No Monetary Policy Is Not Just Another Name for Fiscal Policy

I just read John Cochrane’s essay “Inflation and Debt” in the Fall 2011 issue of National Affairs. On his webpage, Cochrane gives this brief summary of what the paper is about.

An essay summarizing the threat of inflation from large debt and deficits. The danger is best described as a “run on the dollar.” Future deficits can lead to inflation today, which the Fed cannot control. I also talk about the conventional Keynesian (Fed) and monetarist views of inflation, and why they are not equipped to deal with the threat of deficits. This essay complements the academic (equations) “Understanding Policy” article (see below) and the Why the 2025 budget matters today WSJ oped (see below).

And here’s the abstract to his “Understanding Policy in the Great Recession” article:

I use the valuation equation of government debt to understand fiscal and monetary policy in and following the great recession of 2008-2009. I also examine fiscal and monetary policy alternatives to avoid deflation, and how fiscal pressures might lead to inflation. I conclude that the central bank might be almost powerless to avoid inflation or deflation; that an eventual fiscal inflation can come well before fiscal deficits or monetization are realized, and that it is likely to come with stagnation rather than a boom.

The crux of Cochrane’s argument is that government currency is a form of debt so that inflation is typically the result of a perception by bondholders and potential purchasers of government debt that the government will not be able to raise enough revenues to cover its expenditures and repay its debt obligations, implying an implicit default through inflation. However, the expectation of future inflation because of an anticipated future fiscal crisis may suddenly — when an expectational tipping point is reached — trigger a “run” on the currency well before the crisis, a run manifesting itself in rapidly rising nominal interest rates and rising inflation even before the onset of a large fiscal deficit.

This is certainly an important, though hardly original, insight, and provides due cause for concern about our long-term fiscal outlook. The puzzle is why Cochrane thinks the possibility of a run on the dollar because of an anticipated future fiscal crisis is at all relevant to an understanding of why we are stuck in a lingering Little Depression. Cochrane is obviously very pleased with his fiscal theory of inflations, believing it to have great explanatory power.  But that explanatory power, as far as I can tell, doesn’t quite extend to explaining the origins of, or the cure for, the crisis in which we now find ourselves.

Cochrane’s recent comments on a panel discussion at the Hoover Institution give the flavor of his not very systematic ideas about the causes of the Little Depression, and the disconnect between those ideas and his fiscal theory of inflation.

Why are we stagnating? I don’t know. I don’t think anyone knows, really. That’s why we’re here at this fascinating conference.

Nothing on the conventional macro policy agenda reflects a clue why we’re stagnating. Score policy by whether its implicit diagnosis of the problem makes any sense.

The “jobs” bill. Even if there were a ghost of a chance of building new roads and schools in less than two years, do we have 9% unemployment because we stopped spending on roads & schools? No. Do we have 9% unemployment because we fired lots of state workers? No.

Taxing the rich is the new hot idea. But do we have 9% unemployment-of anything but tax lawyers and lobbyists–because the capital gains rate is too low? Besides, in this room we know that total marginal rates matter, not just average Federal income taxes of Warren Buffet. Greg Mankiw figured his marginal tax rate at 93% including Federal, state, local, and estate taxes. And even he forgot about sales, excise, and corporate taxes. Is 93% too low, and the cause of unemployment?

The Fed is debating QE3. Or is it 5? And promising zero interest rates all the way to the third year of the Malia Obama administration. All to lower long rates 10 basis points through some segmented-market magic. But do we really have 9% unemployment because 3% mortgages with 3% inflation are strangling the economy from lack of credit? Or because the market is screaming for 3 year bonds, but Treasury issued at 10 years instead? Or because $1.5 trillion of excess reserves aren’t enough to mediate transactons?

I posed this question to a somewhat dovish Federal Reserve bank president recently. He answered succinctly, “Aggregate demand is inadequate. We fill it. ” Really? That’s at least coherent. I read the same model as an undergraduate. But as a diagnosis, it seems an awfully simplistic uni-causal, uni-dimensional view of prosperity. Medieval doctors had three humors, not just one.

Of course in some sense we are still suffering the impact of the 2008 financial crisis. Reinhart and Rogoff are endlessly quoted that recessions following financial crises are longer. But why? That observation could just mean that policy responses to financial crises are particularly wrongheaded.

In sum, the patient is having a heart attack. The doctors debating whether to give him a double espresso vs. a nip of brandy. And most likely, the espresso is decaf and the brandy watered.

