To Solve Inflation, First Solve Deficits, This Theory Advises

Expect to hear more about the fiscal theory of the price level as governments struggle with rising debt and inflation

By Greg Ip of The WSJ. Excerpts:

"But fiscal and monetary policy aren’t so easily separated. After all, fiscal stimulus had some role in pushing inflation up, and as the Fed raises interest rates to combat that inflation, it will worsen deficits. Britain had to abandon deficit-financed tax cuts over fears they would drive inflation and interest rates higher."

"The fiscal theory of the price level (FTPL), as it is known, argues that monetary and fiscal policy don’t just interact; they are, ultimately, inextricable. If fiscal policy is irresponsible, even a responsible central bank can’t control inflation."

"In a 1981 paper, though, Thomas Sargent (like Mr. Friedman a future winner of the Nobel Prize in economics) and Neil Wallace challenged this orthodoxy: A government that runs unsustainable deficits will, one day, fail to sell enough bonds, at which point the central bank will have to finance the shortfall by printing money. The central bank may initially try to control inflation by raising interest rates sharply. But this will widen deficits further and ultimately make inflation even harder to control. “Persistent high inflation is always and everywhere a fiscal phenomenon, in which the central bank is a monetary accomplice,” wrote Mr. Sargent, currently a professor at New York University and a senior fellow at Hoover Institution, in 2013."

"The public will anticipate this eventuality long before it happens and act in ways that drive inflation up now, not in the future, argues Hoover Institution economist John Cochrane, author of “The Fiscal Theory of the Price Level,” a 558-page examination of the theory to be published next year."

"Thus it’s not the money supply but the government debt, and whether the public expects it to be repaid, that determines inflation"

"the distinction between money issued by the central bank and bonds issued by the Treasury becomes irrelevant."

"But FTPL is frustratingly difficult to apply to real life. Debt soared after the 2008 financial crisis yet inflation fell, instead of rising as FTPL might imply. Responding to Mr. Bianchi, Ethan Ilzetzki of the London School of Economics noted that Japan has by far the highest debt among major advanced economies, but the lowest inflation. FTPL, he said, is “a ticking time bomb that (so far) refuses to detonate.”

"Mr. Cochrane said FTPL can explain these results: Japanese savers are willing to lend to their own government at rock bottom interest rates, which makes future debt service and deficits less burdensome. Rising debt after 2008 did put upward pressure on inflation but that usefully offset the threat of deflation from soaring unemployment, he said; the balance of these opposing forces yielded a low, positive inflation rate. Mr. Cochrane acknowledges FTPL doesn’t provide a clear-cut debt level at which inflation takes off: “You get more inflation when you get more government debt than people think the government can or will repay.”"

"Sargent and Wallace wrote back in 1981 that fiscal policy doesn’t always dominate monetary policy; sometimes the opposite happens."

"In the U.S., FTPL’s greatest value may be as a reminder to Congress and the Fed to pay attention to each other. Said Mr. Cochrane: “The bottom-line message is…that fiscal and monetary policies always have to work together.”"

Related post: 

How Government Spending Fuels Inflation

Excerpt:

"The new theory holds that when the overall amount of government debt is more than people expect the government to repay, we see inflation. The price of everything goes up, and the value of the dollar declines.

How does this work? “The U.S. government has $20 trillion of debt outstanding,” Mr. Cochrane says. “That means, over the long run, people must expect taxes to exceed spending by $20 trillion to repay the debt.” But if they think the government will be able to pay back only $10 trillion in today’s money, “people will try to get rid of their government debt fast, before it is worth less. They try to sell it in order to buy other things,” driving up the price of everything else. “That keeps going until all prices have doubled—until the $20 trillion promise is only worth $10 trillion at today’s prices.”"