Stabilizing The Future
A discussion with John Cochrane on The Rasheed Griffith Show
Full Transcript Below
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Show Notes
Should Canada dollarize? Should sovereign debt be modeled as risk-free? Why is monetarism unfit for modern financial markets? John Cochrane, Senior Fellow at the Hoover Institute and blogger at The Grumpy Economist, joins Rasheed on the podcast. They discuss core themes in macroeconomics and why financial tools are underutilized in stabilizing economies to make them more conducive for growth.
Links and Recommendations
Toward a Run-free Financial System by John H. Cochrane
Fiscal Histories by John H. Cochrane
The Fiscal Theory of the Price Level by John H. Cochrane
Macro Markets: Creating Institutions for Managing Society's Largest Economic Risks by Robert Shiller
Indexed Units of Account: Theory and Assessment of Historical Experience by Robert Shiller
Central Banking 101 by Joseph Wang (also, previous podcast with Joseph)
Money Changes Everything: How Finance Made Civilization Possible by William Goetzmann
Key Quotes:
There’s a lot less of using financial products as insurance, rather than just using financial products to get rich or to trade at high frequency. Economists view financial markets as giant insurance markets. And that seems to be underutilized. Even the ones we have seem to be underutilized. - John Cochrane
And
The best thing we could do for our children is to keep Western civilization alive; to keep innovation going, and to get economic growth going back again. And then allowing that to be spread to the parts of the world that desperately want it. So yes, invest in good institutions that foster economic growth. That's what we should be doing for our grandchildren. - John Cochrane
Full Transcript
Rasheed: Hi, John. Thank you so much for joining me on the podcast today.
John: It's great to be here.
Rasheed: I'm going to start with finance. So it's never been obvious to me why the theoretical inflation target should not be 0%. It's normally 2%. But why not 0%?
John: I like the idea of zero. I kind of like the idea of a price level target.
And let me explain the difference. Even a 0 % inflation target, the way our current central banks work, if you get 1 or 2 % inflation by mistake, you just swallow that. Prices stay one or two % permanently higher, whereas I'd like to slowly bring them back to where they were so the prices are always the same in the long run.
We don't steadily shorten the yard of the meter every year to slightly advantage tailors. Why should we steadily depreciate our standard of value? The common argument against that is that, central banks like to have some higher inflation so that when a recession comes, they can lower interest rates.
So the interest rate you get has to be inflation compensation, say 2 % plus a little bit more real, another one or 2%. The standard interest rate would be about, you know, 2 % inflation, another 4 % interest rates, the standard thing to do. So then they think this gives you room to lower interest rates to zero to stimulate an expansion, which is like the theory that it's good to wear shoes that are too tight all day long because it feels so good when you take them off in the evening.
That's a theory you can debate. First of all, whether it matters what past inflation was for the stimulative effects of 0% interest rates now. And second, how important is it for central banks anyway to do all this stimulating in a recession? Central banks can screw up economies.
But it's not so obvious to me that all the yields of the world come down to 1 or 2 percentage points of the overnight federal fund. So I would rather not sacrifice the beauty of a steady standard of value over time for those goods.
Rasheed: Is it justified to model sovereign debt as being risk-free?
John: You have some great questions there! Nice and short too, I love them. Unlike my answers. Justified. Realistic. Sovereign debt is like all debt. Sometimes you don't get paid back. And, historically, sovereign debts were riskier than private debts. I remember reading about one of the first great financial crises when Edward III defaulted on the Peruzzi Bank in 1357 or something of the sort.
Lending to kings was never a great idea. They tended to waste it. And, when you think of it at first principles, private debt, if you get a mortgage on your house, the bank gets the title to your house. You've got some collateral. If you default, they've got something valuable there. If you lend to a government, by and large, you have no recourse.
They only pay you back because they feel like paying you back. They pay you back because they're trying to keep up their reputation for the future, but you're really on the good faith and trust of governments. And of course, governments don't just default on debts, fairly routinely. See: Argentina. Governments also inflate away debts, which from you as an investor's point of view is the same thing.
In the US government, the cumulative inflation in this post-pandemic inflation was about 15%. And that means that people who held U.S. government bonds had exactly the equivalent of a 15 % loss in capital value exactly as if there was a 15 % haircut, a 15 % restructuring. Economically, it's just the same.
So governments inflate away debt all the time. Government debt is risky, guys! Now, why people are willing to lend to governments at such astronomically low rates, given how poor governments' plans are for paying the debt back and the options for default are inflating it away, I don't know. But to finally close on your question, why do we perceive it as so risky?
Governments such as the U. S, first of all, advanced Western economies have been pretty good about paying back their debts without inflating them away in the larger post-war period. And second, for many financial purposes, inflation is less harmful than explicit default. So the slow erosion of value due to inflation doesn't quite muck things up as much as just, "we're not paying it back". And so in that sense, government debt has been pretty nominally risk-free, even though there are some risks.
