and sueys and long-tem inteestates did not point to expectations o ige ination. Te unemploy-ment ate ad slowly declined om 9% to 7%, and ten as now teconentional wisdom said it could e ute loweed toug moestimulus. By 1980, owee, ination ad climed ack up to 14.5%

wile unemployment also ose, peaking at 11%.

Oe te oad sweep o istoy, seious ination is most oen teout oseman o an economic apocalypse, accompanying stagna-tion, unemployment, and fnancial caos. Tink o Zimawe in 2008,Agentina in 1990, o Gemany ae te wold was.

Te key eason seious ination oen accompanies seious economicdiculties is staigtowad: Ination is a om o soeeign deault.Paying o onds wit cuency tat is wot al as muc as it used to eis like deaulting on al o te det. And soeeign deault appens not inoom times ut wen economies and goenments ae in toule.

Most analysts today een tose wo do woy aout ination ig-noe te diect link etween det, looming defcits, and ination.Monetaists ocus on te ties etween ination and money, and tee-oe woy tat te Feds ecent massie inceases in te money supply

will unleas similaly massie ination. Te iews o te Fed itselae lagely Keynesian, ocusing on inteest ates and te aoemen-

tioned slack as te dies o ination o deation. Te Feds inationawks woy tat te cental ank will keep inteest ates too low otoo long and tat, once ination eaks out, it will e ad to tame.Fed does, meanwile, tink tat te cental ank can and will aise


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ates quickly enoug sould ination occu, so tat no one need woyaout ination now.

All sides o te conentional ination deate eliee tat te Fedan

stop any ination tat eaks out. Te only question in tei minds iswete it actually will o wete te ea o ige inteest ates,unemployment, and political acklas will lead te Fed to let inationget out o contol. Tey assume tat te goenment will always aete fscal esouces to ack up any monetay policy to, o example,issue onds acked y tax eenues tat can soak up any excess moneyin te economy. Tis assumption is explicit in todays academic teoies.

Wile te assumption o fscal solency may ae made sense in

Ameica duing most o te post-wa ea, te size o te goenmentsdet and unsustainale utue defcits now puts us in an unamiliadange zone one eyond te ealm o conentional Ameican mac-oeconomic ideas. And seious ination oen comes wen eentsoewelm ideas wen actos tat economists and policymakes donot undestand o ae ogotten aout suddenly emege. Tat is teisk we ace today. To popely undestand tat isk, we must fst un-destand te ideas undelying ou deates aout ination.

h

Te Fedeal Resee, and most academic economists wo opine on pol-icy, ae an essentially Keynesian mindset. In tis iew, te Fed managesmonetay policy y canging oenigt inteank inteest ates. Teseates aect long-tem inteest ates, and ten motgage, loan, and oteates aced y consumes and usiness oowes. Lowe inteest atesdie ige demand, and ige demand educes slack in makets.Eentually tese tigte makets put upwad pessue on pices and

wages, inceasing ination. Hige ates ae te opposite eect.Te Feds mission is to contol inteest ates to poide just te

igt leel o demand so tat te economy does not gow too quicklyand cause excessie ination, and also so tat it does not gow tooslowly and sink into ecession. Ote socks like canges in oilpices o natual disastes tat aect supply o demand can inuence

te tigtness o slack in makets, so te Fed as to monito teseand atully oset tem. Fo tis eason, most Fed epots and OpenMaket Committee statements stat wit lengty desciptions o tendsin te eal economy. Its a toug jo: Een Soiet cental plannes, wo


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could nee quite get te pice o coee igt, did not ace so dauntinga task as fnding just te igt inteest ate o a complex and dynamiceconomy like ous.

Te Fed descies its ecent unconentional policy moes using tissame geneal amewok. Fo example, te ecent quantitatie easingin wic te Fed ougt long-tem onds was descied as an altenatie

way to ing down long-tem inteest ates, gien tat sot-tem atescould not go down ute.

One seious polem wit tis iew is tat te coelation etweenunemployment (o ote measues o economic slack) and inationis actually ey weak. Te cats elow sow ination and unemploy-

ment in te United States oe te past seeal decades. I slack andtigtness doe ination, we would see a clea, negatiely sloped line:Hige ination would coespond to lowe unemployment, and ice

esa. But te cats sow almost no elation etween ination and un-employment. Fom 1992 to 2001, ination and unemployment declinedsimultaneously. Moe alaming, om 1973 to 1975, and again om 1978to 1981, ination ose damatically despite ig and ising leels o un-employment and ote measues o slack.

o Uo: 1966-1984

Unemployment Rate

In

fationRate

14%

12

6

8

10

0

2

4

10%9876543

72

71

197069

67

1966

1980

79

78

7776

7574

73

68 1984

83

82

81

Souce: St. Louis Fed.


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6%

1

0

3

2

4

5

o U o : 1985-2011


Unemployment Rate

InfationRate

5 6 7 8 9 10%43

1990 91

92

9395

87

8889

090807

06

05

0304

0201

2000

99 98

97

9694

1985

2010

2011

86

Tis lack o coelation sould not e supising. I ination weeassociated only wit ooming economies, Zimawe wic expe-ienced ougly 11,000,000% ination in ecent yeas sould e te

icest county on eat. I dealuing te cuency yielded stimulus andimpoed competitieness, ten Geeces many dealuations in te de-cades eoe it joined te euo sould ae made it te eny o Euope,not its asket case.

