Reforming the Euro: Lessons From Four Crises

With Luis Garicano and Klaus Masuch. Book draft, comments welcome. The euro started with a good monetary-fiscal framework. However, innovations in a series of unexpected crises changed the monetary-fiscal foundations of the euro dramatically. We tell the story, and suggest reforms. Read the book>

Expectations and the Neutrality of Interest Rates

April 24 2024. (Rewrite).  The paper>

Abstract: Our central banks set interest rates, and do not even pretend to control money supplies. How do interest rates affect inflation? We finally have a complete economic theory of inflation under interest rate targets and unconstrained liquidity. Its long-run properties mirror those of monetary theory: Inflation can be stable and determinate under interest rate targets, including a peg, analogous to a k-percent rule.

Uncomfortably, stability means that higher interest rates eventually raise inflation, just as higher money growth eventually raises inflation. Sticky prices generate some short-run non-neutrality: Higher nominal interest rates can raise real rates and lower output. A model in which higher nominal interest rates temporarily lower inflation, without a change in fiscal policy, is a harder task. I exhibit one such model, but it paints a more limited picture than standard beliefs. Generically, without a change in fiscal policy, monetary policy can only move inflation from one time to another.

The last decade has provided a near-ideal set of natural experiments to distinguish the principal theories of inflation. Inflation did not show spirals or indeterminacies at the long zero bound. The large monetary-fiscal expansion of the covid era produced a temporary spurt of inflation. The same money unleashed in quantitative easing had no such effect.

This paper resulted from a talk at the  “Foundations of Monetary Policy” conference celebrating 50 years since the publication of ``Expectations and the Neutrality of Money,'' Federal Reserve Bank of Minneapolis, September 2022. Slides Video of my presentation at the Hoover Economics Policy Working group, Dec 14 2022. Programs (updated 4/17/2024).

Fiscal Narratives for US Inflation

Fiscal Narratives for US inflation. Jan 29 2024. I wrote it as comments on Chris Sims “Origins of US Inflation Since 1950” at the 2024 AEA meetings. It is mostly a distillation previous writing and talks, trying to tell the story of US inflation episodes from a fiscal theory point of view. Slides here. Video of AEA presentation here.

Long-term bonds and new-Keynesian models.

Comments on “Downward Nominal Rigidities and Bond Premia” by François Gourio and Phuong Ngo, at the Fall 2023 NBER Asset Pricing meeting. (November 2023). My slides are here. A YouTube video of the conference is here, I start at 7:35. The paper is really nice, using asymmetrical price adjustment costs to make the Phillips curve steeper at high inflation, thus change the inflation-output correlation and the risk premium in the term structure. Faced with a clean paper, my discussion talks about broader issues: how to think about term premiums (long term yields vs short term yields), and complaint about why we persist in using the same new-Keynesian models despite pathologies that have been known, and in some cases fixed, for 30 years. The latter is the most fun.

The Fiscal Theory of the Price Level

Updated Jan 21 2023. Now published by the Princeton University Press.

A book, trying to put the fiscal theory in one place, and with the clarity and simplification that hindsight brings. I stress how to use the fiscal theory, over theoretical controversies. And I had to extend what’s already published to stitch it all together.

I will eventually revise the book, so please continue to send typos, comments, things that seem unclear or wrong, places where I repeat too much or not enough, and more.

Additional resources:

Table of contents, sample chapters, and Online Appendix (Manuscript format, not as pretty as the final version. Includes Table of Contents, Preface, Chapters 1, 2, 8, 9, 11, 12, 13, 14, 15, 22, 23, 24, 25, Blbliography, and Online Appendix. Note: Table of contents links to the online appendix don’t work. You have to scroll to the bottom, but it’s there.) 1/21/2023.

Typos. 12/28/2022. For now a short, but sadly not empty, list.

Revised Chapter 5. 1/4/2023. Yes, the book is barely out, but I’m already revising. Giving talks over the last year, and writing some of the essays below, I’m understanding things better. This is a first draft of a much improved presentation of fiscal theory in sticky price models, which is really a central lesson of the book. I push the v vs. v* stuff to where it’s needed.