Rasheed: Is there an upper limit to which U S debt to GDP can reach before we start to see any real material, negative effects?
John: Yes. Your next question is gonna be, what is that upper limit? And I can just say, I don't know.
So all governments can only borrow up to the amount that people think in present value terms they will be able to repay. Do people have faith that the US government can and will choose to repay? And at what interest rate? Good questions. Why is US government debt so valuable right now given the not very serious promises to repay? I don't know. Why is Tesla stock so high right now, given the likely profits of battery-powered electric cars? I don't know either, but there we are. People do seem to think, and I think there's some sooner or later, the U S government will not. I hope we're still a serious country. And after we've tried everything else, we'll get serious about our debt and do the simple reforms that it takes.
Now, where is that limit? One way of reading the current inflation is that for 10 years, lots of people said, just borrow money, print money, hand it out, and that's the key to prosperity. The Arliss, the Jeers, the modern monetary theorists, the whole Washington consensus of 2010 to 2020 was, there's secular stagnation, there's a savings glut, there's unlimited demands for U. S. government bonds, blah, blah, blah, print it up and they will come. We tried it. 5 trillion bucks in new debt. Guess what? We've got inflation. So that kind of proves that at least in those circumstances, about 100% debt to GDP was all that the U. S. could borrow and any more people would try to unload and therefore create inflation. Has that number increased slightly? I don't know. Japan seems to be able to borrow a whole lot more. It's a fraction of GDP. People trust it. Somehow more than the U. S., but there is that moment of trust. Now, of course, governments can raise that a lot.
So if the U. S. went back to sober, constructed fiscal policies that were running steady primary surpluses, I think the U. S. could borrow 150, 200 % of GDP with no problem. So it is all contingent on if people expect there to be a plan to pay it back, how much you can borrow? And that's why, you know, Reinhart and Rogoff are pretty good about this, they document as well.
Argentina has had a debt crisis with 40 % of debt to GDP. The US, Europe, and UK all seem to run into trouble around 100 % debt to GDP. Japan is, depend on how you count it, 150, 250 % of GDP. So it all depends on how much faith we have and especially faith in your long-run economic growth. That's how you pay back debt, it's long-run economic growth.
So that's a long-winded answer or way of saying, I don't know, and nobody else does. But it's out there somewhere. The idea is that there's this flat demand curve for government debt and the saving plot that will always absorb all the debt you want to offer at, 1 to 2 % interest rates or negative in real interest rates.
Good luck with that one. The wall is out there somewhere.
Rasheed: Why isn't the concept of Indexed Units of Account, that are endorsed by Robert Shiller for example, more popular among economists?
John: Oh, I thought the problem was that it's only popular among economists.
Rasheed: Even then it doesn't seem that popular among economists either.
John: Yeah, Chile has a very interesting one, the Unidad de Fomento, an indexed unit of account. Why are TIPS (Treasury Inflation-Protected Securities) not more popular except among economists? Most economists I know who think hard about their investments buy TIPS. These are inflation-protected government bonds, which are inflation-protected, great deal.
Only economists seem to buy them. Those are hobbled by being way too complicated and taxable. But why is inflation protection from banks less popular? I think part of the answer is the fixed costs of doing anything. And so as long as inflation is not a problem, people don't put in the effort to worry about creating the institutions to protect you against inflation.
So in fact, in the 1970s, there was a lot of interest in inflation protection of various sources. There was indexation in most contracts against it. So you'd start with why don't we index contracts? And we're used to in the 1970s and. Countries with high and variable inflation do. And I think one of the problems of our institutions being good enough to kill inflation up until 2020 is that people are doing it.
If there are never any fires around, people stop buying fire insurance too, cause, it's costly. It's the other, it's a deep question. There are lots of securities. Bob Schiller has been great about inventing new securities. Like why don't people buy securities to protect against house price fluctuations?
Each of us who holds a house is exposed to a lot of loaded coalitive idiosyncratic risk. I got a lot of money loaded into Palo Alto real estate. If Palo Alto falls relative to other places, I'd take a big capital loss. Why don't people want to buy those things? People seem to want to buy securities that you can trade a lot, not securities that protect against fundamental economic risk.
I think that the ultimate interesting feature of our financial markets is that all sorts of innovations that would be great for retail customers don't survive on trading-oriented financial markets. You have to do the institutional business of Putting together the business and then selling it, marketing.
Why do we buy house insurance? Plain insurance. We can't buy real estate price insurance, but we can buy fire insurance. Because people put together insurance companies and sent salesmen out and spent a lot of time knocking on doors, which seems to be what you need to do to get retail prices. So a lot of thoughts there, wonderful economic ideas that seem to not take hold as fast as we'd like in the real world.
