John Cochrane: prediction

Transcript context

…Easy questions. I wish I could say the manuscript’s forthcoming. It’s turning into the key to all mythologies, but there is a draft. This is a big book project I’m working on. I put the drafts up on my website as it goes along. I just wrote a “g greater than r” section last week. I knew this was coming. [laughter] Let me just back up. The fiscal theory — for those of you who haven’t heard of it — this is an attempt at the basic plumbing of where inflation comes from. It’s not about the Fed printing up too much money. It’s not about the magic of controlling interest rates. But fundamentally, money gains its value because the government can soak it up by charging taxes at the end of the day. That seems perfectly obvious, but it actually changes a lot about how all of the monetary theory we do works. Among other things — I’m just backing up here for a second for our listeners — it says that the distinction between money and government bonds isn’t that important. What matters is overall government debt and the government’s ability to pay that debt back. And inflation comes when people lose faith in the government’s ability to pay back its debt. They try to get rid of the debt because they know it’s not going to get paid back. What do you do with it? You buy stuff, and that drives up the price of goods and services. That’s your quick background. What is the fiscal theory at the price level? Now, r less than g stuff — it’s a broader issue than fiscal theory. It’s the question of debt sustainability, and it’s a big deal right now. Does our government have to pay back debt or can it borrow? Here’s the strategy: borrow money and never pay it back. In other words, just roll over the debt. Let it grow at the interest rate. For you and me, that doesn’t work because the repo man comes calling. But for the government, if the economy grows faster than this rate of interest, then the ratio of debt to GDP will come back all on its own without the government having to do a lot to pay back that debt. So this is the shining promise. If that’s true, and if it scales — this is the crucial thing — if you can borrow more, and the interest rates don’t go up, then government debt is a money machine. Nobody needs to work anymore. No one needs to pay taxes anymore. You can tell that’s not the case. [laughs] The question’s why is that not the case? When you look at the strategy, that’s not about . . . I’m going to route that back to answering your question. Today’s fiscal question has really nothing to do with the r greater or less than g, even though it’s been a technical issue that makes economists just love writing papers about it because you get to do all sorts of limits and transfer salary conditions and interesting models about it. The reason is, what’s in prospect for the US is not borrowing once and then running no surplus or deficit for 40 years while we slowly grow out of the debt. What’s in prospect for the US is borrowing forever and ever. at’s in prospect for the US is not borrowing once and then running no surplus or deficit for 40 years while we slowly grow out of the debt. What’s in prospect for the US is borrowing forever and ever. If the interest rate is 1 percent less than the growth rate, that gives you 1 percent of GDP for free, but the US is borrowing 5 percent of GDP forever. That doesn’t compute even if r is less than g. If r is less than g — finally in answer to your question — big fiscal borrowing must be repaid by taxes. Anything over 1 percent of GDP has to be repaid by taxes. If it isn’t going to be repaid by taxes, people are still going to try to get rid of that government debt and they’ll cause inflation.…

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