Understanding the Recent Inflation

A Fiscal Theory Perspective

John Cochrane stands out as one of our most incisive financial economists, consistently delivering clearheaded analysis of complex economic phenomena. His recent essay "Monetary-Fiscal Interactions" offers particularly valuable insights into the forces behind America's recent inflation surge. What follows is my synthesis of his key arguments and their implications for understanding this critical economic episode.

The inflation surge of 2021-2023 caught many economists and policymakers off guard. After decades of low, stable inflation, prices suddenly jumped to levels not seen since the 1980s. But what caused this dramatic shift, and why did inflation eventually ease without the severe recession that conventional wisdom predicted would be necessary?

In his recent essay "Monetary-Fiscal Interactions," Stanford economist John Cochrane offers a compelling alternative explanation through the lens of fiscal theory—one that not only explains what happened but also warns of troubling implications for future monetary policy effectiveness.

The Puzzle That Conventional Theory Couldn't Solve

The recent inflation episode presented several mysteries that traditional monetary theory struggled to explain:

• Sudden onset: Inflation broke out abruptly in February 2021, despite no unusual monetary policy actions.

• Fed inaction: The Federal Reserve kept interest rates at zero for a full year after inflation began, yet prices didn't spiral out of control.

• Painless decline: Inflation peaked and began falling before central banks significantly raised rates, and without the deep recession that standard doctrine said would be necessary.

These puzzles led many to blame "supply shocks," "greedflation," or pandemic-related disruptions. Cochrane argues these explanations miss the fundamental driver of inflation: fiscal policy.

The Fiscal Theory Explanation

Cochrane's analysis centers on his "fiscal theory of the price level." The core insight is elegantly simple: inflation occurs when people lose confidence that government debt will be repaid through future tax revenues.

Think of government bonds like any other investment. If shareholders doubt a company's ability to generate future profits, they try to sell their stock, driving down its price. Similarly, if bondholders doubt the government's willingness or ability to run future budget surpluses sufficient to repay its debts, they try to exchange their bonds and money for goods and services—driving up prices until the real value of debt falls to match what people believe will be repaid.

The COVID Spending Shock

During the pandemic, the U.S. government spent nearly $5 trillion, much of it in direct payments to individuals and businesses. The Federal Reserve monetized about $3 trillion of this spending. While emergency spending during a crisis can be justified, Cochrane argues the critical difference came afterward.

Previous crisis responses followed a predictable pattern: emergency spending followed by promises to return to fiscal discipline. The 2008 financial crisis, for instance, came with deficit-reduction promises scheduled for future years.

But 2020-2023 was different. Rather than signaling a return to fiscal normalcy, the Biden administration passed an additional $2 trillion stimulus in February 2021, followed by massive spending bills including the CHIPS Act and the “hilariously”named Inflation Reduction Act. Congress suspended PAYGO rules requiring spending cuts to offset spending increases. The prevailing wisdom became "don't worry about debt repayment"—interest rates were low, and proponents of modern monetary theory suggested debt wasn't a constraint.

This shift in expectations, Cochrane argues, is what triggered inflation. Bondholders holding $5 trillion in new government debt asked themselves: "Is this a good investment to hold for the future, or should I get rid of it fast while I can?" Many chose the latter, spending their money and driving up prices until inflation reduced the debt's real value back to sustainable levels.

The Model Behind the Theory

Using a standard New Keynesian economic model augmented with fiscal theory, Cochrane demonstrates how a 1%-of-GDP deficit with no repayment plan generates the inflation pattern we observed:

1. Inflation surges initially in response to the fiscal shock, even with no change in monetary policy.

2. Inflation then naturally subsides once the price level has risen enough to "inflate away" the excess debt.

3. No recession is required—the inflation is self-limiting once its work is done.

This matches what happened: inflation peaked in mid-2022 and began falling before the Federal Reserve had significantly tightened policy, and without triggering a recession.

Why Other Explanations Fall Short

The Money Supply Story

Monetarists point to the dramatic expansion in money supply (M2) as evidence that monetary factors drove inflation. But Cochrane notes a crucial distinction: the Federal Reserve conducted a natural experiment that reveals the difference between fiscal and monetary causes.

During quantitative easing (2008-2020), the Fed bought over $4 trillion in bonds, increasing bank reserves nearly one hundredfold—yet this massive monetary expansion had no visible effect on inflation. But when the Fed bought a similar amount during COVID to fund deficit spending without clear repayment plans, inflation surged.

The lesson: printing money to buy existing government debt (pure monetary policy) doesn't cause inflation, but printing money to fund new government spending without plans for repayment (fiscal policy) does.

Supply Shocks and Relative Prices

Many economists blamed supply chain disruptions and sector-specific demand shifts (people buying Pelotons instead of restaurant meals). But Cochrane points out a fundamental flaw in this reasoning: supply shocks affect relative prices, not the overall price level.