Rasheed: And, still on Bob Shiller, his whole idea of general macro markets, where you can have these assets on macro variables, they aren't popular either. And those things could have potentially very useful effects, especially for developing economies.
John: Absolutely. Developing economies and developed economies.
Suppose you work at some industrial plant in the Midwest and when a recession comes and you're going to be in trouble or the exchange rate changes and your business is going to go under, your towns go under. So insurance against macroeconomic events makes all sorts of sense, doesn't it? And yet it doesn't develop.
It hasn't been marketed and people don't buy it. And again, exchanges seem to be oriented towards things that there's news about that people can trade and make money on. So, you know, there's a lot of inflation products that people tried to put on exchanges and they just died because there was no interest.
There's no news about inflation that you can trade on, whereas there's news about, I don't know, corn futures and stuff like that. I think it just requires a greater institutional buildup than has happened so far and enough risks that there are people interested. Now, yeah, developing economies in particular, when the U.S. catches a cold, Jamaica gets the flu, I guess is the story, similarly with Chile. And they're countries you would think would protect them. So they can protect themselves in commodity markets fairly easily. It's a lot less using financial products as insurance, rather than using financial products to get rich or to trade at high frequency.
And then economists view financial markets as giant insurance markets. And that seems to be underutilized. Even the ones we have seem to be underutilized.
Rasheed: You wrote a paper for a few years ago and in it, you had a great phrase. Where you said that runs are "pathologies of specific contracts". So I'm curious, John now in our complex world of abs shallow banking, your dollar markets. Is it still possible to architect a run-free for the national system?
John: Oh gosh. And you wanted short answers?
I think yes. And so let's, let me just unpack for your readers a little bit. A bank run. So first of all, we have to clarify, that people in charge of these things use a lot of big words that don't mean anything, and the deep secret is they don't mean anything. What does systemic risk to the financial system mean?
That word has started to mean in a sort of policy circle, somebody somewhere might lose money and be mad at it on a mark-to-market basis. No, it's not a problem. What is the problem of run and especially systemic run? So what's a bank run? Think of Jimmy Stewart and wonderful life or Mary Poppins. Sorry. Old movie references.
Are there any new movie references for bank runs? Those are great.
When do you run to Silicon Valley Bank? When do you run to the bank to get your money out before the other guy? That's a specific contract. So you run to get your money out of the bank.
Suppose the bank loses money. Why do you run to get your money out? Whereas when Tesla loses money, you don't run to Tesla to cash in your stock at a higher value. All you can do is say, gee, I wish I had sold it yesterday, and go home and have a stiff drink. Tesla doesn't promise you your money back. You have the shares.
And if Tesla loses money, the shares go down in value. That's that. You can't run to Tesla and say, give me my money back. The bank takes your money and invests your money. And the nature of its contract with you is that you can run and get your money back. They promise you face value. You gave them a hundred bucks.
You get back a hundred bucks with interest. Whereas Tesla promises nothing. You might get some dividends someday, but there's no promise there. You get face value. You get a full face value. We're never going to say, hey guys, there's a haircut here. You can't get it all backward. We lost some money here.
And you get it. First come, first serve. That's a crucial part of the contract. If everybody shows up at the bank and says, I want my money back, the bank says, we don't have it, but everyone can get 90 cents on the dollar, then there would be no incentive to run, or at least to get first in line. But it's first come, first serve until all the money runs out.
And if we can't do that, we go bankrupt. And we have trouble. Normally, a bank that made that kind of promise, if it's a solvent bank, could borrow money, could get money to pay off its depositors, could sell its asset portfolio. And there's some problem of selling its asset problem. And a fundamentally solvent bank, can't get enough money to satisfy a run, should be able to issue equity.
It's a good deal. You get to buy up the Inc.’s assets. And there's some problem with getting equity. So all of a sudden, from bank runs, from financial crisis and contagion and so forth being all around the corner, you see there's a long list of things you need to get a bank run going. So I wanted to just explain this to your listeners who aren't deep into this stuff.
Good catch. Bank runs are a phenomenon, not of risky assets in banks. Bank assets are very safe. A portfolio of bonds, and a portfolio of loans is so much safer than spaceships to Mars. Yet where are all the regulators? They're sitting at the bank assets, not at Tesla's assets. Why? Because banks are funded by this run-prone liability, this liability that has a catch to it, that now and then people run and can cause the bank to go bankrupt, to fail, even when it shouldn't, even when it is fundamentally solvable.
So the secret to stopping a financial crisis is to stop runs, and the way we go about it now is just silly when you think about it, although it follows patch on patch. Our government, when a run happens, says, "Don’t worry everybody, the government will give you the money". That works great to stop the run, doesn't it?