Moeoe, coelation is not causation. In te Feds iew, slack andtigtness ause ination and deation. Tee is een less suppot otis iew tan o te idea tat slack, o te lack teeo, can elialy

eastination.Keynesians ae awae o tese diculties, o couse, and tey ae

an answe: expectations. In essence, tey ague tat a oomlet can oc-cu i te pulic can e supisedwit ination. I people ae ooledinto tinking ige pices ae eal, teyll wok ade. I peopleknow ination is coming, owee, tey will just aise pices and wages

witout canging tei economic plans o actiities. Tee eally is anegatiely sloped cue in te cats, tey would ague, ut an incease

in expected ination sis te wole cue up. Since expectations aead to measue independently, tis iew is ad to dispoe, ut tatalso means it is ad to use o anyting moe tan stoytelling aete act.


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In tis analysis, te stagations o 1973-75 and 1978-81 epesentedinceases in expected ination, wile te decline in ination omte 1980s to 2000 wic occued witout sustantial inceases in

unemployment epesented a Fed ictoy in conincing people tattey sould expect lowe ination.Tese iews ae eident in Fed caiman Ben Benankes July 13 tes-

timony eoe te House Financial Seices Committee:

Reasons to expect ination to modeate include te appaent sta-ilization in te pices o oil and ote commodities, wic isaleady sowing toug to etail gasoline and ood pices; te

still-sustantial slack in U.S. lao and poduct makets, wicas made it dicult o wokes to otain wage gains and o fmsto pass toug tei ige costs; and te staility o longe-temination expectations, as measued y sueys o ouseolds, teoecasts o poessional piate-secto economists, and fnancialmaket indicatos.

To Benanke, costs, slack, and expectations die ination and not

te money supply, o te national det. In tis iew, monitoing testaility o long-tem expectations is ital, as is making sue tatexpectations stay ancoed. We do not want people to espond tolittle lips o ination wit a ea tat long-tem ination is aout toeak out.

So ow does te Fed know wete expectations ae stale? Tecental anks moe extensie epots mio te logic o te quoteaoe: Tey point to sueys, oecasts, and low long-tem inteest ates.But te toule is tat sueys, oecasts, and long-tem inteest ates didnot anticipate te ination o te 1970s. Fo example, te cat on tenext page plots te inteest ate on ten-yea Teasuy notes and te ina-tion ate oe te past ou decades. I long-tem inteest ates oeedeliale wanings o ination, we would see te inteest ates ise beeinceases in ination. Tat does not appen. Appaently ancos canget unstuck quickly, and ination can supise te ond maket as well

as te Fed.Teeoe, to tust tat stagation will not eak out, we need someundestanding owhy expectations migt e ancoed. As many aca-demic economists and Fed ocials see it, te anco is a elie in


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te Feds undamental tougness and commitment to fgting ina-tion. Today, in tis iew, people eliee tat te Fed will espond toany meaningul ination y aising inteest ates muc moe quickly

and damatically tan it did in te 1970s no matte ow ig un-employment is, o ow loudly Congess and te pesident sceam tatte Fed is tottling te economy wit tigt money, o ow muc tecedit constaint and sae te anks cowds insist tat te Fed iskilling te anking system, o ow many tempoay actos, costsocks, o ote excuses analysts can come up wit to explain awayemeging ination.

o r r

Fe. 82 Oct. 95June 68

Mont

July 09

Ination

16.0

10-Yea Teasuies

0.0

2.04.0

6.0

8.0

10.0

12.0

14.0

Rates


Expectations ae een moe cental in te New Keynesian teoiespopula among academics and cental-ank eseac stas aound te

wold. Tese teoies old tat te Feds announcement o its inationtaget sould by itsele enoug to coodinate expectations, and ocete economy to jump to one o many possile multiple equiliia.

Tis line o academic teoy is making its way into policy analy-sis. Fo example, Intenational Monetay Fund cie economist OliieBlancad ecommended last yea tat te Fed induce some moe in-ation in ode to stimulate te economy, and agued tat, to do so,te Fed needed simply to announce a ige taget. Tis iew also

elps to explain te Feds gowing commitment to communicating itsintentions. Fo example, te Feds majo stimulatie action oe tesumme was its announcement tat inteest ates would stay low o along time in te utue; it did not make any concete policy moe.


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Tis iew is in many ways eminiscent o te wage-pice spialtinking o te 1940s, o een te Wip Ination Now uttons tatFod-administation ocials used to wea on tei lapels. I we just talk

aout lowe ination, lowe ination will appen.But ae ination expectations eally ancoed ecause eeyonetinks te Fed is ull o awks wo will aise ates damatically at tefst sign o ination? Does te aeage peson eally pay any attentionto Fed pomises and tagets, so tat ination expectations will coodi-nate towad watee te Fed wants tem to e?

