March 21, 2024 Reading Time: 5 minutes
The US Capitol, seat of Congress, on the back of a fifty dollar bill.

John Cochrane’s The Fiscal Theory of the Price Level examines the relationship between fiscal policy and inflation, which many consider to be the increase in the price level of a basket of goods and services. An influential and accomplished economist at the Hoover Institution, Cochrane is one of the most forward-thinking economists today. His approach challenges conventional wisdom and presents a compelling case for reevaluating our understanding of the economy. 

I learned much from reading the book and while interviewing him about it on my Let People Prosper Show podcast. I highly recommend reading this extensive book, though I have reservations about fiscal policy trumping monetary policy when considering the influence on inflation.

Cochrane begins by laying out the foundational principles of his theory. He emphasizes the roles of government debt, taxes, and inflation expectations on prices. He argues that traditional economic models, which focus primarily on the role of central banks in controlling inflation through monetary policy, such as those by Milton Friedman, overlook the substantial effect of fiscal variables on prices. 

By uniquely integrating fiscal considerations and the public’s expectations about those factors into economic analysis, Cochrane aims to provide a more robust framework for understanding and predicting inflationary trends. He delves into various theoretical and empirical aspects of fiscal theory, drawing on a wide range of literature and evidence to support his arguments. 

He explores the implications of government budget constraints, the role of Ricardian equivalence that assumes a balanced budget over time, and the potential limitations of conventional monetary tools in controlling inflationary pressures. His thorough examination of these issues provides readers with a comprehensive understanding of the complexities of studying the relationship between fiscal policy and inflation.

Cochrane’s arguments are persuasive and well-supported, but some aspects of his analysis warrant scrutiny.

One area of contention is Cochrane’s emphasis on the primacy of fiscal policy in driving inflationary dynamics, particularly his assertion that the Federal Reserve plays a secondary role compared to Congress in shaping inflation outcomes. While Cochrane makes a compelling case for the importance of fiscal variables, the penultimate creator of inflation is the Fed when it creates more money than the goods and services produced. 

Milton Friedman, who extensively studied the role of the Fed in economic activity and inflation, said: “Inflation is always and everywhere a monetary phenomenon. It is a result of a greater increase in the quantity of money than in the output of goods and services which is available for spending.”

The Fed controls what’s called “high-powered money” of various assets on its balance sheet. These assets include mostly Treasury securities from the tens of trillions of dollars in debt issued by the federal government. It also includes mortgage-backed securities, lending to financial institutions, federal agency debt, and other lending facilities. 

I agree with Cochrane that federal deficits give ammunition to the Fed when it purchases Treasury debt, grows high-powered money, contributes to more money chasing too few goods and services, and results in inflation. But other assets on the Fed’s balance sheet also matter, especially since the Great Financial Crisis in 2008 when the Fed started quantitative easing

Cochrane’s framework overlooks the significant role of monetary policy in influencing inflation expectations and shaping the broader economic environment. While fiscal policy can play a role in determining long-term inflation trends, as the debt distorts interest rates in the market, the Fed’s control of the money supply to target the federal funds rate and influence other rates along the yield curve remains a potent tool for managing expectations. 

While we should challenge Congress to adopt a fiscal rule for sustainable budgets to relieve excessive spending that drives up the national debt, this does not undermine the source of inflation: the Fed. 

But if Congress could balance its budget, which hasn’t happened since 2001, it would remove a bullet the Fed could shoot at the economy. In other words, a sustainable fiscal policy, wherein Congress passes balanced budgets by limiting government spending — the ultimate burden of government and the source of budget deficits — would help control inflation. While this could mitigate the assets available for the Fed to add to high-powered money, it would not solve the inflation problem because of many other available assets.

Another issue that arises from considering fiscal policy the prime mover of inflation is how it works in practice. Fiscal policy is not directly expansionary or contractionary, as it is just taking funds from some people to give to others, with many of the takers being politicians and bureaucrats in government. These actions move money around in the economy without increasing productive activity that creates goods and services.

There are roles for the federal, state, and local governments, but those should be limited to those outlined in constitutions. If Congress would abide by the Constitution, whereby it funded only limited government instead of the bloated federal government today, then fiscal policy would not be so burdensome. Fiscal policy would also not fall into the Keynesian trap of trying to “stabilize economic activity,” as the only thing that governments typically stimulate is more government because of the created failures due to the limited knowledge and rent seeking by politicians and bureaucrats.

The underlying problem is usually government failures that cannot be resolved by more government.

When Congress returns to its limited, constitutional roles, the federal budget will be drastically cut, resulting in lower taxes and opportunities to pay down and retire the national debt. This would also help reduce the massive distortions throughout the economy from government spending, taxes, and regulations. It would also decrease the Fed’s influence on the economy, but not entirely because of the other assets available for its disposal.

The Fed also distorts economic activity through its ability to influence each stage of the production process with the assets on its balance sheet and its effect on interest rates.

When the Fed purchases Treasury debt and increases high-powered money, the new money does not go to everyone simultaneously. Instead, the money trickles down from the financial sector to other sectors based on credit availability and other factors, in what is called the Cantillon effect. The manipulation of different markets throughout the production process of goods by the new money and the influence the purchase of assets by the Fed has on interest rates create boom and bust cycles. There is ample evidence about these economic steps, especially from the Austrian business cycle theory.

Fiscal policy influences many steps in the production process through subsidies, tax breaks, and regulations, which hinder the voluntary production of individual goods and services through a well-functioning price system. But Congress cannot increase the money supply, which only the Fed can do, nor influence the general price level nor the resulting inflation.

All things considered, Cochrane’s comprehensive exploration of fiscal theory and extensive analysis of its implications for the price level riveted me. His methodical dissection of economic concepts and pragmatic approach to examining fiscal policy offered a fresh perspective on economic dynamics.

In conclusion, the Fiscal Theory of the Price Level offers a valuable contribution to the ongoing debate surrounding the determinants of inflation and the role of fiscal policy in the economy. While I’m sympathetic to Cochrane’s arguments, it is essential to recognize the importance of a central bank’s monetary policy in causing inflation through its balance sheet.

Additionally, we should acknowledge the distortions caused by government policy, whether fiscal or monetary, and recognize the secondary role of fiscal policy compared to monetary policy in addressing inflationary pressures. To ensure sound economic outcomes, it is imperative to establish strong fiscal and monetary rules that provide an institutional framework limiting the burdens of government actions on our lives and livelihoods.

Despite my dissent on the emphasis placed on fiscal policy’s role in inflation, the book’s productive discourse on the delicate dynamics of key economic elements make this an important contribution to inflation studies.

Vance Ginn

Vance Ginn, Ph.D., is founder and president of Ginn Economic Consulting, LLC and an Associate Research Fellow with AIER. He is chief economist at Pelican Institute for Public Policy and senior fellow at Americans for Tax Reform. He previously served as the associate director for economic policy of the White House’s Office of Management and Budget, 2019-20.

Follow him: @VanceGinn.

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