But, the government gives you the money, then leaves all sorts of perverse incentives around that take too much risk. So the government swoops in. Why do we have all those regulators looking at a diversified portfolio of loans and no regulators looking at spaceships to Mars? Because the government is guaranteeing the liabilities to stop the runs.
And then time after time, the whole thing breaks down and it gets worse. I've tried to articulate a vision of a financial system where what our regulators do is not so much regulate assets, but make sure that the liabilities, the deposits don't have this peculiar feature that they're prone to regrets.
The best way to do that is for banks to get their money instead by Offering run-prone liabilities where it’s not just deposits, but also short-term overnight financing and some of the complicated derivatives-based stuff that we talked about. They get their money to make risky investments by issuing stock and long-term bonds that have to wait for a while, can't run immediately, and get your time.
And then we could end private sector financial crises forever. Wouldn't that be lovely? So immediately people say, "Oh, but this, but that, but you know", but ending financial crises forever without government bailouts and massive regulation. That's pretty nice. Now you jump to how you do this in a world of derivatives, where you can synthesize short-term debt unless you want to get deep into the weeds of derivatives.
I'll say, I believe it is possible, but it raises some issues. Usually, derivatives books are matched, meaning there is no risk there. If I wrote an option, I also bought an option. But in bankruptcy, all that kind of unravels. That's what we found with Lehman Brothers. So when there's a lot of derivatives involved, it's going to be a little trickier.
But the basic business of a bank, taking money from investors and putting it into either government securities or loans, that business can be totally risky. And if people want to have this deposit, this run-prone security like deposits, banks have to take that and bundle it into short-term government securities or reserves of the Fed.
That cannot fail because the value of the assets can never fall below the value of liabilities. It can't fail. And then if banks want to invest in risky stuff like lending money to me to build a house in Palo Alto, for that, they got to issue equity or long-term debt, and it's very easy to issue equity. Look at Tesla. Be my daily example.
So maybe it might cost 1 % or two more on your mortgage, but that's not the end of the world compared to stopping financial crises. So that vision I think does hold. And so I call it equity-financed banking and narrow deposit taking, and we could have a great financial system that provides all sorts of easy payment systems open to people of lower incomes, all the lending you want to finance businesses, and no more financial crisis.
You just have to follow two rules. Risky loans, issue equity finance at risky loans. Want to issue deposits, funnel them into reserves. So sorry for the long answer, but I thought the background might be useful.
Rasheed: Does the Eurodollar market have a large effect on the transmission of interest rates in the US?
John: Oh, wow. I don't know. Why? How? Tell me a story and I'll tell you if I like it or not.
Rasheed: Well, okay. So the Fed does not target money supply anymore. It targets the interest rate, but you have this large liquidity pool of us dollars outside the purview of our regulations and structurally outside Fed policy. It could weaken the ability of the Fed to structurally target the interest rate domestically.
John: Yeah, so my first prejudices are always that markets are pretty well integrated. So yeah, in some sense, we are in a global market and there's a global demand for dollars. Now you can't suck dollars abroad without sucking goods to the US.
So the one thing I learned about international trade is the capital account and the card account always have to balance. When you talk about hot dollars running abroad, it has to. Something has to come back on container ships, but that's part of the global integration of capital markets. So to the extent that there is this whole transmission mechanism, that's one of those fancy words that central bankers like to use to pretend they know what they're doing, about how does the overnight rate that the fed offers on reserves, deposits, banks, holds, the Fed; how does that end up in your mortgage or the value of a long term bond that a company issues to buy a factory? Or if you want to take a dollar-denominated loan on a European bank in London, that price there, and then the dollar versus other currencies that's, I think, what we're talking about with the transmission mechanism.
Then to first order all Overnight dollar loans are going to pay the same thing, and the Fed says what that is, and that will go through international markets the same way it goes through domestic markets. So I'm going blah, blah, blah here, but I don't see a real problem, but I do see you're exactly right that the Fed should think about this in terms of an internationally integrated capital market, at least for dollars, because so many dollars trade offshore.
Rasheed: I wonder, especially since '08, when the fed had effect has essentially internationalized, the balance sheet substantially, at least compared to any time before in history. But I do wonder how explicitly the Fed takes the rest of the world into consideration perhaps outside of crisis periods.
John: I think they do. So one thing that happened during both of the recent crises is the Fed opened swap lines with central banks, except the Chinese central bank, where everyone but China and I guess Russia now could easily get dollars in foreign central banks because in some sense dollars are around the world.
So to that extent, I know that the Fed has thought hard about making sure that A scarcity of dollars in foreign hands doesn't cause financial problems abroad. But the Fed is, I say some mean things sometimes, but it's a pretty darn good institution. And one of the things in which it's good is to pay pretty decent attention to its mandate.
And I think both Bernanke, Yellen, and Powell have been pretty clear about this. Congress said the Fed's job is the US. price level and US employment. And it doesn't think that much about how Its policies are going to affect the rest of the world economically other than how the rest of the world feeds back to the US, which is, that's what Congress empowered it to do.
So if it started being the global central banker and saying, Oh, there's a recession in Portugal, we should do something about it, maybe under Pax Americana, we should, but that's not the Fed's mandate to worry about that sort of thing. And I think by and large, it doesn't, for better or for worse.
Rasheed: Friedman had suggested, I don't know how seriously he meant it, but he has suggested that the Fed should be a department within the treasury, primarily to eliminate any kind of biases when it comes to figuring out who is to blame when inflation goes out of whack. However now when it comes to central bank independence, this is almost a heresy to say. But central bank independence, how meaningful a concept is it when you have strong credible invitationals, that probably could be integrated?
John: Oh boy, that's a great question. So let me riff a little on central bank independence.
Central bank independence is a great thing that we discovered. The main point of it is the central bank is a creature of the federal government and central banks are set up by governments. They are subservient to governments. They are part of the government. So why independence? It's like Odysseus tying himself to the mast or the Christmas club where you force yourself to save.
Governments understand that they will be tempted in the short run to do things that aren't good in the long run. And that's why we write constitutions. Why is there a U. S. Constitution? Why not just let Congress shall pass any darn law it wants to pass? We knew we'd be tempted to do things that weren't good in the short run.
So we constrain ourselves. So an independent central bank is a way for a government to constrain itself. Not to boost the economy ahead of the next election. Not to always inflate, to be able to issue debt and not inflate it away ex-post when it's inconvenient to raise taxes, to pay it back. So by creating this independent institution, you make it harder for yourself to do things that are a risk later.
So that's the argument for independent central banks, and it's a good one. Now that has to come with limited powers. If you want inflation, as central banks sometimes do, there's an easy way to do it. You simply print up money and hand it out to every registered voter. That creates inflation. No question about it.
If you want to reduce inflation, there's a similarly very easy way to do it. You don't have to fool with the federal funds rate, the monetary transmission mechanism, monetary transaction, or anything else. You just go around and take people's money. So if you take 500 from every registered voter, that's going to lower inflation.
No question about it. But even though central banks have the price level as their main mandate, they're not allowed to do that. Why? Well, we live in democracies, right? So taxing and subsidizing our jobs for the democratically elected treasury. So an independent central bank can't do the things that are most important to inflation, fiscal policy.
And that's wisely because we don't put taxing and spending policies in the hands of independent technocrats. Those have to be people who face the wrath of the voters every four years. So independence comes with a mandate, to pay attention to prices and employment and financial stability. And a mandate also means don't pay attention to other things.
So if you set up an independent central bank, you're the central banker, do whatever you want. If you get it into your mind that you're going to save the world- Christine Lagarde wants to save the world from climate change. And off she goes. Print money to subsidize windmills. Sorry, you're not allowed to do that.
Not because it might not be a good or a bad idea, but because that kind of thing we reserve for democratically elected people. The deal with independence in a democracy is you have a mandate that says what you don't pay attention to, as if for every bit as much as it does pay attention to. You have a set of tools: interest rates, buying and selling bonds, but limits. You're not allowed to simply send money to voters. Important limitations on your power in exchange for independence, and even independence is limited. I think the ECB (European Central Bank) has too much independence. The Fed's independence is constrained by the FOMC (Federal Open Market Committee) members, they serve limited terms.
They're appointed by the president, and confirmed by the Senate, and if they don't behave, they will lose their jobs and we'll get somebody else. Whereas the ECB is set up, the head of the central bank can do whatever she wants. And there's very little limitation there. It's in some sense too independent because if the ECB goes off and does stuff that maybe all of Europe wants the central bank to print money to subsidize windmills and electric cars, but there's no mechanism to make sure that the voters are happy with that.
And if she chose something else, maybe she wants to subsidize immigration. I don't know. There are all sorts of worthy causes to subsidize, but that's not the job of a central bank. So you can't have too much independence. So independence, how could I Summarize this as if I hadn't been talking for so long.
Independence is a very good thing, a pre-commitment mechanism, but it has to be limited by the tools and mandates. It has to also be limited by some accountability of the independent central bankers now and then to representative democracy.
Rasheed: I live in Spain. And the question of central bank independence is a hot topic with the ECB I think on either a political spectrum. It’s not a right or left issue is a very concretely bipartisan issue to use that term. They do argue that central bank independence of the ECB goes a bit too far.
John: If I can plug, I'm almost finished writing a book with two other Europeans, Luis Garicano, who's from Spain, and Klaus Masuch, who's in Europe, on the structure of the ECB.
And it is interesting because, of course, the ECB is one of the few all-European Union institutions. There is no Congress. There is a European Parliament, but it's much, much weaker than the American Congress. It was set up as a very independent institution with a very limited mandate, which is to worry only about price levels, not worry about employment, only a price level mandate, and a very limited set of tools.
And the ECB through the various crises now is buying a lot of sovereign debt as well as subsidizing climate policies. So it has a lot of Italian debt on its balance sheets and is therefore deeply involved in keeping Italy and used to be Spain afloat. And those are things that the ECB wasn't set up to do.
And in part because there isn't the kind of Europe-wide oversight that the U. S. Congress and presidential system imposes on the Federal Reserve.
Rasheed: There's quite a lot of misunderstanding when it comes to QE and QT, where people are surprised that QE didn't call inflation because they don't understand the portfolio rebalancing effect of QE. However, in fiscal theory, you can understand why QE did not cause inflation. It seems to me that this is a clearer example of why fiscal theory over monetarism is more appropriate for understanding our modern financial system.
John: Yes, you're talking to a biased reporter on that one. So I will advertise a little to your listeners. I have written a book called "The Fiscal Theory of the Price Level", and I'll advertise before they go out and buy a 600-page overpriced book, find my website, and there's a bunch of essays. that are easier to read with just graphs and stories on what is this fiscal theory of the price level.
Now I, of course, regard the experience of quantitative easing, and quantitative tightening as entirely consistent with fiscal theory, but the larger point on does QE works and what does work means, you don't have to believe in fiscal theory to get that. So Larry Summers has been very outspoken on quantitative easing having had no effect whatsoever.
And he's certainly not yet a fiscal theorist. I'm proud to report it making headway even with Larry. So let me explain. What was this QE and QT that we talked about so much? The reserves, the amount of money banks held at the federal reserve used to be like 10 to 50 billion. And banks can exchange those reserves for cash freely.
So reserves and cash are the same thing. In the 2010s, to stimulate the economy, interest rates were zero, and central banks couldn't lower interest rates anymore. So what did they do? Ben Bernanke called it helicopter money. Helicopter money, real helicopter money is just dumping money from helicopters, which is both fiscal policy and monetary policy, because that's a transfer payment to individuals- what central banks did, the European Central Bank, the American Central Bank of England, Bank of Japan in huge quantities. What they did was they bought government bonds and they also brought mortgage-backed securities guaranteed by the government. So they take in three to five trillion dollars worth a huge amount of money worth of government bonds and issue in return bank interest-paying bank accounts at the Federal Reserve, which counts as money.
So if you're an old-fashioned monetarist, you think the only thing that causes inflation is the quantity of money. You would honestly say, and they did, they wrote op-eds in the New York Times, and the Wall Street Journal, this is going to lead to hyperinflation like Germany in 1922. Because you take what used to be 10 billion, you raise it to 3 trillion.
My goodness, the quantity of money explodes. What happened when they did this? When they announced it, interest rates went up and down a couple of basis points. So there was an effect of the announcement. But of course, the Fed says it's going to do something it's never done before. Bond markets are going to go a little up and down.
But inflation stayed absolutely where it was, absolutely no effect on inflation. It did allow central banks to say, look, we're doing something, we're doing something, which I think was the main point. And I think there is a strong argument, my colleague Jim Hamilton wrote in a very nice paper that by doing something that per se was meaningless, they signaled that they thought this was a big crisis and they were going to leave interest rates low for a long time.
So it had an effect as a signal that short-term interest rates were not going to rise anytime soon. But Ben Bernanke said it's something that works in practice and not in theory. I think you've got to worry about anything that doesn't work in theory, because in the end, it doesn't work in theory. You need a better theory, but if it works, there has to be a theory of why it works.
And when you think about it, if you're holding a hundred dollar government bond, or better, you're holding a money market fund that holds a hundred dollar government bond. And instead, I buy that government bond from the money market fund. Hi, the Fed. And I issue, instead, interest-paying reserves at the Fed.
The Fed is nothing more than a giant money market fund that holds government bonds. So, we've taken one money market fund that holds government bonds and given you a different money market fund that holds government bonds. Or, I've taken your $20 bills and I've given you 25 and it's 10. If I give you a $20 bill, no question you're going to go out and spend it.
But if I give you two 5s I take your 20, Why does that have any effect at all? So I thought the first of the order, it didn't have any effect. And that's related to fiscal theory, the price level, which says that the composition of government debt doesn't matter as much as the overall quantity, but you can see the point, even if you don't buy this whole fiscal theory.
Rasheed: And just to stick on fiscal theory a bit in a previous interview, you typically say that monetarism is 99% correct. But the 1% is where fiscal theory comes into adjustment. But it doesn't seem like it's 99% correct especially now in our world where we have a very different kind of financial system. And very different kinds of Fed targets. But it seems that fiscal theory is a lot more fit for purpose.