So what if this really is not a “macro” problem? What if this is Lee Ohanian’s 1937-not about money, short term interest rates, taxes, inadequately stimulating (!) deficits, but a disease of tax rates, social programs that pay people not to work, and a “war on business.” Perhaps this is the beginning of eurosclerosis. (See Bob Lucas’s brilliant Millman lecture for a chilling exposition of this view).

If so , the problem is heart disease. If so, macro tools cannot help. If so, the answer is “Get out of the way.”

Cochrane seems content to take the most naïve Keynesian model as the only possible macro explanation of the current slump, and, after cavalierly dismissing it, concludes that there is no macroeconomic explanation for the slump, leaving “get out of the way” as the default solution. That’s because he seems convinced that all that you need to know about money is that expected future fiscal deficits can cause inflation now, because the expectation triggers a “run” on the currency. This is an important point to recognize, but it does not exhaust all that we know or should know about monetary theory and monetary policy. It is like trying to account for the price level under the gold standard by only taking into account the real demand for gold (i.e., the private demand for gold for industrial and ornamental purposes) and ignoring the monetary demand for gold (i.e., the demand by banks and central banks to hold gold as reserves or for coinage). If you looked only at the private demand for gold, you couldn’t possibly account for the Great Depression.

PS I also have to register my amazement that Cochrane could bring himself to describe Lucas’s Millman lecture as brilliant. It would be more accurate to describe the lecture as an embarrassment.

HT:  David Levey


20 Responses to “No Monetary Policy Is Not Just Another Name for Fiscal Policy”

  1. 1 Lars Christensen December 22, 2011 at 10:28 am

    David, I completely agree. I am puzzled anybody educated at the University of Chicago seems to have such little knowledge of monetary theory and policy.

    By the way it should be pretty clear that we are in a situation is strong deflationary pressures so why is Cochrane worried about a run on the dollar? Wouldn’t that not be exactly what we would like to see? Wouldn’t exactly be a “solution” if the market really started to fear that the public debt in the US would partly monetised? It is extremely odd that Cochrane does not realise it? But it seems that Cochrane thinks a weaker dollar in itself would be a problem…

    I think the thinking of Cochrane shows what is wrong with many academic economists today. If just they can build “funny” mathematical models that give “odd” results then it is a success. It is terribly depressing that a lack of knowledge of the real world no longer is disqualifying, but rather it seems like a the sure road to stardom.

    Finally isn’t Chicago economists educated to trust the market? If the US was on the brink of fiscal disaster (and/or monetarisation of the public debt) shouldn’t that then be visible in bond yields? It the market really that stupid? And one could of course wonder what currency Cochrane recommend to be long in? Does he still have his salary paid in dollars? If he is so negative on the outlook for the dollar I am very sure that we can find somebody in the financial markets who would like to be on the other side of that bet (basically the entire European banking sector…)


  2. 2 Scott Sumner December 22, 2011 at 3:32 pm

    You may be being a bit too harsh with Lucas. There are only a few dozen economists in the world who think money was tight in 2008. At least he recognizes that the big fall in NGDP in late 2008 and early 2009 was the key problem in the contraction.

    I wish our views were more popular, but they aren’t.

    BTW, I’m pretty sure Lucas doesn’t buy into Cochrane’s monetary theory.


  3. 3 Frank Restly December 22, 2011 at 4:12 pm

    Just read John Cochrane’s article and two things to note:

    The increased debt and deficits that we have now are the result of two things:

    1. The wars in Iraq and Afghanistan
    2. The Bush tax cuts of 2001 and 2003

    You know it and I know it. The “entitlement programs” that Mr. Cochrane makes mention of did not put us in this mess.


  4. 4 Noah Smith December 22, 2011 at 11:19 pm

    OH MY GAWD, John Cochrane, why do you say such things. Thus tempting me to embark upon a giant rant pointing out how each of your points is wrong. Thus causing me to seem even more like a grouch to my readership and to procrastinate actual work even more. WHY, COCHRANE!!! (shakes fist)


  5. 5 MG December 22, 2011 at 11:57 pm

    Another mole pops its head up: “We don’t know what caused it, therefore we can’t fix it.” It’s actually a variation of the “We can’t do anything but wait it out” mole.

    Instead of playing along with the endless whack-a-mole game these folks employ (and that often employs them), I wish someone would categorize their arguments, along with the refutations of same, in one place. It really shouldn’t be that hard to do. Basically, they have a handful of arguments that are used over and over again, with slight variations to make them seem fresh and clever, so refuting them is easy enough, given the number of good economists out there who have done it. It then becomes easy enough to name them, and attach the best refutations written in the clearest, plainest language possible, and then aggregate them on one website. You aren’t losing the war of ideas; you’re losing the war of message management, and this would be a step towards changing that.

