Episode 32. Economic Growth, Macro-Models, and a Move to the Hoover Institution
Podcast Interview Transcript
Am thrilled to announce that the Capitalism and Freedom in the 21st Century podcast has become an official podcast of the Hoover Institution and a podcast of the Hoover Institution Economic Policy Working Group! Watch here on YouTube as John Cochrane, the Rose-Marie and Jack Anderson Senior Fellow at the Hoover Institution, joins me in making this announcement and interviews me a bit on my background. We then discuss various macroeconomic and economic policy topics including the fiscal theory of the price level, about how inflation can be explained by fiscal and monetary policy, New Keynesian macroeconomic models at central banks, and economic growth.
Jon Hartley: This is the Capitalism and Freedom in the 21st Century podcast where we talk about economics, markets, and public policy. I’m Jon Hartley, your host. Today, my guest is John Cochrane, who is the Rose Marie and Jack Anderson Senior Fellow at the Hoover Institution, and is the co-chair of the Hoover Economic Policy Working Group. John is a prior guest on the show, but this time we're going to do something a little bit different. We have something of an announcement to make. That being that the Capitalism and Freedom in the 21st Century podcast is becoming the official economic podcast of the Hoover Institution Economic Policy Working Group. It's very fitting that the Capitalism and Freedom in the 21st Century podcast become a part of Hoover as this podcast gets its name from the 1962 book, Capitalism and Freedom by Milton Friedman. Hoover is where Friedman called home from after he left the University of Chicago after winning the Nobel Prize in the late 1970s to his death in 2006. Hoover has also been the home of many luminaries, including Thomas Sowell, George Shultz, John Taylor, and of course, John Cochrane. John's going to explain a little bit more about Hoover's economic policy working group and what this means for the podcast and interview me a bit as well introducing me to the Hoover audience here.
John: Thanks, yes, to our devoted listeners. Half of the purpose of this show is to introduce the Economic Policy Working Group angle to Jon's already faithful listeners, but the other half is to introduce Jon and the podcast to the Hoover community where this podcast will now be hosted. So, Jon, let me ask you, you get to introduce yourself a little bit after I introduce you. Jon is currently a graduate student at the Stanford Economics Department. I like to say star graduate student. I'm gonna embarrass you a little Jon. Jon is one of the smartest economists I know, as well as remarkable for being interested in public policy and public outreach at an age when most economic graduate students are simply sitting in the bowels of the library working on equations. Jon runs this podcast. He is incredibly well connected. Everybody I know seems to already know Jon Hartley, and you're only in grad school. Jon has a background University of Chicago, a little time at Goldman Sachs. Tell the Hoover audience just a little bit of your background, Jon. And then a little bit about what the philosophy of the Capitalism and Freedom podcast has been, and we'll talk about what it's gonna be in the future.
Jon Hartley: That's very kind, John, and a very, very kind introduction. And perhaps I should be spending more time working on research in those same libraries and basements where various graduate students are. So, for those who aren't familiar with this podcast, these are one-on-one interviews with experienced economists, policymakers, people in financial markets. We usually ask questions about their careers, their main ideas and contributions. We like to focus on a lot of long-term trends rather than the news of the day. But the idea is to really just focus on a lot of the key ideas, many of which were actually mentioned in Milton Friedman's 1962 book, Capitalism and Freedom. He talked about a lot of things in that book that I think were quite prescient and quite relevant to today, whether these are topics like occupational licensing, universal school choice, fiscal policy, and monetary policy these are topics that have been sweeping the nation in recent years or sweeping the United States. We've spoken with former Arizona governor Doug Ducey, who's the first governor to pass these policies in the US. We spoke with Morris Kleiner, who's the world's leading expert on occupational licensing. We've also had really amazing discussions with academics you know, key contributions, you know, and some who've, you know, represented, I think, key transformations in economics, and one being Steve Levitt, for example, who co-authored the book Freakonomics. He actually announced his retirement on this podcast a few weeks ago, after which the podcast kind of exploded in popularity, and so it's been quite amazing to go to economics conferences and talk to people who I've never met before saying that they listen to the podcast. It's been a pretty amazing experience. To give just a little bit of background about myself, as John mentioned, I'm an economics PhD student at Stanford. I've had some good number of policy stints in a number of places like the World Bank, IMF and US Congress Joint Economic Committee on top of spending several years at Goldman sachs. Most of my research is focused on two streams. One stream is focused on business cycle, macro and finance (many of the same topics that John works on). The second stream is working on sort of economic growth and regulation, so things like zoning, occupational licensing, things that are holding back growth or might be causing growth, firm dynamics (things like management quality being a factor of production) or to what degree antitrust policy can that hurt or help growth. So those are some of the topics that I work on, but in terms of some of the topics I think are really interesting and have been a real theme of this podcast, including our prior discussion, are topics like DSGE models. One theme for those who aren't as familiar with what a Dynamic Stochastic General Equilibrium (DSGE) model is, they're kind of what it's often called the workhorse macroeconomic and business cycle model that places like central banks use including the Federal Reserve. They’re models maintained by central banks around the world and economists like myself and John have to write them down in our papers. But I think, sometimes we're a bit skeptical of how useful they really are. On the podcast, we've spoken with Larry Summers on this podcast and we've talked about some of his original debates with Ed Prescott and who is sort of one of the key figures in starting DSGE real business cycle models. I think John and I are both a little bit skeptical whether any central bankers out there actually move their dots (interest rate forecasts) based on what's coming out of the house DSGE model compared to, say, Vector Autoregressions (VARs). I'm going to probably pass this back to you, John.
