Part 4: The fiscal theory of the price level
Interest rates near zero have coincided with slowly declining inflation. That observation, together with my quick review of current theory, suggests that if the Fed continues to raise interest rates, it will produce more inflation. But the data also suggest that any rise in inflation will be a slow affair, just as the decline in inflation at zero rates has been slow.
Again, I don’t think more inflation is a good idea. But as an intellectual exercise, if we want more inflation, is there anything central banks can do to produce it in the short run? What about helicopter drops, fiscal stimulus, and other creative ideas?
The fiscal theory of the price level is a new perspective on just where inflation comes from. (Well, it’s sort of new. I’ve been working on it for 20 years, and others for longer.) This theory says, fundamentally, that money has value because the government accepts that money for taxes, and inflation is a fiscal phenomenon over which central banks’ conventional tools—open-market operations trading money for government bonds—have limited power unless coordinated with that fiscal policy.
In theory, then, central bankers could mingle fiscal policy with monetary policy to spur inflation. The late Milton Friedman’s famous proposal to drop money from helicopters to spur inflation is actually fiscal policy. In the US economy, a helicopter drop is accomplished by the Treasury borrowing money and writing checks to people, and then the Fed buying the Treasury bonds. The Economist (“Unfamiliar ways forward,” February 20, 2016) describes this scenario in some detail:
. . . a central bank and its finance ministry . . . collude in printing money to pay for public spending (or tax cuts). . . . The government announces a tax rebate and issues bonds to finance it, but instead of selling them to private investors swaps them for a deposit with the central bank. The central bank proceeds to cancel the bonds, and the government withdraws the money it has on deposit and gives it to citizens. “Helicopter money” of this sort—named in honour of a parable told by Milton Friedman, a famous economist—is as close as you can get to raining cash from a clear blue sky like manna from heaven, untouched by banks and financial markets.
Such largesse is, in effect, fiscal policy financed by money instead of bonds. . . . But the unaccustomed drama—indeed, the apparent recklessness—of helicopter money could increase the expected inflation rate, encouraging taxpayers to spend rather
than save.
Will it work? Alas, “recklessness” is crucial. Normally, when a government sells a lot of bonds, people think that it is sooner or later going to soak up these bonds with taxes. That’s the only reason people are willing to buy the bonds, and the only reason the government can raise revenue by selling the bonds. But if the government drops $100 in every voter’s pocket and simultaneously announces that taxes are going up $100 tomorrow, even helicopter drops have no effect. In the Economist’s proposal, canceling the bonds says, “We are really going to be reckless. We’re not going to soak up this money, so you’d better spend it before it loses value.”
Our governments have spent centuries building up a reputation for paying their debts so they can sell bonds at good prices. That reputation is now hard to break. It’s especially hard to break just a little bit; we know how to create Zimbabwe, but creating 2 percent inflation is as hard as smoking just one cigarette a week.
As you can see, though, central banks cannot accomplish a helicopter drop alone. Many of them are legally forbidden from doing so. Central banks must always buy something—usually government bonds—in return for creating money. They can’t send checks to people.
Why? The people who set up our monetary systems understood all this very well. Their memories were full of disastrous inflations, and they knew that printing money without promises that taxes would eventually soak up that money would lead quickly to inflation. So, yes, central banks are prohibited from doing the one thing that would most quickly produce inflation, for about the same reason that wise parents don’t keep the car keys in the liquor cabinet. There are also all sorts of good political economy reasons that an independent central bank should not lend to specific businesses or send checks to voters.
One can get more creative. The central trick is finding a way to promise that we’re going to pay back only 98 percent of the debt next year. If we were on a gold standard, a schedule of 2-percent-per-year devaluations would work. We’re not, and we shouldn’t be.
But I’m not going to go further than that. Why? Shh. Zero inflation is great! I see little argument that raising inflation will be good for the economy, and plenty of argument that permanently killing inflation will be good for the economy and for financial markets. If central banks have the wrong pedal, but we’re driving the right speed anyway, why wake them up?
John H. Cochrane is distinguished senior fellow at Chicago Booth and a senior fellow of the Hoover Institution at Stanford University.
This essay is adapted from two posts on The Grumpy Economist blog.