Yet i neite a widespead elie in te Feds tougness no te co-odinating action o te Feds ponouncements is te key to te stale

expectations we ae seen o te past 20 yeas, wat does explain tem?One plausile answe is easonaly sound fscal policy, wic is te centalpecondition o stale ination. Majo explosions o ination aound te

wold ae ultimately esulted om fscal polems, and it is ad to tinko a fscally sound county tat as ee expeienced a majo ination. Solong as te goenments fscal ouse is in ode, people will natually as-sume tat te cental ank sould e ale to stop a small uptick in ination.Conesely, wen te goenments fnances ae in disaay, expectations

can ecome unancoed ey quickly. But tis link etween fscal andmonetay expectations is too oen unacknowledged in ou conentionalination deates and its not only te Keynesians wo ignoe it.

h r r

Fo 50 yeas, monetaism as een te oemost altenatie toKeynesianism as a means o undestanding ination. Monetaists tinkination esults om too muc money casing too ew goods, atetan om inteest ates, demand, and te slack o tigtness o makets.

Monetaists today ae plenty o eason to woy, as te moneysupply as een allooning. Beoe te 2008 fnancial cisis, ankseld aout $50 illion in equied esees and aout $6 illion inexcess esees. (Resees ae accounts tat anks old at te Fed;tey ae te most impotant component o te money supply, andte one most diectly contolled y te Fed.) Today, tese esees

amount to $1.6 tillin. Te monetay ase, wic includes teseesees plus cas, as moe tandubledin te past tee yeas as a esulto te Fedeal Resees attempts to espond to te fnancial cisisand ecession.


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Monetaists ea tat suc inceases in te quantity o money po-tend ination o a simila magnitude. Fo example, in a 2009 Wall Steet

Junalop-ed, economist Atu Lae waned:

Get eady o ination and ige inteest ates . . . Te unpec-edented expansion o te money supply could make te 70s lookenign . . . . We can expect apidly ising pices and muc, mucige inteest ates oe te next ou o fe yeas . . . .

In an inteiew wit te Wall Steet Junalealie tis yea, PiladelpiaFed pesident Cales Plosse issued a moe muted (ut simila) waning:

We ae all tese excess esees sitting in te anking system, atillion-plus excess esees . . . . As long as [te excess esees] aejust sitting tee, tey ae only te uel o ination, tey ae notactually causing ination . . . i tey ow out too apidly, we willpotentially ace some seious inationay pessues.

Wile I also woy aout ination, I do not tink tat te money supply

is te souce o te dange. In act, te coelation etween ination andte money stock is weak, at est. Te cat on te next page plots te twomost common money-supply measues since 1990, along wit cangesin nominal goss domestic poduct. (M1 consists o cas, ank esees,and cecking accounts. M2 includes saings accounts and money-maketaccounts. Nominal GDP is output at cuent pices, wic teeoe in-cludes ination.) As te cat sows, money-stock measues ae not wellcoelated wit nominal GDP; tey do not oecast canges in ination,eite. Te coelation is no ette tan te one etween unemploymentand ination.

Wy is te coelation etween money and ination so weak? Te iewtat money dies ination is undamentally ased on te assumption tattedemando money is moe o less constant. But in act, money demand

aies geatly. Duing te ecent fnancial cisis and ecession, people andcompanies suddenly wanted to old muc moe cas and muc less o any

ote asset. Tus te sap ise in M1 and M2 seen in te cat is not estundestood as sowing tat te Fed oced money on an unwilling pulic.Rate, it sows people clamoing to te Fed to excange tei isky secui-ties o money and te Fed accommodating tat demand.


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o G o U: 1990-2011


(All seies ae 100 log gowt since 1990, and detended.)

Money demand ose o a second eason: Since te fnancial cisis,inteest ates ae een essentially zeo, and te Fed as also statedpaying inteest on ank esees. I people and usinesses can ean 10%

y olding goenment onds, tey aange tei aais to old littlecas. But i onds ean te same as cas, it makes sense to keep a loto cas o a ig cecking-account alance, since cas oes geat li-quidity and no fnancial cost. Feas aout oads o esees aout toe unleased on te economy miss tis asic point, as do citicisms ousinesses unpatiotically sitting on piles o cas. Rigt now, oldingcas makes sense.

Moden monetaists know tis, o couse. Te olde iew tat tedemand o money is constant, and so ination ineitaly ollowsmoney gowt, is no longe commonly eld. Rate, todays moneta-ists know tat te uge demand o money will soon suside, and tey

woy aout wete te Fedeal Resee will e ale to adjust. Laecontinues:

. . . te panic demand o money as egun to and sould con-

tinue to ecede . . . . Reduced demand o money comined witapid gowt in money is a suefe ecipe o ination and igeinteest ates.

19951990 201020052000

M1M2GDP

-30-25

-20

-15

-10

-5

0

5

10

15

20

PercentChange


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Laes woy is just tat apid gowt in money will not cease wente panic demand ceases. Plosse wites similaly:

Some people ae questioned wete te Fedeal Resee aste tools to exit om its extaodinay positions. We do. But tequestion o te Fed and ote cental ankes is not can we do it,ut will we do it at te igt time and at te igt pace.