If computer chips become scarce, TV prices should rise relative to restaurant prices or wages. But why should TV prices rise rather than wages or restaurant prices fall? And why should all prices rise together? Supply shocks can't explain why the common component of all prices increased—that requires excess demand, which ultimately requires the money to pay those higher prices.

Supply shocks may have been the "carrot" that led the horse of fiscal policy to pull the cart of inflation, but the carrot didn't move the cart—the horse did.

The Troubling Implications for Monetary Policy

Perhaps the most significant contribution of Cochrane's analysis concerns what it reveals about the limits of monetary policy. The conventional view holds that central banks can always defeat inflation by raising interest rates sufficiently high. But fiscal theory suggests this power depends critically on fiscal cooperation.

The Fiscal Cost of Higher Interest Rates

When central banks raise interest rates to fight inflation, they impose three fiscal costs:

1. Higher debt service: At 100% debt-to-GDP, each percentage point of higher real interest rates increases the deficit by 1% of GDP

2. Bondholder windfalls: If higher rates successfully reduce inflation, bondholders get paid in more valuable currency—someone must pay for this windfall.

3. Recession-induced deficits: The economic slowdown that supposedly helps reduce inflation also triggers financial bailouts, unemployment benefits, and stimulus spending.

This creates what Cochrane calls "unpleasant interest-rate arithmetic": higher interest rates pour fiscal gasoline on the inflation fire, potentially offsetting their inflation-fighting benefits.

The 1980s Revisited

The conventional wisdom points to the early 1980s as proof that determined monetary policy can defeat inflation through high interest rates alone. Fed Chairman Paul Volcker raised rates to nearly 20% and held them there through a brutal recession until inflation came down.

But Cochrane argues this interpretation misses the fiscal side of the story. The 1980s featured massive fiscal reforms alongside tight monetary policy:

• Major tax reforms that lowered marginal rates from 70% to 28% while broadening the base.

• Social Security reform that secured the program's finances for decades.

• Deregulation that spurred economic growth.

• Most importantly, a sustained period of budget surpluses that paid for the higher interest costs and bondholder windfalls.

The debt-to-GDP ratio in 1980 was just 25%. Today it's 100%, and the political appetite for fiscal reform appears far weaker. The 1980s demonstrated the power of coordinated monetary-fiscal policy, not monetary policy acting alone.

The Dangerous Path Ahead

Cochrane's most sobering analysis concerns the future. Congressional Budget Office projections show debt continuing to rise indefinitely—trajectories the CBO itself labels "unsustainable." But these projections assume no major crises occur.

Given that we've experienced "once-in-a-century" crises roughly every decade (2001, 2008, 2020), the next emergency is likely to arrive while fiscal space is already constrained. What happens if China invades Taiwan, triggering a global financial crisis that requires $10 trillion in emergency spending? Will investors, having already taken a 10% haircut from the 2021-2023 inflation, be willing to lend such massive sums to a government with no credible plan for repayment?

This loss of fiscal space represents the greatest threat to future economic stability. Without the ability to credibly promise repayment, governments lose access to the debt markets that allow them to respond to crises. And without fiscal cooperation, central banks may find themselves powerless to control inflation.

Key Takeaways

Cochrane's fiscal theory perspective offers several crucial insights:

1. The 2021-2023 inflation was fundamentally fiscal in origin, caused by massive spending without credible repayment plans rather than monetary policy or supply shocks.

2. Inflation naturally subsided once it had accomplished its work of reducing debt's real value to sustainable levels—no recession was required.

3. Monetary policy's inflation-fighting power depends critically on fiscal cooperation—central banks may be far weaker than commonly believed when acting alone.

4. The loss of fiscal space poses the greatest economic risk going forward, both for crisis response and inflation control.

5. Pro-growth policies offer the best path forward, as higher GDP automatically generates higher tax revenues without requiring explicit tax increases or spending cuts.

The Bottom Line

Cochrane's analysis suggests that the recent inflation episode was not an aberration to be forgotten, but a warning about the dangerous fiscal dynamics underlying modern economies. The temporary nature of this inflation should not be mistaken for proof that fiscal constraints don't matter.

Instead, policymakers should focus on restoring fiscal sustainability before the next crisis hits. This doesn't necessarily require painful austerity—pro-growth policies that expand the tax base may be more effective than tax increases or spending cuts. But it does require acknowledging that there are indeed fiscal limits to government debt, and that crossing those limits has consequences that go far beyond government bond markets.

The choice is stark: restore fiscal discipline during good times, or face the prospect of both fiscal and monetary policy becoming ineffective precisely when they're needed most. The inflation of 2021-2023 may have been just a preview of what could come if these warnings go unheeded.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies.