A commenter has several questions for John Cochrane. I will try to answer them myself.
1. I can’t take a t-bill and use it to pay for coffee at Starbucks. For that I need money. That’s true for all consumption, and consumption is the biggest part of the economy. So the money supply has to be important–there is a difference between t-bills and money.
2. Mr. Cochrane claimed (as I understand it) that inflation will happen when the public loses faith in the gov’t’s ability to pay its debts. But isn’t that likely to be deflationary?
3. Mr. Cochrane’s wonderful equation is inflation = inflation expectations + pressure. He never comments on the pressure term, but I assume that refers to things like demographics, new technology, changes in consumer sentiment, etc.,
My guess is that if you go to Starbucks, you will see most of the transactions taking place without money. Customers use credit cards. Or ApplePay. Or who knows what?
In today’s economy, it is hard to imagine that the amount of money in circulation determines spending. Instead, I think that wealth, broadly defined, determines spending. I think of private-sector wealth as anchored in reality. Stocks have to pay real dividends. The connection may be loose, but it is there. But government-printed wealth is artificial.
Government artificially creates household wealth when it spends more without raising taxes. It pays for its spending either with t-bills or money, and the private sector can count these as wealth. (You can argue that the private sector should not count these as wealth. Almost fifty years ago, when the “rational expectations” fad was sweeping the economics profession, Robert Barro wrote a famous paper arguing that people do not count government bonds as wealth.) The way I look at it, t-bills and money are both treated as wealth, so I don’t think that the difference between the two is as important as the fact that deficit spending raises perceived wealth, and higher perceived wealth raises spending and inflation.
Regarding (2), if my creditors lose confidence in my ability to repay my debts, they cut me off and my spending goes down. That is deflationary. But if the government’s creditors lose confidence in its ability to repay its debts, the government has an option that I don’t have: print more money. That will be inflationary. If instead the government adopts a “sudden stop,” meaning that it sharply cuts spending and/or raises taxes substantially, then that will indeed be deflationary.
Regarding (3), an important source of pressure is the additional private-sector wealth created by deficit spending. Too much wealth chasing too few goods, as it were.
I think that John would tell the story somewhat differently. Rather than focus on wealth perception, he would say that unsustainable deficit spending raises concern that the government will have to print money. As this concern gets built into expectations, people will take steps to protect themselves from a government default and/or a lot of inflation. Many of those precautions in fact hasten default and trigger inflation.
I don’t have a problem with John’s story. He has government deficits affecting expectations, and I have deficits affecting pressure. It could be both.
I tend to be suspicious that when anyone labels some types of wealth “artificial” they are (whether intentionally or not) employing a rhetorical trick to explain why their past expectations or predictions have not proven accurate. I am skeptical that anyone can predict the financial future better than markets at a rate much better than chance.
So then, any asset that can be exchanged for cash today has a “real” enough wealth value today for me. No asset is guaranteed not to lose a lot of value in the future. The market price of all assets today, and every day, is based on the supply and demand for the tiny portion of the total amount of them traded today.
Talk of “artificial” wealth confuses more than it clarifies and provides too much cover for bad predictions. You don’t need this term to argue for the policies you think are best.
“I am skeptical that anyone can predict the financial future better than markets at a rate much better than chance.”
I get what you’re saying, but the fact is we don’t have real markets, or real price discovery anymore. And yes…as a result there are some people who can predict financial futures better than chance because in reality they’ve got either control of the market or access and control over other people who do.
We don’t have real markets anymore. Haven’t for some time.
>—We don’t have real markets anymore. Haven’t for some time.”
This is naive nostalgia. There never was a time when there weren’t insiders with the advantage of inside knowledge. And there never will be. The “real” markets you speak of are useful idealizations like a frictionless plane in physics. In general, markets are bigger, more liquid, and harder to game than they used to be.
The overwhelming majority of people without insider knowledge are the ones who beat the market at a rate you would expect to happen by chance.
Of course we have real markets. Which people are these that have control over markets though that they can better predict them than others? This kind of runs counter to what Arnold is saying. He thinks the the powerful market players are failing to predict inflation that outsiders like him see coming. If he’s right, he could profit greatly from it, as could anyone. There’s no law against betting on inflation, so market predictions still very much matter, and their failure to predict it still requires an explanation.
Yeah, FIT type thinking is supposed to be all about thinking in bets, right?
Since I have little confidence in my own ability to predict the financial future, I am betting that diversification is the best strategy for me.
My own reasonably successful investment history taught me many lessons. Most involved learning not to think I was smart enough to beat the market averages.
Right – very very few have been able to consistently beat market averages. Invest in index funds.
Or vacations to enjoy life now! (It’s later than you think … better to enjoy “while you’re still in the pink.”)
Not saying i have all the answers (i don’t), but we know markets aren’t forward looking. If we are building a future inflation problem, the market (and especially the bond market) is the last place i’d look for confirmation (see the 1970s).
Government bonds are artificial wealth (mostly) because they net out to zero, as they have to be paid back either through taxation or more borrowing. Very rarely does government spending go into productive investments that produce a stream of income to repay the debts. As such it isn’t wealth it is just an accounting shift.
>—-“Government bonds are artificial wealth…”
Isn’t it strange then how U.S. government bonds are the most universally accepted collateral and readily tradable asset in the world? Why wouldn’t people demand “real” wealth instead?
If you have any doubt that wealth gets its value from social convention you should read Milton Friedman’s brief and brilliant essay “The Island of Stone Money.”
Perhaps if you had read more than 5 words of the response you would have noticed that the discussion is about net wealth. If I give you $100,000 then you are wealthier and I am less wealthy by that exact amount, If you just look at household balance sheets then it makes it appear as if government debt is net positive because there is no inclusion for the future cost of servicing that debt, which must fall on households in one way or another.
I did read all the words in your response Tom. You are not using the term “wealth” in a conventional way.
You want people to only use the word “wealth” for the type of wealth that goes into net income producing investments. That is not a conventional definition. By that standard, a store of unused gold or land is not a form of wealth. They would typically be generating some expense to hold without generating any income and so wouldn’t be “real” wealth. I am arguing that any asset that can be turned into spendable cash today is “real” wealth today. All assets are subject to drops in future value, some more than others of course.
If you have personal knowledge of which assets will gain and lose value in the future you should be very rich as a result of that extraordinary knowledge. You are aware it’s possible to short government bonds, right?
Tom cullis, you wrote “government bonds are artificial wealth (mostly) because they net out to zero, as they have to be paid back… taxation”.
From an individual person’s point of view I think it’s real; not artificial, to some extent. If I own a Treasury bond and I have to pay all of the tax that refunds the bond principal and interest, then the set of contracts (bond and tax obligation) have close to net zero value to me. I say “close to net zero” because I might place some small positive value on the government activity.
In reality, I don’t have to pay all of that tax because the government debt was smaller the day I was born and bigger the day I die. This means the set of contracts (bond and tax obligation) have real value for me.
You wrote… “very rarely does government spending go into productive investments that produce a stream of income to repay the debts”.
This is probably wrong even when the spending is not for public roads and other “traditional infrastructure”. For example if old people die sooner there will be less child care. So Medicare for the old subsidizes child care for the young who will pay taxes in the future. Yes, I know, only a subset of the population has a lot of inter-generational involvement because the population is very mobile but this just serves to illustrate that on a logical basis what you said was probably wrong.
Well…
OK, just today Eurostat reported EU core inflation through 12 months to June at 0.8%.
Yes, core inflation in Europe is under 1%.
Japan has borderline deflation.
China CPI was up 1.3% in May, on year.
So, most of the developed world is under 2% inflation, and well under at that.
The US is running about 4% inflation, some of that on global oil prices (think OPEC), and lot of it on property zoning and tight housing markets. Used cars evidently also.
Maybe we see some moderate inflation in the US for a few years. Maybe not.
The rest of world? Seems unlikely.
I guess if you think the US is headed for inflation, there are some short US dollar plays to be made.
You can short US Treasuries. That has not worked for 40 years, but maybe the times are a-changing….
Yes, it is very hard to see how fiscal deficits cause inflation when the past 30 years have increasing fiscal deficits across a broad suite of countries and decreasing inflation across that same suite. What looks to be happening is massive crowding out, large deficits are correlating with lower future growth over and over again
I think if there were crowding out we would see higher real interest rates.
We are probably looking at capital gluts for the next several decades.
I wish I knew how to raise productivity, which seems to have fallen in developed countries all over the world.
It may be the solution is not easy macroeconomics, but rather tackling structural impediments one by one by one by one, such as property zoning.
Global free trade has made labor a cheap commodity which might have induced people to spend less rather than more on productivity.
One of the confusing factors involved in talking about money is that our terminology is still linked to physical currency. A “cash payment” can mean immediate payment by any means: debit card, credit card, or a pile of paper currency. Mr. Kling referred to the government “printing money,” but there is a tiny relationship between the money supply and the involvement of any physical printer. “I paid cash for my house” generally does not mean a large briefcase of $100 bills. Mr. Kling responds to the questioner’s statement about needing “money” to pay for a Starbucks as though he meant dollar bills. But “money” is the vaguest term of all. But I do know that at present I can’t directly pay for anything in a means denominated in T-bills. I’ve heard it asked, “What is the inherent value of a Bitcoin?” But the same can be asked of the dollar. What the hell is a dollar?
Good point.
Due to COVID, my local coffee providers have not been accepting cash lately, but only credit cards. Does that mean cash has ceased to be money, like t-bills? Hint: No.
The thought experiment you have to do here is this- what would happen if the Federal Reserve simply burned or X-ex out all the bonds on its balance sheet?
The Treasury Secretary could probably do this on her own initiative by minting a few of those trillion dollar platinum coins, depositing them at the Treasury’s account at the Fed, then using the proceeds to buy the equivalent amount of USG bonds back from the market, monetizing the debt.
Right now, the Fed’s balance sheet counts bonds as an asset and the dollars it has issued, physical and electronic, as liabilities. What happens if the bonds are never resold into the market (and I don’t think they ever will be, either)?
And look at what is happening with the RRP. Almost a trillion dollars each night to be unwound the next morning. What if the Fed stopped RRP altogether?
“Too much wealth chasing too few goods, as it were.”
They’re chasing hot stocks and hot housing markets.
There’s plenty of low cost stocks, like Gamestop last year (not now tho! 🙂 ), and plenty of low cost housing, especially in Black majority school districts, which are NOT being chased, nor are increasing much.
Nobody’s chasing Big Macs nor most food.
No hyperinflation without food shortages.
Hence the inflation is mostly in quasi assets like housing.
No matter the dollar value of my house, its value to me remains constant as one equivalent housing unit. If it appreciates 50%, so will the equivalent house I would have to buy to live nearby.
Unless you don’t already own a house, then it got more expensive without your income going up.
It’s no wonder that the average age of homeownership keeps going up. It’s mostly people already in the game trading with each other.
Your higher inflation belief seems to be succinctly captured in this quote… “Government artificially creates household wealth when it spends more without raising taxes. It pays for its spending either with t-bills or money, and the private sector can count these as wealth.”
Since U.S. Treasury bond issuance when it is without the Federal Reserve’s involvement requires the private sector to pay money to the government, the private sector already had the wealth to pay for the new bond issuance. So the relevance of the more wealth causes more inflation explanation in this situation is not strong. The government is time shifting the spending from the future to now. Consider that the private sector that had to pay for the bond is time shifting consumption to the future so that has a dis-inflationary effect. The net inflation result is undetermined.
When U.S. Treasury bonds become Federal Reserve assets, then there is money produced but when inflation expectations are low, people don’t mind holding money. “Mr. Cochrane’s wonderful equation is inflation = inflation expectations + pressure” and it is wonderful indeed. Perhaps the pressure is negative because 2021 April, May, June, private nonfarm employment numbers all appear to be much higher than the 2019 average.
I agree there has been a large increase in “artificial wealth” in the pandemic period if I define that as more money and high price to earnings ratios for stocks. However, most people know that if you spend according to wealth you might never become wealthy or the wealthy will not be wealthy for long. Most people spend out of needs and wants. This might be the “pressure” from the Mr. Cochrane quote. Perhaps in the 1970s the needs and wants exceeded the capacity to produce even though boomers were joining the workforce and LFPR was increasing for women. Somehow they couldn’t produce enough real GDP and of course inflation expectations were jolted. Perhaps in 2020 and 2021 our “wants” decreased just enough voluntarily or involuntarily.
All this makes me sound like I’m predicting higher inflation is temporary but I am certainly not certain.
To elaborate…
Regarding the increases in employment in 2021 April, May, June: of course I am suggesting that these people will produce enough that their new situation is dis-inflationary, not like the 1970s experience, but in this matter I am just guessing.
“Since U.S. Treasury bond issuance when it is without the Federal Reserve’s involvement requires the private sector to pay money to the government, the private sector already had the wealth to pay for the new bond issuance. ”
It’s not the guy who bought the bond that is wealthier. It is the guy who wound up being paid by the government with the money that it got for selling the bond.
Suppose you are a money market fund shareholder and I am a government contractor. You invest $1000 in a government bond, with no change in your net wealth, as you say. But I get $1000 in payments from the government, and my wealth is up $1000. So overall the private sector gains $1000 in artificial wealth.
When the government gets around to raising taxes to pay off the bond, someone in the private sector will lose wealth and the artificial wealth will have gone away. But for now, I assume nobody plans for that.
“The overnight reverse repo program (ON RRP) is used to supplement the Federal Reserve’s primary monetary policy tool, interest on excess reserves (IOER) for depository institutions, to help control short-term interest rates. ON RRP operations support interest rate control by setting a floor on wholesale short-term interest rates, beneath which financial institutions with access to these facilities should be unwilling to lend funds.”—-Fedspeak
You mean, the Fed is propping up interest rates?
From the Dallas Fed yesterday:
Inflation Forecast
Our estimates put the “bleed-through” to future inflation at about 0.25 percentage points for each full percentage point that headline inflation currently exceeds trimmed mean inflation (as described in Koenig and Armen 2015). With trimmed mean inflation now running at 1.9 percent, and headline inflation 2.0 percentage points above that, the average historical bleed-through effect on its own implies a trimmed mean inflation forecast 0.5 percentage points higher than if headline inflation had not exceeded trimmed mean.
Of course, there are other factors that influence the inflation outlook, such as labor market slack, structural changes in the U.S. and global economies, and longer-run inflation expectations. Factoring in those influences, our forecast for four-quarter trimmed mean inflation in the second quarter of 2022 is 2.3 percent, as shown in Chart 1.
Based on our expectation of labor market conditions continuing to tighten, trimmed mean PCE inflation should increase to 2.4 percent by year-end 2022 and remain at that level through mid-2023. This also implies a headline PCE inflation rate of 2.4 percent by year-end 2022. Given the unusual nature of this business cycle, there is significant uncertainty around this forecast.
—30—
Inflation in the mid-2% range.
Well, we will see….S&P just hit a record high….
I (sort of) responded to this post in a piece on my own blog, here:
https://trotskyschildren.blogspot.com/2021/07/the-case-against-inflation.html