John: Let's come back to that one. I want to do a little more intro first. So, the Hoover Institution, those of you who don't know it, combines scholarship and policy and outreach. Most of us senior fellows have been academics and now work for Hoover and continue academic work but also try to do things in the policy space as well. The economic policy working group is sort of the bureaucratic institutional structure that brings together everything we do at Hoover in the economic policy space. It includes a whole list of interesting people who you will get to know over time because one thing I think we're going to do is have Jon interview interesting people associated with what we do. We have a seminar series which brings in more interesting people that Jon will get to talk about. We have conferences, there’s an annual monetary policy conference which is getting more and more successful I think and various other things going on. A range of topics, not just macro, Taylor Rule or money, that we've been talking about here, but healthcare, health insurance, energy, climate, state and local, all the zoning regulation stuff that Jon mentioned are prime concerns. And we are not just banging on the wonders of the free market. The challenge, of course, today is that those of us with a free market bent like Jon and I, look at the ghost of Milton Friedman the current challenges to that legacy, of course, on the left, the advance of the progressive state and on the right, economic nationalism and those other trends that we need to think about and deal with. So those are kind of the broad things of the economic policy working group and I think it's going to be wonderful to bring Jon's great interview style together with the people and the topics that we cover in the economic policy working group. So, you'll never get bored, Jon.
Jon Hartley: Well, that's very and if you just say, John, and really excited one to be working with all these wonderful scholars that Hoover has; I will say, we've actually interviewed quite a few people at Hoover already, but there's many still to interview and so I'm very excited for those future discussions.
Hoover John: Wonderful. Okay. - Well, as long as we've got some time left, Jon, why don't we talk about economics a little bit?
Jon Hartley: Let's do that.
Hoover John: What have you been working on this summer?
Jon Hartley: So, you know, it's funny you ask, you know, one topic that I've been working on quite a bit. It's also a topic that you've been working on quite a bit for the past few years, on that being the fiscal theory of the price level and really trying to understand to what degree we can test the fiscal theory at the price level it's a key equilibrium condition in the fiscal theory is one that you can empirically test because, you know, like MV equals PQ or, you know, the monetary base, velocity, you know, prices and quantities, you can see all those, they are observable. Similarly, you know, with FTPL, you can observe debt, money, prices, and with a lot of history, you can look at the future path of surpluses and you can discount them back. And one thing I think I've been a bit surprised about is actually I think how well the fiscal theory actually kind of works for a macro theory. It certainly doesn’t work perfectly, but I think it works actually a bit better than at least I expected it to going into it.
Hoover John: Let's back up just a second and explain to our listeners who, I'm sure everybody knows exactly what the fiscal theory of the price level is, of course, but the fiscal theory of the price level states that the fundamental determinant of inflation in our economy is not so much money, not so much interest rates, those matter, but the fundamental question is, is there more government debt than people think our government has the will or ability to repay. And when that happens, people try to get rid of government debt quick before it becomes worthless, and in doing so, they drive up inflation. So that's the basic concept of the fiscal theory of the price. I'm glad, Jon, you're taking up this challenge because the basic idea is just like price is present value of dividends. It's the theory of asset pricing applied to government finances. When people think that there aren't gonna be any dividends, they try to dump the stock, the price goes down. When people think the government isn't gonna be able to raise taxes over what it spends, they try to dump the government debt and the price level goes up, same mechanism. But we've been asked trying to test prices, present value dividends for 40, 50 years and it's still contentious. You still say the word efficient market, it's basically that statement and people go bananas about, of course, it's not efficient. And of course, there's all sorts of false steps. It's kind of, the whole thing is kind of vacuous if you let the, you know, prices expect them about present value of dividends. Well, what’s expected? Who’s discount rate? And once you put those things in, you know, the usual criticism is that it's vacuous. So how are you dealing with this central problem, which permeates all of asset pricing that take into its full generality? It's very hard to test, because you don't know what the expected dividends are.
Jon Hartley: You don't know what the discount rate to take the present value is. Well, I think that's a central challenge. And so, one thing that we can do is we can make some assumptions. With the benefit of hindsight, we have hundreds of years of fiscal data that's been compiled by great economists like Carmen Reinhart, Ken Rogoff, among many others, others that have compiled data on interest rates. And what you can do is, you know, you can go back to, say, 1800 and you can, you know, with the benefit of knowing what the future fiscal history will be or what the future path of surplus is will be. You can discount those future surpluses is back using a long-term discount rate. What it was in 1800 and you can repeat that and iterate forward and straightforward and recalculate that. And you can compare that present discounted value to the real value of government debt or your debt-to-GDP ratio. And so, this is something that others have done, yourself have done in different ways. There's a paper by Hanno Lustig and co-authors that's forthcoming in Econometrica where there's a sort of a similar government debt valuation exercise, I would say it's a little more complicated, and it's not exactly testing fiscal theory of the price level exactly either, but it's the same idea that you're trying to take seriously this idea that the real value of government debt, you can compare it to the present discounted value of future surpluses.
John: Let me put in a plug here or what you're doing in the larger scheme of things, especially if any young researchers are listening, we've got a brand-new theory, it says that basically prices present value explains inflation in a way people haven't really thought about before. We have 50 years of accumulated methodology on how you apply that insight to stocks and bonds and is simple low hanging fruit to apply that methodology to government debt and inflation questions. Now, low hanging fruit is not always as easy to eat as it seems, because there's hundreds of little puzzles to work out, ways to implement it, but this sort of the big picture of how we would go to about to do this is fairly straightforward. So, I think this is a very exciting research area, and I'm glad to see you doing it. So let me shift the conversation a little. I want to ask you about our other big issue, which this is one of the things that's been on my mind. And I just finished a paper called “Expectations and the Neutrality of Interest Rates”, which talks about this, but the part of why it's on my mind. But you listeners may have seen that, you know, there's an Atlantic article. Nobody knows how the Fed actually does things. There's a Scott Sumner blog post. Nobody knows how interest rates actually work. And the point of my article was really to look at the very basics and to realize that there is a standard doctrine of monetary policy. It says higher interest rates, lower spending, makes the economy worse, and through the magic of the Phillips curve that lowers inflation. But there is no faintly respectable modern economic model that embodies that doctrine. It simply doesn't exist. And of course, even the pieces of the doctrine are starting, the verbal doctrine. People are starting to notice that the Fed did raise interest rates. Inflation did come down. It’s not clear whether the Fed just jumped in front of the parade or not. I happened to think it did. But nonetheless, the price mechanism, the Fed didn't have to induce a recession. So just how does now people can spin epicycles on this? Oh, the Fed changed expectations. Well, the Fed's been giving speeches to try to change expectations for 30 years. This is the first time it's actually worked. But there is no respectable model. So that of higher interest rates, lower future inflation. Now that contrasts with what goes on in the bowels of the policy world, and in much of academia, where people write incredibly complicated multi-equation models, and people in the policy world, and the central bank and the international organizations, they write these New Keynesian DSGE models, they're beautiful models, but they don't work the way the words say we think monetary policy works. They do not produce; higher interest rates do not produce steadily lower future inflation. That's just not how the equations and the predictions of the model work. So, I'm curious, and if you want, we can go into exactly why this doesn't work, but how do we bridge the, how in your contact with the policy world, how is this cognitive dissonance, how is this schizophrenia that's been going on for 30 years, get patched over?
Jon: Well, it's a great question. And my sense is this, and this may certainly offend certain sensibilities of people that have spent their entire careers on DSGE models, but my experience working in various policy organizations and having talked to a lot of people who have worked very closely with central bankers or been former central bankers themselves that there's basically a bifurcation that goes on. I would imagine or I would kind of put it this way central banks are essentially the biggest subsidizer of DSGE research and DSGE research broadly speaking is actually lost a lot of I would say interest in broader academia, broadly speaking, if you look at the number of macro papers and the number of people just working on the DSGE models or just say macro models in general, in departments and economics departments, has declined really significantly, especially since like the 1990s or so. And largely they've been replaced by applied economists, people that are working on largely apply micro topics, but with really good identification. And what sort of happened, I think in tandem in the 1980s, you know, beginning with Kydland and Prescott and the rise of real business cycle DSGE models is that macro economists were more focused on theory and less focused on very good reduced form identification. And so we have a lot of central bankers, increasingly fewer who have PhDs. There's a great Financial Times article that was written by Robin Wigglesworth a few weeks ago that said and made this observation that now only 50% of FOMC members have PhDs compared to say 75% say a decade or two ago. I think what's in part going on and the reality is that central bankers don't really pay attention to DSGE models. I think that they use VARs and VARs to forecast big macroeconomic variables like inflation and growth and those sorts of things. But at the end of the day, most central bankers will not change their, say their dot or their monetary policy reaction function based on something that's coming out of, some wisdom that's coming you know, DSGE framework, or coming out of a DSGE model, say like FRB-US that's estimated by, by, you know, the economists at the Fed staff in DC. Now, that said, I think, some insight from DSGE models that are used, you know, things like, you know, aggregate demand slopes down, you know, maybe this idea that higher interest rates can slow down inflation. That's not something that's I think necessarily exclusive to a DSGE model. I think at some level, I think more policymakers have like an IS-LM kind of model at the back of their minds rather than a highly technical, you know, 100-page DSGE macro model. But I do think that there really are a lot of empirical examples in the past. Think the Volcker disinflation and what happened there or, you know, the observation that Milton Friedman and Anna Schwartz made in the monetary history of the United States that money supply and its contraction contributed to how deep the Great Depression is. So, I think, in my mind, at least in terms of, I think the best way forward is really to improve our empirics. So, I'm a big fan of a good identification. I'm a bit of an empirical macroeconomist. And I think that the way forward for macro, in my opinion, which is probably a bit different than yours, John, is that I think we need better empirics, better identification. And that's not easy, given that so many things are endogenous and macro and perhaps impossible. But to me, I think that's a better way forward and perhaps a better way to get policymakers thinking about research because I think to be honest like I think I don't think that people on the FOMC are reading new hundred plus page macro papers they get released on the NBER working papers series on a weekly basis. That's just my sort of view on things. Again, I fully agree with you that I think theory is broken in that sense. But I guess the question is, do you need a better model to beat a model in the words of Bernanke and many others, or should we really just follow the data and see what we can glean from that?
John: You said several mouthfuls here. Well, let me react to you about, I've got a list of the eight things you said that I wanted to react to here. So, first of all, my view is actually, the models might be right. And the bottom line where I come to is a combination of New Keynesian DSGE with, but fiscal theory of the price level repairs the most outstanding obvious problem of the DSGE models.
That most outstanding problem is an assumption that inherently there are multiple equilibrium and the Fed acts by making everybody jump to an equilibrium that the Fed likes by threatening to blow up the economy if we don't do it. Literally, that's in there. You've got to be kidding. But that's easy to fix with fiscal theory of the price level. And then you get what I think is quite sensible, which is a view of the economy, which is the way we think it works. There's this production, and there's workers, and there's markets and there's various kind of shocks and interest rates do and do their thing. So, I'm not against the models and in fact what I said was I said something very careful. We don't have a model that encompasses standard doctrine. Now it's not obvious that the doctrine is right and the models is wrong, rather than the models are right and the doctrine is wrong, cause that doctrine really just comes from stories that are repeated over and over again. The doctrine, again, that you raise interest rates that cools the economy and then the magic of the Phillips curve lowers inflation. That the latter part is especially troublesome. Now, you also made fun of 100-page models and that's not really where the trouble is. There's a one-page version of the model. That doesn't work either. The famous three equation model, which includes some, there's something like price stickiness, that's a crucial part of why this monetary policy, although we don't really know what that is. This is not about overly complicated models. These are about models that even boil down to their essence. Don't work the way you think. And I'll just, I don't want to get too deep into models, but there's a clear intuition from why. I suppose the Fed raises the interest rate, the nominal interest rate. Now normally we think of a bottom line that real things remain the same. If you measure something in feet or meters, that doesn't change it. So, the Fed can raise then the interest rate, but then the puzzle is, well, why doesn't then next year's inflation rise so that the real interest rate remains the same? Why does next year's inflation go down? That's the fundamental puzzle, because in the models that's there is no model where next year's inflation goes down when the Fed raises trace this year. The verbal doctrine is a static, you said ISLM. This is a view, a static view, a view that eliminates time. And the central thing what I meant by a respectable model is one that treats time correctly. The intuition people have said well with higher interest rates that's going to lower output and lowering output somehow is going to lower prices and then they jump from that to not prices go down today but prices slowly go down tomorrow so you have sort of a verbal and adjustment mechanism to a static model produces dynamics but that's not how you do respectable economics. Respectable economics today is intertemporal it's today versus the future so when I raise the interest rate interest rate, that's, that's gonna typically raise tomorrow's inflation. That's the kind of fundamental problem. So, it's not about being overly complicated. It's about just sort of fundamental economics that might be right, but does not comport with the standard story. People now you also said, I'm sorry, I got a laundry list here. So, I gotta go through it. People aren't in graduate school, your it's they're not working on macro and inflation. They're all doing difference-in-difference, empirical things, trying to find tiny, tiny little causal, exogenous causal changes in the sea of endogenous facts that we have. But it's really weird. When we went through a financial crisis, there was an outpouring of what caused the financial crisis. And then we had the sovereign debt crisis. And there was an outpouring of what caused the sovereign debt crisis. And we've just had an inflation that we haven't seen since the Reagan era. And you would think there would be an outpouring of what caused this inflation. The answer is no. People would just, oh, is a supply shock or greed or shrink inflation or whatever. Can we get back to work on doing a difference in difference of whether, you know, green ties or yellow ties, you know, raise your GDP by 0 .0001 percent. Now you said empirical, and of course the problem with macro is that those tools don't work. They don't work because you don't have natural experiments. And this central problem of causation versus correlation is one that is not as easily solvable, the VAR, the vector auto regression, trying to do it. But that, I think, is completely played out. It was a brilliant idea when Sims introduced it in 1980, but it requires the notion of an exogenous monetary policy shock. And there is no such thing as an exogenous monetary policy shock. You know, the best we can find are two or three tiny movements, but measuring, and that's not even really the question. The question we want to know of monetary policy is not, what if the Fed sneezes raise 25 basis points? Question we want to have asked in monetary policy, what happened in 1980 was not a sneeze. It was a change in the rule. And the change in the rule changed the expectations. So, there's one data point, Volcker raised interest rates, big recession, inflation came down, but you look over history, There's other totally contradictory data points. The end of the German hyperinflation, when the fiscal problem was solved, interest rates went down, there was no recension, there was an economic boom. They printed up way more money and they borrowed more money. What, what, wait, it's totally opposite. So that's the central problem. And as our models, I think are, I think it's an exciting time for us because our models are completely played out And we need to go back to absolute basics. Does raising interest rates lower inflation and raise the value of the currency? If so, wow. That's like the most basic question you can ask. I think I know the outline of how to do it, but our current models do not do that. And our current empirical procedures, our VARs, they're loaded for forecasting. They're used just for finding correlations; for causal analysis that's completely played out and is answering the question we're not really interested in answering. And you said forecasts. How well have central bank forecasts been doing lately? They've been a complete disaster in park as they ignore supply shocks. They ignore the whole real business cycle. And they say, oh, we had supply shocks. And then I said, okay, well, where's the supply shock in your model? Oh, we don't have any supply shocks in the mall. Well, why not? I think it's a supply I think what I wanted to point about is you said PhDs in central banks, it's not obvious to me that given the state of economic knowledge, more PhDs in central banks is going to be a good thing rather than a bad thing. Central banks, remember, never had PhDs. It was not a College of Cardinals or a theological disputation club. It had bankers that had regular people and the Fed has set up to be a representative institution. It's not obvious to me that PhDs are gonna do any better, especially if they know too much of the models and not enough of the historical doctrine matters. Doing policy is very different from doing research. Doing research, your job is to have 100 crazy ideas before breakfast on the hope that one of them works out. Doing policy is about not screwing up. The loss function is entirely different. Loss function for academia is I can throw away my bad ideas. Loss function for policy is don't screw up even. What do you do to tenure? I guess like.
Jon: I feel like in academia, perhaps it creates a lot of risk-loving behavior in the sense that not getting tenure requires you to take a lot of risks on certain ideas.
John: That's, I don't know, getting tenure seems to require taking very little risks and doing exactly what the AER is likely to publish without too much complaining, but having influence after you get tenure and doing something important in life, which may or may not mean getting famous in economics, getting famous in economics about getting a thousand other people to do what you do would cite you. It's not necessarily about being right, but long-lasting influence being right. Yes, it's about taking an intellectual risk and which is not if you do policy, Jon, you do policy someday, no more intellectual risks. You gotta be very, very, I think wise policy is very conservative, even I, I just gave you a lecture about higher interest rates don't, I don't know how they lower inflation, but you put me in charge of the Fed, inflation goes up. I'll tell you what I'm going to do. I'm going to raise interest rates. I don't know why it works. I don't know if it works, but until we know for certain something else works, that's what you got to do.
Jon: Well, I think it's quite ironic that Jay Powell's, I guess, idea or central idea or approach to policy, which he refers to is you know, the risk averse approach to, sorry, “risk management approach to monetary policy”. And I think, you know, that's not, that's making it immediately clear, you know, it's kind of, you know, keep going until you break something, I guess, type of approach.
John: I think monetary policy needs more of a risk management approach. You know, they sort of say, here's the forecast and here's what we're gonna do, rather than, you know, what our military colleagues here at Hoover do. It just, they teach us, you don't say, well, the forecast is they're coming on the left flank. So that's what we'll meet them. They, you go, well, what if it's the left flank? What is the right flank? What if they come down the center? Or what if they come around by, you know, you gotta think much more about risks than the Fed typically does.
Jon: Yeah, I mean, it's interesting. Like, I guess, I don't know how you frame it from a risk, but I think a related problem it's really just, I think, a group thing. And you go back to, for example, October of 2021, after inflation had started to shoot up in April, May of 2021. And at that point, by October, 2021, it was very clear that it wasn't just used car prices that were driving the big jumps in CPI that we were seeing, we were starting to see things like shelter, home prices are owned or occupied, rent prices increase. And even still, the Fed waited another six months to start raising interest rates in March 2022. And I think there was this idea that inflation was going to come back down on its own and wouldn't need help from the Fed. And this was just this idea that you know, promoted by the media. I really think that forecasters were moving away from what their, you know, VARs would suggest, you know, just that this supply shock was a one, you know, one in a hundred-year type event. But, you know, even so, I think, I think independent thinking is, I think that's somewhat rare thing. Another thought is, you know, I think just on, on sticky prices and sticky wages, you know, I've heard the stories of how it came back to modeling, how sticky prices, sticky wages first got inserted into macro models in the first place. And my understanding is basically, you had RBC models which said that there was no role for policy to have any real economic effects. And a lot of the early New Keynesian modelers basically said, we want policy to matter; so we can throw sticky prices or sticky wages into the RBC machinery and make policy matter again. What’s important is there wasn't some sort of, you know, great, you know, empirical insight necessarily that that it was, you know, sticky wages that were causing massive fluctuations in unemployment in history. You know, there was some work written by Bewley and others afterward, but I think it's kind of funny how it was something that was sort of inserted into models to make them work the way that such modelers wanted them to work without necessarily a ton of empirical basis. But, and just I guess maybe I would push back a little bit on some of those natural experiments. I do think, you know, especially, you know, for economic historians there, I think there are great natural experiments to look at when it comes to monetary policy. We have great instances of, you know, the money base being cut by massive amounts. You know, and for example, I think in France, there's a great Francois Velde paper. There's the 1863 Currency Reduction Act in the Confederate United States where the money supply was contracted and it could only be contracted in one part of the Confederacy, the Eastern part of the Confederacy because the Union forces have taken the Mississippi so the new gray back notes couldn't make their way to the Western part of the Confederacy, which is like Texas and so forth. And so, inflation from your gold backed prices actually went down pretty significantly in the Eastern part of Confederacy versus the Western part. So, I think things like that are what you see in and Francois Velde, you know, in France, I think these are, you know, obviously historical episodes tha, economy may look very, very different now, but, I think they're interesting. And, you know, exogenous identification, some would even say, you know, there's some of those monetary policy shock series, whether it's, you know, from folks like Nakamura-Steinsson, give you some exogenous variation, you know, breaking an exchange rate peg or stopping UI benefits or some sort of cutoffs across states. I think these are interesting, I think examples of good identification that can sort of help us to answer, at least begin to answer some macro questions or identify some parameters. Sure, might be partial equilibrium, not perfect. But in my opinion, gets us some answers maybe with some precision, even though it might not be global.
John: You've given me another laundry list here, so hold your horses. First of all, I want to violently, loudly agree with you on what you just said, that I find lately historical episodes are the most convincing natural experiments we have for and macroeconomic theories, as opposed to, you know, fancy statistical analysis with a lot of assumptions and identified VAR by some identification restriction. And I just want to point up some that I've been making lots of pay in my own writing. I regard the inflation episode that we just had. Inflation came from seemingly nowhere. The Fed didn't, you know, do anything with interest rates, particularly unusual. 8 percent inflation where they come from. And then inflation went away without repeating 1980. So that's a historical episode. Well, the federal government printed up five trillion dollars of cash and gave it to people. And the fiscal theory of the price level does exactly that. And the other theories clearly don't. So, there's a historical episode that I think helps you distinguish theories. The other one is the zero -bound era. When interest rates hit zero, and the Fed did massive QE, our existing theories made very clear predictions about what happens. At the zero bound, you have deflation spirals in old Keynesian models, you have multiple equilibria and sunspots in new Keynesian models, and when you do QE, you have hyperinflation in monetarist models that the comparison of QE which did nothing and the COVID expenditures which caused inflation is just crucial for monetarism says those two have the same effect. Fiscal theory says they don't. So, this is an example of historical episodes that are just screaming. Theory A makes a clear prediction. Theory B makes a clear prediction. The episode tells us what happened and yet nobody's paying any attention. So, the problem and I love Velde's work on a chronicle of a deflation foretold for your listeners, the Velde and Sargent macroeconomics of the French Revolution, another masterpiece. Their work on US fiscal and monetary theory, more masterpieces. So that's, I think that's incredibly useful work. The problem right now is sort of our professional problem. It doesn't look very technical. So, you can't impress hiring committees and econometrica editors with all the equations you can run. You can just convince people of stuff that's right. It's like Tom Sowell's work, doesn't have lots of regressions. It's utterly persuasive by assembling facts. Now, maybe hopefully economics will at some point produce reward things that are actually producing knowledge. but I totally agree that's kind of where my own thinking is going to try to send anything out. Something about central banks not having independent thinking and that's true. There is kind of this bubble where they talk to each other. It's funny because the Fed is set up so much as a responsive structure. The regional banks, the FOMC members, they're not supposed to be there to represent schools of thought, they're supposed to be there to represent communities and you get its stock. And I think the greatest example and the disadvantage of having too many PhDs around is just one, you mentioned one episode, but the episode earlier, the flexible average inflation targeting is a beautifully constructed New Keynesian DSGE marginal line against the supposed problems of deflation at the zero bound, which we cure by making promises about what we will do 10 years from now if inflation should ever come. And the promise of if inflation ever comes 10 years from now will be slow to react, will be the thing that stimulates us today. That was just New Keynesian DSGE doctrine. It took over within the central banks. And it was, and you know, like the original marginal line, sorry, you know, it was the wrong, the wrong problem at the wrong time. And it's a great example of both the kind of group thing, but how the group thing wasn't was affected by, you know, I would say too many PhDs, and not enough people saying, you know, you got to be kidding about this time. And last, you said sticky prices. And this was a very deep thing that you said. Now, sticky prices are, everybody recognizes the models of sticky prices are kind of silly. This is a problem we have in economics. We're like the drunk who looks for our keys where the light is not over by the car where we drop the keys. Because they are, we kind of sense, like the historical experience that inflation causes output booms and deflation is sort of associated with recessions and we don't know why. So, what making prices sticky artificially kind of produces models that do that kind of thing and lets you explore it. You also mentioned it helps to sell things to central banks and here, you know, we just noticed our last two recessions have had nothing to do with monetary policy. There was a financial crisis and there was a lockdown and it caused the recessions. You can't ask for a better real business cycle view of the world, but you are right that telling central banks they're not very powerful is not a really good way to get yourself invited back to central banks. And it is funny that the whole macro has so totally focused on monetary, but we all kind of agree monetary policy might, you know, 1%, 2 % here and there, but sort of the central things that cause big economic perturbations are not anymore monetary policy. Friedman turned out to be wrong, maybe not about history, but about current events. Recessions are not caused by monetary policy mistakes. And this isn't just doctrine. This is what you can see in every empirical estimate, even your VARs. Monetary policy shocks just aren't that important for recessions. And, you know, in fiscal theory, the Fed is on the edge of helping here and there, but, you know, fiscal policy is really important. Milton Friedman won far too much on the importance of central banks. In the '50s, people thought inflation had nothing to do with central banks. There's wage price spirals and stuff like that. Then Milton Friedman, said yeah, it's all central banks. And now, you know, recessions are no longer all central banks and inflation we're starting to discover is not all central banks. So, it's a problem that your most important customer (central banks) with the deepest pockets wants a theory where central banks are really powerful and it's not obvious, they are.
Jon: Okay, stop having so many beautiful ideas and I'll stop having such long responses. So, here's another, I guess the last just a couple monetary policy question. I'd love to talk to you a bit about economic growth and regulation and other growth -related topics as well.
John: Let me just interject. Monetary policy, I do it because I think it's interesting, but economic growth is the important issue of our time. The fall in economic growth is the tragedy, is the Europe's end of economic growth is the tragedy, and it really has nothing to do with the Fed and monetary policy. It's about regulation, innovation, dynamism, all those things. So yes, that's the important question. And we're off. We're the drunk looking for the car keys over where the light is and not where we dropped, economic growth.
Jon: Absolutely, I have one last question on just monetary policy. So one is, you mentioned FAIT or flexible average inflation targeting. and just inflation targeting the past 30 plus years. And the history behind, I think it's really interesting. You know, for those that aren't really familiar with, you know, how central banks, you know, are targeting things. There was a period of time at the height of sort of Milton Friedman's thinking in the 1980s when central banks were trying to target monetary aggregates that they were taking MV equals PQ very seriously. And then they realized they kind of couldn't really target it or control and very well or in part because money demand is a bit unpredictable. And from there, that's kind of how this New Keynesian machinery kind of emerged or the whole concept of targeting an interest rate as well as targeting an inflation rate emerged. And it was really the Reserve Bank of New Zealand that began inflation targeting and sort of chose this 2 % level of targeting. And then other central banks around the world followed, the Fed started following, but didn't officially declare their 2 % target until actually the early 2010s. But the whole world sort of following this 2 % idea by and large by the end of the 1990s. And what's interesting is in those debates, if you look back and there were a number of people, like for example, Paul Volcker, who is very much against 2 % was in favor of a 0 % inflation target. That's the central Paul Volcker being president of Fed or the chairman of Fed for quite some period of time and killing the inflation of the 1970s and I can age or at least being credited. But with that, maybe there's more of a fiscal policy story that we could tell. But other central bankers like John Crow, who was the governor of the Bank of Canada in the early 1990s, was in favor of 0 % inflation targets. I know John, you've spoken quite a bit or written quite a bit about not being as worried about the inflation as we should. Let's say some recession hits the US economy in the coming the Fed drops and just rates to zero, back to the zero lower bound. And so, we start getting worried about deflation again. What would you say to those people in macro circles?
John: Oh gosh, so once again, there's a whole history here. Yes, central banks, there's a question of the target and the instrument. So, what do central banks want to control? You know, are we driving to Las Vegas? Are we gonna go to Santa Barbara? And then what do they actually, is the steering wheel, the money supply or the nominal interest rate? Or those are central questions that we've chained around on over the years. As you mentioned, it used to be the money supply that turned out not to work. Central banks went back to what they've always been doing which is targeting and using the nominal interest rate to try and steer inflation where The, the other question is, is the set of goals should central banks worry about one thing inflation or a whole bunch of other things inflation, our official mandate in the US is inflation and, and employment, but there's a whole bunch of other things people want central banks to do as well you know exchange rates and inclusive employment and climate and all sorts of things now. So, just quick on the history of this, in the 1980s the US Fed and other central banks went back to interest rates and felt that higher interest rates was what you do to control inflation. In the early 1990s, a bunch of countries, including starting with New Zealand, in innovative with the idea that the central bank would not try to do five things at once, inflation, unemployment, of other things, they would just worry about inflation. And I think this is very wise, the best way to raise employment within the constraints of what monetary policy can do is to just have very stable inflation. And it's when inflation goes up and down, and then the Fed has to fight it all the time that you get fluctuations in employment. By the way, it is kind of weird that the Fed is supposed to be in charge of inflation, and it can't do the one thing that creates inflation or gets rid of inflation. It can't give people money and it can't take away people's money. And the Fed is supposed to worry about employment, but God forbid it should talk about, you know, tax rates, employment policies, and so forth, which is actually what determines employment anyway, within the constraints of what it can do. So, what happened was New Zealand and the other countries, it was a political deal with the central banks as well, was you worry about inflation, we will evaluate you by how you do on inflation and nothing else. I think also they always included fiscal and microeconomic reforms, which is actually, I think, an important part of the deal. And we, by the way, will pay our debts, and we won't count on you to print up money to pay our debts. That was a crucial part of the deal, and we'll get rid of a bunch of regulations. What happened was Not, you mentioned the Volcker experience, high interest rates and a big recession to combat inflation. The inflation targeting countries got rid of inflation big overnight. The idea was it was supposed to insulate central banks from political pressure, not to raise interest rates. And so, they could be tough and repeat Volker if they had to. And they never had to. It was just instantly inflation went away, sort of like the end of the German hyperinflation. So that was a big success. And through the 19th through the formation of the euro central banks were told this is beautiful. Just worry about inflation. Don't worry about anything else. Everything else will take care of itself if you just worry about inflation. Now we've kind of slid back on that a lot. Central banks are now doing all sorts of other things beyond just targeting inflation. And but we are left at least in the doctrine and also, we're starting to realize central banks maybe don't have as much control with it. We're left with a doctrine of exactly what do you mean by target inflation? You're right, 2% was just picked out of a hat. I personally like zero, but the, you know, the arm feds mandate is price stability. The European Central Bank's mandate is price stability. What do you think they meant when they said price stability? Do you think they meant 2 % inflation forever or do you think they meant price stability. That's a legalism, but then there's the economic question, which I don't know how deep you want to get. I kind of like price stability in part because I'm not that concerned about adding stimulus from the central bank. The central banks just not screw up. That's good enough.
Jon: In the U.S., it's price ability and full employment.
John: Now, the theory is It's the same theory as the theory that it feels good. If you wear shoes that are too tight all day long, cause it feels so good to take them off at night, that if it's 2 % in normal times, then you can have higher interest rates and lower them more. All right, maybe, maybe not. I don't think so.
Jon: I guess the divine coincidence idea that you're just targeting inflation, you end up also targeting full employment…
John: There's a kid in bigger question of what do we mean by this 2% inflation? And this really comes up with the inflation that we've had. So, if you say you have a 2% inflation target, does that mean inflation is on average 2% over long periods of time? You might think yes, absolutely no, because they always catch up with in a forward -looking direction. It's 2% where mistakes are forgiven. So, if you have your impression of a 2% inflation target, it might mean, well, if it goes up 8% in one year, you've got to years of zero or 1% that, you know, kind of bring it back to 2% over the average. Uh -uh. Central banks' interpretation of price stability is 2% inflation forever, and if we ever screw up, we just forget about it and try to get back to 2% in the future. But not, we, you know, we bring the level of prices back to where it was. And that's actually, that's the deepest part of the 2% target that I think bears bear some, bear some worry. So yeah, I think zero would be fine. Price stability should mean price stability, but that is that last remaining part of the debate still.
Jon: Well, speaking about your books, you know, and it would be, do you remiss not to plug your, your perhaps, dare I say, magnum opus, The Fiscal Theory of the Price Level that came out two years ago. You're also working on a new book, a related one on, my understanding is on fiscal theory, but in the Euro area. Can you explain just a little bit about that and the idea behind that book?
John: I'm very excited about this. The book is titled: “Reforming the Euro: Lessons From Four Crises“. I'm working with Klaus Masuch at the European Central Bank (ECB), and Luis Garicano, who is, LSE, University of Chicago, and an ex-member of the European parliament, and a great theorist. We're finishing up due to July 15th a manuscript which will be available on my website for free until it gets published by Princeton in the spring on reforming the structure of the euro and of course the central problem of the euro it was set up quite clear -headedly really amazing the things they thought about compared to standard monetary doctrine at the time. The problem of a common currency without a fiscal union is that of course each individual country has an incentive to borrow a lot of money and say help, help, help print money to bail us out. So, the ECB and the Euro was set up very thoughtfully to try to stop that problem. The ECB would not buy sovereign debts. The ECB would not work to hold down spreads. And countries were supposed to follow debt and deficit limits to not get in trouble in the first place. And we'd solve that problem. Well, not really. And in part because when putting it together, they didn't really want to write a prenup. It would have been impolite to say, Now, if you do feel like defaulting, let me remind you that you are now just like a country, you default, and to put in a bankruptcy and resolution mechanism, which they didn't do. So that was a beautifully set up separation of monetary and fiscal policy, and it kind of fell apart. Now, it fell apart in the most human of all ways, things that nobody ever imagined, in fact, happened. The financial crisis happened. Nobody was thinking about financial crises. Financial crisis happened, and the ECB started to intervene. The sovereign debt crisis happened. Nobody thought there would be sovereign debt crisis anymore. The ECB started buying Greek bonds. QE happened, and the ECB decided, well, somewhat we don't buy sovereign debts. We're gonna buy lots of bonds and print up lots of euros. COVID happened. The ECB bought more, and step by step, we're now in a situation where, you know, every time there's a hiccup and the Italian spread, the ECB starts buying Italian debt. So, the, you know, we're economists, it's about incentives, the incentives for countries to run good fiscal policies for people not to expect the ECB to intervene routinely are gone. So that basic structure of the euro, the monetary and fiscal part of the year. And it's banking too. By pretending sovereign debt was risk-free, it means banks are loaded up with sovereign debt. So, banks are like hostages now, because if Greek fails, Greece fails, all the Greek banks fail. Why? Because banks are allowed to load up on sovereign debt as if it's risk -free in a way they can't load up on carburetor. Well, that's nuts, but nobody forgot our order fixing that. So, the book points out this beautiful structure that was set up, how it fell apart in in the exigencies of four crises, isn't it? If you put me in a crisis, I'm gonna bail everybody out just like they're gonna, you gotta get through the crisis, but then nobody fixed the structure in between the crisis. They just said, oh, great, a river of money solved it. So, let's go get ready to print up another river of money. So, we're at the point now where Europe needs to put that genie back in the bottle and get some structures that will get the incentives right again, not for everybody not to count on the ECB, always to print money to solve every problem cause it won't always be. So that's the short summary of the book and wait. Well, this probably won't come out till July 15th. July 15th, the draft will be up on our website and look forward to it next year from Princeton University Press and many more podcasts about this wonderful effort.
Jon Hartley: I'm very excited to read that. It's a super exciting development. So lastly, I just wanna talk about economic growth. The question I think is perhaps the most central question in the field of economics, why are countries rich or why are countries growing or why do certain countries have levels of GDP per capita that are much higher than others. I think this is a really important question.
John: Let's not solve all the world's problems in one podcast, Jon. I think what we've done for our listeners is tee up the many issues that we'll continue talking about along with tariffs that's probably going to be in in the soon industrial policy that's going to be in soon. How much money should the government throw should on electric vehicles, specially made in the US by union labor. We got a whole bunch of issues coming to talk about over the coming years.
Jon: Absolutely. Well, this is really such an exciting opportunity and Hoover is such a great group of scholars many who will be appearing on the podcast soon. And of course, really wonderful to have you on, John, as always, I really want to thank you so much for joining us today and also for this wonderful collaboration between the podcast and the Hoover Economic Policy Working Group, really excited to be part of the team and really excited to continue to engage on a lot of these same ideas that we've been talking about.
John: This is going to be great fun, Jon. And I hope all of you tune in to the new home of Capitalism and Freedom in the 21st Century podcast at the Hoover Institution EPWG.
Jon: Wonderful. Today, our guest was John Cochrane, who is the Rose Marie and Jack Anderson Senior Fellow at the Hoover Institution and the Chair of the Economic Policy Working Group. This is the Capitalism and Freedom in the 21st Century podcast where we talk about economics, markets, and public policy. I'm Jon Hartley, your host. Thanks so much for joining us.