John: Well, I was trying to be polite. Now the sense in which it was 99 % right is that most of the episodes that convince you that inflation comes from too much money printing, too much money chasing too few goods, are in fact that money was created to finance intractable government deficits.
So they are also the same as too much debt chasing, too few goods cause inflation. So I think they were right about that. And I think monetarism is the way to understand gold coins. So if you have an economy where the price level is the number of gold coins. That's not a fiscal theory. It doesn't apply.
Why do we value gold coins? They're pretty, why would you work so hard for them? The basic story is that this is the liquid asset that we hold, even though it's intrinsically not valuable, but we hold it to make transactions. I think that kind of makes sense for the gold coins economy, but it doesn't make sense today.
And yes, we have so many liquid assets. I would say the number one thing why it doesn't make sense today is our governments don't limit the money supply. So for the monetarist view that money demand intersects with money supply is what determines the price level, and I mean just money supply. So crucial difference is how many bank accounts you have as well as how many overnight reserves and cash you have.
That's the crucial thing, not the total quantity of government debt. For that to work, the government has to limit its supply. If the government gives you as much money as you want in return for bonds, then MV = PY, Milton Friedman's famous license plate, it describes how PY determines M, not how M determines P and Y.
And that's the world we live in. Our central banks target interest rates and they give you all the money you want at those interest rates. MV still equals PY, but that's how PY determines M unless you control the money supply. That theory just doesn't work anymore. Plus, there's the problem if we have so many liquid assets, what's money?
None of us has cash anymore. We're law-abiding citizens. Cash is mostly for illegal stuff. So the second problem is what's money? We're mostly just paying with credit cards, which is just an accounting system. But the deepest problem is when central banks don't limit the quantity of money, you can't use monetarist ideas.
Rasheed: Was there an explicit point in time where we could see it shift a layer from a money supply target to an interest rate target?
John: Consider the gold standard, so the classical 19th-century gold standard, how did it work? Governments issued currency. That was backed by a promise to deliver gold.
So you'd think, well, we're done. One gold coin equals one dollar. That's what determines the value of the dollar, right? The U. S. didn't have a central bank for the whole 19th century. So if you think central banks are, you know, the whole economy will collapse without it, we didn't have one at all.
We had the Treasury. And the Treasury issued these pieces of paper, and the pieces of paper said, come to the Treasury and we'll give you a gold coin. People did and that's what turned the value of the dollar. But most nothing like England, the Bank of England was fooling around with interest rates the whole time, even though they're on the gold standard.
And you would think you don't need anything else. They were fooling around with interest rates. And what they were trying to do was to stabilize, especially international things. If there was an outflow of gold, they would raise the interest rate to kind of bring gold back in. Fooling around with interest rates has been going on forever at central banks. So what was the central bank doing?
It was using restrictions on money to target interest rates. But except for a brief period in the early 1980s, they've been focused on the level of interest rate as their measure of monetary tightening. And then, yeah, starting in the 1990s is when abroad, the bank of New Zealand, I think was one of the first, and of course the ECB was set up and they just- "we are setting the interest rate and we give you all the money when you want this interest rate". And the Fed is slowly but surely, its operating procedures. There was a sort of Cheshire cat pretense that we were limiting monetary quantities, but that all vanished in the last 20 years. And now there are no reserve requirements at all.
So when you go take a class in monetary theory, they'll probably still tell you the quantity of money is determined by the reserve requirements and the money multiplier. But so there are no reserve requirements. So there's no money multiplier. Throw that section of the class out. I don't know what you're going to talk about. Tell jokes or something of the sort.
Rasheed: Should Canada dollarize?
John: Oh boy, all my Canadian friends are going to get mad at me about this. Yeah, and Argentina should dollarize. Or maybe we should all abandon it and give in. Swiss franc guys, they seem to do a good job. This isn't as crazy as it sounds. If Canada should have its currency, why shouldn't Minnesota have its currency?
Why shouldn't California have its own currency? Actually, why shouldn't my house have its own currency? I'm the one in charge of printing up money. That's a good question. Now, I'll tell you the standard story, and I think the standard story is right. So there are advantages to having a common currency, which is the exchange rate's always the same.
We have a common standard of value and your country isn't hurt with exchange rates going up and down. It's really weird that the relative price since you're in Spain, the relative price of your tapas and my dinner goes up and down so much all the time just because the exchange rate goes up and down. Why should the relative price of tapas in Spain and tapas in Palo Alto change by 10 % over here?
I'm saying tapas, right? If we all use the same currency, we can use the same standard. We all use the meter. Well, the U. S. should use the meter. We all see the advantage of a common set of international standards of measurement. Why not the measurement of quantities? And you can see the advantages that fixed exchange rates or using the dollar would have.