Te Fed can instantly aise te inteest ate on esees, teey in e-ect tuning esees om cas tat pays no inteest to oenigt,oating-ate goenment det. And te Fed still as a uge potolio

o onds it can quickly sell. Moden monetaists teeoe concede tatte Fedan undo monetay expansion and aoid ination; tey just

woy aout wete it willdo so in time. Tis is an impotant con-cen. But it is a emoed om a elie tat te astounding ise in temoney supply makes an equally astounding incease in ination simplyunaoidale.

And like te Keynesians, te monetaists do not conside ou defcitsand det wen tey tink aout ination. Tei omal teoies, like

te Keynesian ones, assume in ootnotes tat te goenment is solent,so tee is nee pessue o te Fed to monetize intactale defcits. But

wat i ou uge det and looming defcits mean tat te fscal ackingo monetay policy is aout to ecome unglued?

h

You dont ae to isit igt-wing we sites to know tat ou fscalsituation is die. Te Congessional Budget Oces annual Lng-Tem

Budget Outlk is scay enoug. Annual defcits ae now unning aout$1.5 tillion, o 10% o GDP. Aout al o all edeal spending is o-owed. By te end o 2011, edeal det eld y te pulic will e 70%o GDP, and oeall edeal det (wic includes det eld in goen-ment tust unds) will e 100% o GDP. Te CBO oesees a decline indefcits accompanying its pediction o a stong economic ecoey, utpedicts tat te det eld y te pulic will still ise swily to 100% o

GDP and eyond in just te coming decade. Ten, as te Bay Boomesetie, ealt-cae entitlements and Social Secuity oligations alloon,and det and defcits explode. And te CBO is optimistic. In a ecentpape aptly titled Tempting Fate, Alan Aueac (o te Uniesity o


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Calionia, Bekeley) and Douglas Gale (o te Bookings Institution)poject a long-tem fscal gap o etween 5 and 6 pecent o GDP.

Tee actos make ou situation een moe dangeous tan tese

gim numes suggest. Fist, te det-to-GDP atio is a misleading statis-tic. Many commentatos tell us tat atios elow 100% ae sae, and notetat we suied a 140% det-to-GDP atio at te end o Wold Wa II. Buttee is no sae det-to-GDP atio. Tee is only a sae atio etween acountys det and its aility to pay o tat det. I a county as stonggowt, stale expenditues, a coeent tax system, and solid expecta-tions o utue udget supluses, it can oow eaily. In 1947, eeyoneundestood tat wa expenditues ad een tempoay, tat uge defcits

would end, and tat te United States ad te powe to pay o and gowout o its det. None o tese conditions olds today.

Second, ocial edeal det is only pat o te stoy. Ou goen-ment as made all sots o o alance seet pomises. Te goenmentas guaanteed aout $5 tillion o motgage-acked secuities tougFannie Mae and Feddie Mac. Te goenment clealy consides te iganks too impotant to ail, and will assume tei dets sould teyget into toule again, just as Euope is aleady ailing its anks out o

losses on Geek ets. State and local goenments ae in toule, as aemany goenment and piate defned-eneft pensions. Te edeal go-enment is unlikely to let tem ail. Eac o tese commitments couldsuddenly dump massie new dets onto te edeal Teasuy, and coulde te tigge o te kind o un on te dolla explained ee.

Tid,utue defcits esulting pimaily om gowing entitlementsae at te eat o Ameicas polem, not cuent det esulting ompast spending. We could pay o a 100% det-to-GDP atio witout in-ation, at least i we etuned pomptly to gowt and didnt ack up a

wole lot moe det fst. But een i te United States eliminatedalloits outstanding det today, we would still ace teile pojections o u-tue defcits. In a sense, tis act puts us in a wose situation tan Ielando Geece. Tose counties ae accumulated massie dets, ut tey

would e in good sape (Ieland) o at least a stale asket case (Geece)i tey could wipe out tei cuent dets. Not us.

Pomised Medicae, pension, and Social Secuity payments (knownas ununded liailities) can e tougt o as dets in te same waytat pomised coupon payments on goenment onds ae dets. To geta sense o te scope o tis polem, we can ty to tanslate te oecasts


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o defcits in ou entitlement pogams to a pesent alue. Tese es-timates ae oug, o couse, ut typical numes ae $60 tillion omoe swamping ou $14 tillion o actual edeal det.

Te idea tat tese fscal polems could lead to a det cisis is adlya adical insigt. As een te cicumspect Congessional Budget Ocewaned ealie tis yea:

. . . a gowing leel o edeal det would also incease te po-aility o a sudden fscal cisis, duing wic inestos wouldlose confdence in te goenments aility to manage its udget,and te goenment would teey lose its aility to oow at

aodale ates. It is possile tat inteest ates would ise gadu-ally as inestos confdence declined, giing legislatos adance

waning o te wosening situation and sucient time to makepolicy coices tat could aet a cisis. But as ote countiesexpeiences sow, it is also possile tat inestos would lose con-fdence auptly and inteest ates on goenment det would isesaply. Te exact point at wic suc a cisis migt occu ote United States is unknown, in pat ecause te atio o edeal

det to GDP is climing into unamilia teitoy and in patecause te isk o a cisis is inuenced y a nume o oteactos, including te goenments long-tem udget outlook,its nea-tem oowing needs, and te ealt o te economy.Wen fscal cises do occu, tey oen appen duing an eco-nomic downtun, wic amplifes te diculties o adjustingfscal policy in esponse.