Fiscal theory with negative interest rates 4/4/2023, updated 10/1/2023. A short note, putting bonds in the utility function to show that fiscal theory can work with negative interest rates. Debt is the present value of surpluses plus the liquidity services of debt.

The Fiscal Theory of Inflation. A 6 page note. The basic story of fiscal theory is really best told with sticky prices; a period of inflation above the nominal rate slowly inflates away debt. I make this point in a continuous time model, which I now realize is the clearest way. This ended up in the new Ch 5, but this short note makes the basic point very simply.

Program and data archive. Warning: Not very clean.

Subsequent FTPL articles:

Fiscal narratives for US inflation. (Jan 2024) A short, nontechnical account of how fiscal theory explains the rise and easing of inflation 2021-2023, as well as the 1970-1980 rise and fall and the 2010 quiet.

Fiscal histories (June 2022). For the Journal of Economic Perspectives. This is a good place to start. With no equations, it tells a fiscal story of US inflation 1965-2022, as well as institutions including the gold standard, currency pegs and crashes, and the ends of inflations. Much is drawn from the book. Putting the stories all in one place and using them to exposit the workings of the theory is a useful way to see what FTPL is all about, and that it’s not nutty.

Expectations and the Neutrality of Interest Rates. (July 2023) Central banks set interest rate targets, not money supplies. What is our theory of inflation with interest rate targets, that expresses long-run neutrality and short-run non-neutrality? Will the new Lucas stand up?

Trio of blog posts on the effect of interest rates in VARs and New-Keynesian models. (Summer 2023). Takes up where “Expectations and Neutrality” leaves off.

The Fiscal Theory of Inflation. (August 2022). A short essay, emphasizing how fiscal theory picks the path of inflation, not the initial price level, with even slightly sticky prices. Now incorporated into the new Chapter 5.

Inflation Past, Present and Future: Fiscal Shocks, Fed Response, and Fiscal Limits. (May 2022) An essay and talk, presented at the Hoover Monetary Policy conference, and forthcoming in the conference volume. A simple rational expectations FTPL model fits the Fed’s views. I emphasize fiscal-monetary coordination to end inflation, with unpleasant interest-rate arithmetic.

Fiscal inflation (February 2022) An essay for Cato, thinking through the fiscal roots of 2022 inflation. The origin and somewhat longer version of the Covid-19 inflation chapter in FTPL.

A summary article (December 2021) with no equations, outlining how the theory works and how you might integrate it into macroeconomic models.

Most of my opeds lately have been about applying fiscal theory ideas. I won’t list them separately here.

Talks, video, interviews, selected podcasts

Uncommon Knowledge 2/28/2003. Interview with Peter Robinson. Starts with fiscal theory, then wide ranging.

AEI Panel 2/28/2003 on fiscal theory. A lightning 20 minute presentation by me, then insightful comments from Robert Barro, Tom Sargent and Eric Leeper, plus hard questions from Michael Strain.

Vance Ginn “Let People Prosper” podcast 1/17/2023. A nice 45 minute interview, to celebrate the book’s release. Lots of fiscal theory vs. monetarism.

O’Connor institute podcast with Liam Julian 6/14/2023.

Bootcamp/Policy Ed. 9/14/2022 Three short nontechnical videos, made for the Hoover Summer Bootcamp, and very well edited by Hoover’s Policy Ed team. Uses simple fiscal theory ideas to cover current events.

In May 2021 I gave a 1:15 lecture at the European University Institute summarizing the project at that point.

Current slides for FTPL talks (10/12/2022). Slides for “Expectations and the Neutrality of Money”

Selected Media and Reviews

Wall Street Journal Weekend interview (2/18/2022) with Tunku Varadarajan. Mostly about how one might use fiscal theory to think about inflation in real time.

To Solve Inflation, First Solve Deficits, This Theory Advises (11/2/2022) Wall Street Journal by Greg Ip.

Have economists misunderstood inflation? (1/26/2023) Book review in the Economist.

A flawed but useful economic model for a bleak age (4/14/2023). Review by Edward Chancellor at Reuters.

Review by Michael Ben-Gad, in Economic Affairs (7/9/2023)

Review by Melissa Davies, Society of Professional Economists (7/27/2023)

One of The Economist’s “Best Books of 2023”

Fiscal Histories

Nov 7 2022. Journal of Economic Perspectives 36 (4) p. 125–146. I use fiscal theory to interpret historical episodes, including the long quiet zero bound, the gold standard and its end, foreign exchange pegs, the 1970s and 1980s, currency crashes, and the present inflation. That approach lets us see how fiscal theory works, and how it can be useful. Lots of low-hanging thesis topic fruit here! Data and Programs. Last Manuscript (local link).

Inflation Past, Present and Future: Fiscal Shocks, Fed Response, and Fiscal Limits

Final, Oct 12, 2022. In Michael D. Bordo, John H. Cochrane, and Joyn Taylor, eds, How Monetary Policy Got Behind the Curve—and How To Get Back. Stanford, CA: Hoover Institution Press 2022 p. 63-114.

An essay, underlying my presentation at the Hoover Monetary Policy Conference May 6 20-22. There is a model by which the Fed is not behind the curve. Is it right? Stopping inflation will require coordinated fiscal and monetary policy.

Read the paper> Slides

Fiscal Inflation

April 22 2022. In Populism and the Future of the Fed, James Dorn, Ed. Washington DC: Cato Institute Press, 119-130. An essay prepared for presentation at the Cato Institute 39th annual monetary policy conference. Video of the conference presentation. The covid inflation was a classic fiscal helicopter drop. It was not a monetary drop. I explore why this fiscal event caused inflation, and previous ones did not; why people did not expect this one to be repaid. Future inflation will come from future fiscal and monetary policy, but future monetary policy will be constrained by fiscal affairs. I summarized this essay for the Ghost of Christmas Inflation in Project Syndicate and used part of it for Ch. 21 of Fiscal Theory of the Price Level. (Last manuscript here.)

Read the paper>

Portfolios for long-term investors

Jan 13 2022. Review of Finance, 26(1), 1-42 (2022). This is an essay on portfolio theory and practice, which evolved from a keynote talk at the NBER conference, ``New Developments in Long-Term Asset Management” Jan 21 2021. Portfolio practice looks almost nothing like portfolio theory. I offer two ideas: look at the stream of payouts or dividends directly, and ask what the function of asset markets is, and what your role in them is. The average investor holds the market portfolio. How are you different? A lot of fascinating asset pricing hasn’t yet made its way into portfolio theory, and I think about how to do that. Complete the model, and add interesting heterogeneity.

Read the paper (free access link to published version)

doi link. Last Manuscript (but the free access link should work)

Slides for the talk Video of the talk.

The Fiscal Theory of the Price Level: An Introduction and Overview (article)

12/12/2021. I try to boil down the book to a readable article with no equations, focused on how economists would use FTPL. This was a draft of an article for Journal of Economic Perspectives, but the JEP article went in another direction entirely, so I leave this in case a nontechnical introduction to the economic analysis in the book is useful.

Read the article>

The Dog and the Straw Man

The Dog and the Straw Man: Response to “Dividend Growth Does Not Help Predict Returns Compared to Likelihood-Based Tests: An Anatomy of the Dog.” 2021. Critical Finance Review 10(3), 465-470. published version. Response to Erik Hjalmarsson and Tamás Kiss. Their paper is a critique of my “Dog that did not Bark: A Defense of Return Predictability” I respond to the critique.

Read the paper (last ms)>

Whither the Fed?

A talk given at the UCSD Economics roundtable June 11 2021. Inflation, Fed policy, fiscal pressures, and a quick tour of the Fed’s entrenchment of bailouts, and forays to climate change and social justice. Youtube video here, slides here, blog post with a bit more commentary here.