    Did you read or hear Boehner’s, what amounted to a surrender speech today? Even after suffering a humiliating defeat, he stuck to the focus group-tested language his entire movement always employs. That’s a major reason why defeats like those are so rare for their side, despite all the evidence, and all the thoughtful analysis, showing they are wrong. Thoughtful analysis is only part of this, maybe not even the most important part.


  6. 6 Nick Rowe December 23, 2011 at 12:36 am

    “This is certainly an important, though hardly original, insight, and provides due cause for concern about our long-term fiscal outlook.”

    That’s what scares me. The longer the US stays in recession, the bigger the accumulated debt. Then when it does finally escape, and real interest rates need to rise, the debt that was very affordable at low real interest rates suddenly becomes unaffordable if it has to be rolled over.

    Japan look worse than the US.


  7. 7 David Pearson December 23, 2011 at 6:51 am

    Nick makes an important point. The Fed cannot be blamed for 10% of gdp fiscal deficits, but it is creating a dependence on low-to-negative real rates to finance those deficits. Combining persistently high deficits with indirect central bank financing is a potential “no exit” strategy. If the strategy produces more inflation than growth, the central bank is unable to raise real interest rates to stem an inflation overshoot without downgrading the solvency of the sovereign. If that happens, then the tightening of policy is amplified by a spike in the term premium. The result is renewed recession fears, which immediately make the central bank back off. Since >3% inflation will have its own momentum, this repeated backing off would result in a potential unanchoring of inflation expectations.

    I would note, however, that since Japan finances its deficits at positive real rates, the country is less exposed to the “no exit” dynamic than the U.S.. Moreover, its not clear that Japan’s debt-to-gdp ratio is that much higher when including U.S. contingent and off-balance sheet liabilities.


  8. 8 David Glasner December 23, 2011 at 9:51 am

    Lars, Obviously I don’t agree with Cochrane, but just to be fair, he does address the argument that current low interest rates indicate that the market is not anticipating the default he is suggesting may occur. His point is that in this sort of situation market sentiment can shift very rapidly, in other words, panics happen all of a sudden, so it isn’t safe to just look at the bond market and conclude that all is well.

    Scott, I was afraid that you wouldn’t like my unflattering reference to Lucas. He deserves credit for recognizing that tight money was largely responsible for the steepness of the 2008 downturn and the financial panic in September-November. But I was provoked by Cochrane’s reference to the Millman lecture, which I found seriously underwhelming. And if I was too harsh in my assessment of that lecture, I didn’t exaggerate by all that much. I don’t know if this is enough of a mea culpa for you, but it’s the best I can do.

    Frank, Actually as Nick suggests below, the most important factor contributing to the explosion of our debt is our nearly 4-year long Little Depression.

    Noah, I hope that you can work this one out.

    MG, Care to volunteer?

    Nick, I should have made that point a bit more clearly, but in my haste didn’t make the point, which I did make about the euro debt crisis, that bad monetary policy is what is making our debt burden unsustainable. Do you think that Cochrane has ever read Fisher’s Debt Deflation Theory of Great Depressions paper?

    David, But I do blame the Fed for 10% of GDP fiscal deficits, and I suspect that Nick does, too, though he will surely correct me if I am mistaken.


  9. 9 Benjamin Cole December 23, 2011 at 11:41 am

    At this point, I think members of the right-wing are posturing—they want Obama out. Ergo, they are arguing for tight money even when GDP is 13 percent below trend and unit labor costs are falling.

    As for a weaker dollar, it would be welcome, helping with exports and tourism. Bring on a weaker dollar–why do people conflate a strong dollar with a strong economy? See Japan—industrial production down 20 percent since 1995, and yen way up.

    Add on: Now we are supposed to suffer under tight money as something “might” happen in the future. We “might” endure inflation in the future, so we have to suffocate now.

    Raising specters—jeez, is this the strongest anti-Market Monetarism argument? Cochrane’s arguments are peevish and feeble.

    If Romney wins in and boots national health insurance (or starts another war) the right-wing will become mute if the Fed stimulates. I may even vote for Romney, but we need to right monetary policy all the time—not just when a GOP’er is president.


  10. 10 David Glasner December 24, 2011 at 7:22 pm

    Benjamin, A strong economy causes a strong currency, a strong currency doesn’t cause a strong economy. To argue the latter is like arguing that living in Florida is a cause of old age. On the other hand, one should also be careful about saying that a weak currency leads to a strong economy. In other words, it’s complicated.