Benanke as een ecoing tis waning wit a degee o luntnessey unusual o a Fed caiman. In testimony eoe te House BudgetCommittee ealie tis yea, e said:

Te question is wete tese [fscal] adjustments will take placetoug a caeul and delieatie pocess . . . o wete teneeded fscal adjustments will come as a apid and painul e-

sponse to a looming o actual fscal cisis . . . . i goenment detand defcits wee actually to gow at te pace enisioned, te eco-nomic and fnancial eects would e seee.


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Neite te CBO no Caiman Benanke mentioned ination in tesewanings. But pecisely te situation tey wan aout caies a signif-cant isk o ination amid a weakening economy an ination tat te

Fed could do little to contol.

To see wy, stat wit a asic economic question: Wy does papemoney ae any alue at all? In ou economy, te asic answe is tat itas alue ecause te goenment accepts dollas, and only dollas, inpayment o taxes. Te utce takes a dolla om is custome ecausee needs dollas to pay is taxes. O peaps e needs to pay te ame,

ut te ame takes a dolla om te utce ecause e needs dol-las to pay is taxes. As Adam Smit wote in The Wealth Natins, Apince, wo sould enact tat a cetain popotion o is taxes soulde paid in a pape money o a cetain kind, migt teey gie a cetain

alue to tis pape money.Ination esults wen te goenment pints moe dollas tan te

goenment eentually soaks up in tax payments. I tat appens, peo-ple collectiely ty to get id o te exta cas. We ty to uy tings. But

tee is only so muc to uy, and exta cas is like a ot potato some-one must always old it. Teeoe, in te end, we just pus up picesand wages.

Te goenment can also soak up dollas y selling onds. It doestis wen it wants tempoaily to spend moe (giing out dollas) tanit aises in taxes (soaking up dollas). But goenment onds ae tem-seles only a pomise to pay ack moe dollas in te utue. At somepoint, te goenment must soak up exta dollas (eyond wat peopleae willing to old to make tansactions) wit tax eenues geate tanspending tat is, y unning a suplus. I not, we get ination.

I people come to eliee tat onds eld today will e paid o in teutue y pinting money ate tan y unning supluses, ten a lagedet and looming utue defcits would iskutue ination. And tisis wat most osees assume. In act, owee, eas o utue defcitscan also cause ination tday.

Te key eason is tat ou goenment is now unded mostlyy olling oe elatiely sot-tem det, not y selling long-tem ondstat will come due in some utue time o pojected udget supluses.Hal o all cuently outstanding det will matue in less tan two and


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a al yeas, and a tid will matue in unde a yea. Rougly speak-ing, te edeal goenment eac yea must take on $6.5 tillion in newoowing to pay o $5 tillion o matuing det and $1.5 tillion o so

in cuent defcits.As te goenment pays o matuing det, te oldes o tat deteceie a lot o money. Nomally, tat money would e used to uy newdet. But i inestos stat to ea ination, wic will eode te etunsom goenment onds, tey wont uy te new det. Instead, tey

will ty to uy stocks, eal estate, commodities, o ote assets tat aeless sensitie to ination. But tee ae only so many eal assets aound,and someone as to old te stock o money and goenment det. So

te pices o eal assets will ise. Ten, wit pape wealt ig andpospectie etuns on tese inestments declining, people will statspending moe on goods and seices. But tee ae only so many otose aound, too, so te oeall pice leel must ise. Tus, wen sot-tem det must e olled oe, eas o utue ination gie us inationtoday and potentially quite a lot o ination.

It is wot looking at tis pocess toug te lens o pesent alues.Te eal alue o goenment det must equal te pesent alue o ines-

tos expectations aout te utue supluses tat te goenment willeentually un to pay o te det. I inestos tink tat tese supluses

will e muc lowe tat goenment will eite deault o inateaway, say, al o tei utue epayment ten te alue o goen-ment det will e only $7 tillion today, not $14 tillion. Bond oldes

will teeoe ty to sell o tei det eoe its alue alls.I only long-tem det wee outstanding, tese inestos could ty

to sell long-tem det and uy sot-tem det. Te pice o long-temdet could all y al (tus long-tem inteest ates would ise) so tatte alue o te det would once again e te pesent alue o expectedsupluses. But i only sot-tem det is outstanding, inestos must tyto uy goods and seices wen tey sell goenment det. Te only

way to cut te eal alue o goenment det in al in tis situation iso te pice leel to doule.

In a sense, tis confms te Keynesians iew tat expectations mat-

te, ut not tei iew o wat te souces o tose expectations ae. Afscal ination would appen today ecause people expect ination inte utue. A loss o ancoing, to use a Keynesian tem, would tuslikely to lead to stagation ate tan to a oomlet o gowt.


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Te Teasuy poaly oows using sot-tem onds ecause sot-tem inteest ates ae lowe tan long-tem ates. Te goenment tustinks its saing us money. But long-tem ates ae ige o a eason:

Long-tem det includes insuance against cises. It oces ondoldesto ea isks otewise one y te goenment and, ultimately, y tax-payes and uses o dollas. Like all insuance, a pemium tat seemsoneous i tee is no disaste can seem in etospect to ae een e-makaly small i tee is one. And, unotunately, te ey act tat somuc o ou det is sot tem makes suc a disaste moe likely.

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Inteest ates ae ey low, ut tey ae likely to ise. An inceasein inteest ates could also ing on inlation today, compound-ing te inationay eect o a potential det cisis toug a eysimila mecanism.

Just ow low ae todays ates? Te one-yea ate is now 0.2%; te ten-yea ate is aout 2%, and te 30-yea ate is only 4%. We ae not seenates tis low in te post-wa ea. Futemoe, ination is still unningat aound 2-3%, depending on exactly wat measue o ination we

coose. I an inesto lends money at 0.2% and ination is 2%, e loses1.8% o te alue o is money eey yea. Suc low ates ae teeoeunlikely to last. Soone o late, people will fnd ette tings to do wittei money, and demand ige etuns to old Teasuy det.

Low inteest ates ae patially a esult o te Feds delieate eots.Duing te past yeas $600 illion quantitatie easing, te Fed essen-tially ougt aout a tid o te Teasuys ond issues, in an eot toaise ond pices and teey lowe inteest ates. But ot te Feds de-sie to keep ates tis low and its aility to do so ae suely tempoay.

Low inteest ates ae also patly a eection o inestos igt toquality, as tey ae sougt selte in Ameican det amid te fnancialcisis and te emeging Euopean det cisis. U.S. det as long eenpeceied as te ultimate sae ao: Inestos eliee tat te UnitedStates will nee deault o miss an inteest payment, and tat supiseination could not eat away muc o te eal alue o sot-tem det

in a yea. Sot-tem U.S. det is also ey liquid, meaning it is easy tosell and easy to oow against. People ae willing to old it despite lowinteest ates o muc te same eason tey ae willing to old moneydespite n inteest ate.


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But tis special status, too, could cange. It ecame clea duingtis past summes det-limit negotiations tat te edeal goenmentis less committed to paying inteest on its det tan many osees

ad tougt. Fo example, in a July eakast wit Bloomeg epot-es, Pesident Oamas cie political adiso, Daid Ploue, said onte ecod tat te notion tat we would just pay Wall Steet ond-oldes and te Cinese goenment and not meet ou Social Secuityand eteans oligations is insanity, and is not going to appen. Noadministation ocial o congessional ponouncement as coectedo contadicted tis astonising statement. Missing inteest payments

would instantly mean a loss o liquidity o U.S. det, een i te long-

un udget wee not an issue wic o couse it ey muc is. TeS&P atings downgade is only te fst waning sign.

A nomal eal inteest ate on goenment det is at least 1-2%,meaning a 4-5% one-yea ate een i ination stays at 2-3%. A loss ote special saety and liquidity discount tat Ameican det now enjoyscould add two to tee pecentage points. A ising isk pemium wouldimply ige ates still. And o couse, i makets stated to expect ina-tion o actual deault, ates could ise een moe. Low inteest ates can

clim quickly and unexpectedly, as Geece and Spain ae leaned.A ise in inteest ates can lead to cuent ination in te same way a

cange in inesto iews aout long-tem defcits can. Eey pecentagepoint tat inteest ates ise means, ougly, tat te U.S. goenmentmust pay $140 illion moe pe yea on $14 tillion o det, tus diectlyaising te defcit y aout 10%. I we eet to a nomal 5% inteest ate,tis means aout $800 illion in exta fnancing costs pe yea aoutal again te ecent (and aleady unsustainale) annual defcits. Andtis nume is cumulatie, as lage defcits mean moe and moe out-standing det.

Again, pesent alues can elp claiy te point. Te ate o etuntat inestos demand in excange o lending money to te goen-ment is just as impotant to te pesent alue o utue supluses as iste amount o utue supluses tat inestos expect. I inestos decidedtey wee no longe appy to ean 1% (let alone -1%) in eal tems wen

lending to te goenment, ten te eal alue o det today would aeto all just as i inestos decided tat te goenment would inate odeault on pat o te det. And since so muc det is sot tem, a allin te eal alue o te det must pus te pice leel up.


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Tese two actos expectations o utue supluses and defcits, andinceases in inteest ates ae likely to einoce eac ote. I ond in-

estos decide tat te goenment is likely to inate o deault on pat

o te det, inestos ae likely to simultaneously demand a ige iskpemium to old te det. Te two oces will comine to apply eengeate pessue towad ination.

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Tese dynamics essentially add up to a un on te dolla just like aank un away om Ameican goenment det. Unlike a ank un,owee, it would play out in slow motion.

Beoe te fnancial cisis, Bea Steans and Leman Botes olledoe det eey day in ode to inest in motgage-acked secuitiesand ote long-tem illiquid assets. Eac day, tey ad to oow newmoney to pay ack te old money. Wen te maket lost ait in telong-tem alue o tei inestments, te maket eused to oll oe teloans, and te two companies ailed instantly.

Te United States olls oe its det on a scale o a ew yeas, noteey day. So te un on te dolla would play out oe a yea o two

ate tan oenigt. Futemoe, I ae descied o claity a sud-den one-time loss o confdence. Te actual pocess o unning omte dolla, owee, is likely to take moe time, muc as te Euopeandet cisis as tundled along o moe tan a yea. In addition, ecausepices tend to cange elatiely slowly, measued ination can take ayea o two to uild up ae a det cisis.

Like all uns, tis one would e unpedictale. Ae all, i peoplecould pedict tat a un would appen tomoow, ten tey would untoday. Inestos do not un wen tey see ey ad news, ut wentey get te sense tat eeyone else is aout to un. Tats wy teeis oen so little news spaking a cisis, wy policymakes ae likely tolame speculatos o contagion, wy academic commentatos lameiational makets and animal spiits, and wy te Fed is likely toemoan a mysteious loss o ancoing o ination expectations.

Fo tat eason, I do not claim topedittat ination will appen, o

wen. Tis scenaio is a waning, not a oecast. Extaodinaily low in-teest ates on long-tem U.S. goenment onds suggest tat te oeallmaket still as ait tat te United States will fgue out ow to soleits polems. I makets intepeted te CBOs pojections as a oecast,


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not a waning, a un would ae aleady appened. And ou det anddefcit polems ae elatiely easy to sole as a matte o economics (iless so o politics).

But we ae pimed o tis sot o un. All sides in te cuent politicaldeate descie ou long-tem fscal tajectoy as unsustainale. Majomaket playes suc as Pimco wic manages te wolds lagest mu-tual und ae pulicly announcing tat tey ae getting out o U.S.Teasuies and een soting tem, as majo playes like Goldman Sacsamously soted motgage-acked secuities eoe tat cas.

As wit all uns, once a un on te dolla egan, it would e too lateto stop it. Confdence lost is ad to egain. It is not enoug to conince

tis yeas oowes tat te long-tem udget polem is soled; teyae to e coninced tat next yeas oowes will eliee te sameting. It would e a ette to fnd ways to aet suc a cisis tan to ele seacing o ways to ecoe om it.

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Te Fed is noticealy asent om tis teiying scenaio. We aecome to tink tat cental anks contol ination. In act, te Feds

aility to contol ination is limited and te ank would e especiallyimpotent in te eent o fscal o un on te dolla ination.

Te Feds main policy tool is an open-maket opeation: It can uygoenment onds in etun o cas, o it can sell goenment ondsto soak up some money. Tus, te Fed can cange tempsitin ogoenment det, ut not te oeall quantity. Money, ae all, is just adieent kind o goenment det, one tat appens to come in smalldenominations and doesnt pay inteest. Bank esees, wic now payinteest, ae just ey liquid, one-day matuity, oating-ate det. So teFed can aect fnancial aais and ultimately te pice leel only wenpeople cae aout te kindo goenment det tey old esees ocas esus Teasuy ills.

But in te un om te dolla scenaio, people want to get id oalloms o goenment det, including money. In tat situation, teeis essentially noting te Fed can do. Wen tee is too muc det

oeall, canging its composition doesnt eally matte.Te Fed is paticulaly poweless now, as sot-tem inteest ates aeessentially zeo, and anks ae olding $1.5 tillion o excess esees. Intis situation, money and sot-tem goenment det ae exactly te


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same ting. Monetay policy today is like taking away a pesons edM&Ms, giing im geen M&Ms, and expecting te cange to aectis diet.

How can te Fed e poweless? Milton Fiedman said tat te go-enment can always cause ination y essentially dopping money omelicoptes. Tat seems sensile. But te Fed cannot, legally, dop moneyom elicoptes. Te Fed must always take ack a dollas wot o go-enment det o eey dolla o cas it issues, and te Fed must gieack a goenment ond o eey dolla it emoes om ciculation.Wile it is easy to imagine tat giing eeyone a newly pinted $100ill migt cause ination, it is muc less oious tat giing eeyone

tat ill and simultaneously taking away $100 o eeyones goenmentonds as any eect.

Tee is a good eason wy te Fed is not allowed tis most eec-tie tool o pice-leel contol. Witing people cecks (ou equialento dumping money om elicoptes) is asalopeation; it counts asgoenment spending. Te opposite is taxation. In a democacy, an in-dependent institution like a cental ank cannot wite cecks to otesand usinesses, and it cannot impose taxes.

Moeoe, te Feds aility to contol ination is always conditionedon te Teasuys aility and willingness to alidate te Feds actions.I te Fed wants to slow down ination y aising inteest ates, teTeasuy must aise te additional eenue needed to pay o te con-sequently lage payments on goenment det. Fo instance, in te1980s, te loweing o ination appaently induced y monetay tigt-ening was successul (wile attempts to do te same in Latin Ameicaailed) only ecause te U.S. goenment did in act epay ondoldesat ige ates. Monetay teoies in wic te Fed contols te piceleel, including te Keynesian and monetaist iews sketced aoe,always assume tis monetay-fscal policy coodination. Te issue weace is tat tis assumed fscal alance may eapoate. Te Teasuy maysimply not poduce te needed eenue to alidate monetay policy.In tat case, te Fedeal Resee would not e te cental playe.Standad teoies ail ecause one o tei cental assumptions ails.

Again, eents outpace ideas.One migt imagine a esolute cental ank tying to stop fscal ina-tion y saying, We will not monetize te det, ee. Let te est o tegoenment slas spending, aise taxes, o deault. In tat case, people


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migt ee goenment det, seeing deault coming, ut tey would notee te cuency ecause tey would not see ination coming.

But suc eaio y ou Fedeal Resee seems unlikely. Imagine

ow te un on te dolla o det cisis would eel to cental-ankocials. Tey would see inteest ates spiking, and Teasuy auctionsailing. Tey would see illiquidity, maket dislocations, maketsegmentation, speculation, and panic in te ai all tems usedto descie te 2008 cisis as it appened. Te Fed douled its alanceseet in tat fnancial cisis, issuing money to uy assets. It ougt $600illion moe o long-tem det in 2010 and 2011 in te ope o loweinginteest ates y two-tents o a pecentage point. It would e amazing i

te Fed did not poide liquidity and stailize makets wit massiepucases in a goenment-det cisis.

We may get a peiew o tis scenaio coutesy o Euope, wee teEuopean Cental Bank esponding to simila pessues is aleadyuying Geek, Potuguese, and Iis det. Te ECB is also lending astamounts to anks wose main inestments and collateal consist otese counties dets. I a lage soeeign-det deault wee to appen,te ECB would not ae assets le to uy ack euos. As in te scenaio

descied aoe in te context o te dolla, a un on te euo couldtus lead to unstoppale ination.

Neite te cause o no te solution to a un on te dolla, and itsconsequent ination, would teeoe e a matte o monetay policytat te Fed could do muc aout. Ou polem is a fscal polem tecallenge o out-o-contol defcits and allooning det. Todays deateaout ination lagely misses tat polem, and teeoe ails to con-tend wit te geatest ination dange we ace.

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An Ameican det cisis and consequent stagation do not ae to ap-pen. Te solution is simple as a matte o economics. Tis is wy all ote aious fscal and udget commissions o te past ew yeas, egad-less o wic paty as appointed tem, ae come up wit te sameasic answes.

Ou lagest long-tem spending polem is uncontolled entitle-ments. Ou entitlement pogams equie undamental stuctualeoms, not simply pomises to someday spend less money undete cuent system. Congessman Paul Ryans plan to essentially tun


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Medicae into a system o ouces o te pucase o piate insuanceis an example o te ome. Te annually postponed doc fx pom-ise to slas Medicae eimusement ates is an example o te latte.

Ryan and te Oama administation actually poject spending aoutte same amount o money on Medicae in te long un; te dieenceis tat te ond makets ae muc moe likely to e coninced y astuctual cange tan a speadseet o pomises.

Aoe all, we need to etun to long-tem gowt. Tax eenue isequal to te tax ate multiplied y income, so tee is noting like moeincome to aise goenment eenues. And small canges in gowtates imply damatic canges in income wen tey compound oe a

ew decades. Conesely, a consensus tat we ae enteing a lost decadeo no o low gowt could e te disastous udget news tat pusesus to a cisis.

Muc o te cuent policy deate ocuses on oosting GDP o justa yea o two te sot o ting tat migt (peaps) e inuenced ystimulus o ote sot-tem pogams. But not een in te wildestKeynesian imagination do suc policies poduce gowt oe decades.

Oe decades, gowt comes only om moe people and moe po-

ductiity moe output pe peson. Poductiity gowt undamentallycomes om new ideas and tei implementation in new poducts, usi-nesses, and pocesses. Tis act ougt to gie us comot: We ae stilldeeloping and applying compute and intenet tecnology like mad,and iotecnology and ote innoatie felds ae only egun to eauit. We ae still an innoatie county in an innoatie gloal economy.We ae not un out o ideas. But goenments ae a geat capacity tostop o slow down gowt. Witness Geece. Witness Cua.

Ou tax ates ae too ig and evenues ae too low. We sould aimo a system tat does ougly te opposite aising te necessay taxeenue wit te lowest possile tax ates, especially in tose aeas in

wic ig ates ceate disincenties to wok, sae, inest, and conti-ute to economic gowt. Te disincenties implied y ige tax atesmay not sow up o a yea o two, as it takes time to discouage gowt.But wen small eects cumulate oe decades, tey ae paticulaly

penicious eects on gowt.Regulatoy and legal oadlocks can e een moe damaging togowt tan ig tax ates, tax expenditues, and spending. Te unce-tain teat o a isit om te Enionmental Potection Agency, National


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Lao Relations Boad, Equal Employment Oppotunity Commission,Secuities and Excange Commission, o te new Consume FinancialPotection Bueau can e a geate disincentie to iing people and

inesting in a usiness tan a simple and calculale tax.We stand at te ink o disaste. Today, we ace te possiility o adet cisis, wit te consequent fnancial caos and ination, tat teFed cannot contol. In ode to addess tis dange, we ae to ocuson its tue natue and causes. Te cuent ination deate, ocused ontinkeing wit inteest ates and Fed announcements, completely misseste mak. Ou desie to aoid a dangeous ination sould point us inte same diection as just aout eey ote economic indicato and

concen: It sould point us towad fnally inging ou defcits and detunde contol and spuing long-tem gowt.

Inflation and Debt - John Cochrane

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Transcript of Inflation and Debt - John Cochrane