The Fiscal Roots of Inflation

Published June 2022. Review of Economic Dynamics 45:22-40. I apply an asset pricing style return variance decomposition to the government debt valuation equation. Unexpected inflation comes basically all from discount rates: a higher real interest rate devalues government debt via inflation. Big deficits and lower inflation are not a puzzle: discount rates decline. Long term bonds soak up a lot of fiscal shocks, smoothing inflation forward. I also decompose recession related shocks, deficit and discount rate shocks. zip file containing programs and data.

Last manuscript (includes online appendix) > 

A Fiscal Theory of Monetary Policy with Partially-Repaid Long-Term Debt

Published June 2022. Review of Economic Dynamics 45:22-40. Fiscal theory of monetary policy means interest rate targets, sticky prices, and fiscal theory. This paper adds long term debt and the crucial novelty: a surplus process by which the government borrows now and promises future surpluses to repay the debt, yet fiscal policy is active. The model generates reasonable response functions to fiscal and monetary policy shocks, and solves a long-standing problem in fiscal theory models. This, the “fiscal roots of inflation” and “the value of debt” are companions. Zip file with programs

Last manuscript and online appendix >

r<g

February 28 2021. Updated July 28 2021. r<g is an essay on the topic of debt and deficits. Sorry, debts must be repaid. It’s based on comments on Ricardo Reis’ r<g paper given at the spring 2021 NBER EFG, and comments on Neil Mehrotra and Dmitriy Sergeyev’s paper at the summer institute.

Abstract:

A situation that the rate of return on government bonds r is less than the economy's average growth rate g seems to promise that borrowing has no fiscal cost. r<g is irrelevant for the current US fiscal problems. r<g cannot begin to finance current and projected deficits. r<g does not resolve already exponentially-growing debt. r<g can finance small deficits, but large deficits still need to be repaid by subsequent surpluses. The appearance of explosive present values comes by using perfect-certainty discount formulas with returns drawn from an uncertain world. Present values can be well behaved despite r<g. The r<g opportunity is like the classic strategy of writing put options, which fails in the most painful state of the world.

Read the paper>

Low interest rates and government debt

Jan 11 2021. A debate with Olivier Blanchard, courtesy of IGIER at Bocconi. r<g is fun, but it is irrelevant to US fiscal issues. r<g of 1% of GDP does not finance perpetual 5% of GDP deficits, every decade 20% of GDP crisis borrowing, plus big new spending plans. And then unfunded entitlements kick in. Also simple economics of why interest rates are low, and a warning of how it could all fall apart. The paper in pdf form, on my blog. Slides. Video of the event.

Challenges for central banks

This is a talk I gave at the European Central Bank (zoom) Oct 20 2020. I survey the broad challenges facing the ECB and other central banks in a policy review, from interest rates and inflation, to financial regulation, to a list of risks to worry about, and closing thoughts on the wisdom of central banks embarking on climate change policy. pdf here. conference website with other papers and video.

Strategic Review and Beyond: Rethinking Monetary Policy and Independence

This was the 2020 Homer Jones Memorial Lecture at the Federal Reserve Bank of St. Louis. Video of the lecture and more here. The article, (html) (pdf) (local pdf) in the Federal Reserve Bank of St. Louis Review, Second Quarter 2020, 102(2), pp. 99-119. Many thanks to the St. Louis Fed, and gracious host Jim Bullard.

Rethinking Production Under Uncertainty

Published (advance access) Review of Asset Pricing Studies July 2020. I investigate a representation of technology in which producers can transform output across states of nature. This representation lets us write down a complete production-based asset pricing model, in which the discount factor equals marginal rates of transformation.

Read the paper (local copy)>

The Value of Government Debt

Here I apply an asset pricing style price/dividend variance decomposition to the government debt valuation equation, to break the debt / GDP ratio into expected future surpluses and expected growth-adjusted discount rates. Variation in the value of debt / GDP is about half future surpluses and half discount rates. Growth variation does not show up. Zip file with programs and data.

Read More >