  11. 11 Frank Restly December 26, 2011 at 7:41 am


    Please define what you mean by strong versus weak currency. If you are talking about the relative value of one currency versus another (Euro versus Dollar or Yen versus Pound) then the relative strengths of the economies may not be adequately reflected in currency pair valuation (see Chinese Yuan versus U. S. dollar).

    If you are talking about the purchasing power of a currency within its own borders, then that is a function of the productivity (real GDP / total debt outstanding) of the country in question.

    FYI, a country can have a “strong currency” in terms of currency pairs and yet still have a weak economy (Real GDP could barely grow and nominal GDP could contract sharply – aka the Great Depression).

    The biggest determination of the value of one currency over another is the risk free real rate of return that the country offers. In other words, the interest rate that the sovereign is willing to pay on its debt is the biggest determination of the value of the sovereign’s currency. That interest rate is in large part affected by monetary policy decisions.

    And so, John Cochrane is correct in the sense that monetary and fiscal policy are intractably linked.


  12. 12 Frank Restly December 26, 2011 at 7:51 am

    Dear Mr. Cole:

    There is no positive correlation between U. S. trade balance and a weak U. S. dollar. See:

    Trade Weighted Dollar Index (Major Currency)

    Trade Weighted Dollar Index (Broad)


    Net Exports (Goods and Services)

    Prior to 1992 there was a positive correlation between the U. S. trade deficit and the federal debt. That correlation disappeared in 1992 and corresponded with the U. S. equity bubble.


  13. 13 marris December 28, 2011 at 1:19 pm

    Do you have a link to the Lucas lecture? I could not find it in the wake of the Cochrane speech.


  14. 14 Barry December 29, 2011 at 6:50 am

    Notice the extremely poor logic that an (allegedly) smart and logically trained Cochrane is using:

    [Step 1, hidden: Assume: ‘A or B’]
    Step 2: Prove not A’, where A’ prime is a strawman version of A.
    Step 3: Conclude B.
    [Step 4, hidden: repeat year over year, ignoring the fact that B implies things which are the opposite of what is happening, but which fit A well]


  15. 15 David Glasner December 30, 2011 at 9:16 am

    Frank, I don’t have a precise definition for strong versus weak currency. But the common usage seems to be that a strong currency is one which is rising in exchange value against other currencies and a weak one is one falling in exchange value against other currencies. Obviously, it is not enough to focus on just two currencies which may both be strong or weak relative to all other currencies. Monetary and fiscal policy both affect interest rates, but real interest rates are a reflection of expected yields on real capital which are not (and cannot be) determined in any straightforward fashion by the monetary and fiscal authorities.

    Marris, Here’s a link to Lucas’s Milliman Lecture,

    Barry, Thanks for the quick logic lesson.


  16. 16 Frank Restly December 31, 2011 at 1:20 pm

    “but real interest rates are a reflection of expected yields on real capital which are not (and cannot be) determined in any straightforward fashion by the monetary and fiscal authorities”


    First, last time I checked, the federal open market committee buys and sells short term government debt and in the process sets market short term interest rates. If the federal open market committee wants real short term interest rates to rise, they sell enough government debt to force real short term interest rates to rise. If they want them to fall, they buy enough of them to force them down.

    Second, presumably by real capital, you mean all financing instruments (stocks and bonds). Real interest rates are a reflection of expected real yields on all capital financing instruments – are we saying the same thing here?

    And so, what you seem to be saying is that a rise in the real return of one asset class (bonds) could lead to a fall in the real return of another (equities) and so the net return on all outstanding assets could be zero (or negative).

    The real yields on capital cannot be determined by monetary and fiscal authorities this is true. But they can be incentivized and even prioritized. Meaning, that through the proper coordination of monetary (interest rates), fiscal (debt issuance), and fiscal (tax policy), real returns can be given preference over inflation augmented returns.


  17. 17 David Glasner December 31, 2011 at 8:54 pm

    Frank, I said that real interest rates cannot be determined in any straightforward way by the monetary and fiscal authorities. That doesn’t mean that monetary and fiscal authorities have no effect on real interest rates, especially at the short end; it means that they are very limited in their control, with their limited control diminishing the further they go along the yield curve. When I refer to real capital I mean real capital, every long-lived asset, including machines, buildings land, as well as stocks and bonds that embodies an expected future stream of cash flows that is evaluated in terms of a present value. The government’s control of a small (tiny) portion of the stock these instruments is not sufficient to determine their value which is what in effect determines the relevant rates of interest.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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