You don't have to change. Every time I buy something from Europe, it's a pain in the butt. The bank takes a huge fee out of it. Let me tell you about that. Annoying, whereas we'd have a much more integrated financial system if we all used the same currency. Now, the usual argument is that Canada, an individual country, needs to have a central bank that maintains its currency to artfully offset shocks.
Canada is an oil exporter, even though they don't want to admit it these days, and when the price of oil goes down, that's bad for Canadian oil exports. So rather than have the price of things go down in Canada, why don't we just inflate the Canadian dollar a little bit, and let the exchange rate take the pressure, but then the price of goods in Canada doesn't have to go down.
So, central banks can artfully inflate just at the right time to offset shocks and stabilize the local economy. And some places that work. Argentina, I've argued Argentina should dollarize, not because there isn't some hypothetical advantage that a super great technocratic central bank couldn't offset shocks by, artfully devaluing the peso now and then, but because they've been terrible at it by having their own central bank's mistakes.
And their central bankers, I'm sure are good and decent people, but faced with the fiscal problems that Argentina has, they just are not capable of having a non-inflationary currency. They'd be way better off having the dollar. They would be open to some shocks. When there are bad times in Argentina, local prices and wages would have to go down rather than depreciating currency.
But on the other hand, you would never again have all these crazy inflation and government debt crises. Going on the dollar is a pre-commitment that you're going to pay back your debts rather than inflate them away. And that's a great pre-commitment for many countries. I think Greece, it was great for Greece to go on the Euro.
They regretted it afterward. It's part of these pre-commitments like we're talking about the central banks. When Greece goes on the Euro, they're pre-committing that even though for the last 30 years, every five years we had a crisis and we inflated away the drachma, we're not going to do that anymore.
What happens? Everybody's happy to lend money to Greeks at absurdly low-interest rates. Greece turned around and used it to buy Porsches, not to invest in Greece, but they had this wonderful opportunity by pre-committing that they couldn't do this artful devaluation thing. So the same reason if you start a restaurant and you can't get stockholders, you have to issue debt. You've got to commit yourself. I'm not going to inflate away this stuff. I'm going to pay it back. So for a small country with poor institutions, committing yourself that you're going to pay back your debts and that you're not going to inflate to get out of political problems is the advantage of dollarizing.
The disadvantage is you import some shocks that you might otherwise not import. My judgment is for a lot of countries, including Canada, the optimal currency zone, they'd be far better off simply joining the dollar and Canada's probably on the edge. Especially if they want to be integrated with the U. S. economy.
If they're integrated with the U. S. economy, then they're as integrated as California. And I don't think California should have its own currency because let me tell you about inflation and depreciation that we'd be having in California if they did. In part, I also believe in a lot more international integration, and much more free movement of people and goods, which expands the optimal currency zone.
A long answer to a short question. I wanted to acknowledge some of this and some of that question and just my judgment is that the technocratic competence of central banks is overstated and the advantages of having a common standard of value are understated. There are advantages and disadvantages on both sides.
Rasheed: I lived in Panama for a few years and it's all USD there. So the idea of having USD in Latin America is as obvious to me as anything else. And the same as the Caribbean. I'm from Barbados. The Caribbean has many small currencies and they're all pretty bad. So, if you just all use the USD life would be a lot better for people who live there.
John: I think so too.
Rasheed: So John, given your grounding in asset pricing theory, I wonder if your view on discount rates, is diverse materially from how philosophers theorize about intergenerational ethics in the sense of how strong should our ethical obligations be to future persons?
John: Oh, wow. So discount rates, what I observed is that the expected returns at markets vary over time. So this is about the prices people are willing to pay for assets. When prices are high, that doesn't typically mean that earnings are going to be high in the future. Typically means that the prices are going to come back down, meaning you're going to lose some money.
But there are rational reasons for that. In the height of a boom, what else are you going to do? Expected returns are going to be low. In the depths of a recession, everybody's scared. They may understand it's a time of great opportunities, but they think, I just can't take the risks right now. The discount rate's point is that when you understand stock prices or bond deals, it's easy to see bond deals.
If the price goes down, the yield goes up. So the interest rate varies over time. Duh. Stocks, when prices go down relative to dividends and earnings, largely reflect a better opportunity, but it's a better opportunity that people aren't taking because it's usually at the bottom of a recession.
People are scared of risks, which tells you that recessions are times, primarily, of high aversion to risk, rather than people suddenly being thrifty. So that's about market prices. You ask a deep question, which is, ethicists, don't like market prices, in the same way behavioralists don't like market prices, and naggy paternalists around the world don't like market prices, and central bankers hate market prices, and accountants are very reluctant to mark things to market because they think they know better than markets.
So do people know better than markets is a good question. Now, you ask the deepest, there's a lot of sort of distrust of markets because it's greedy capitalists and short-sighted behavior. Of course, we're not behavioral. We at the Fed, we're not prone to any of these psychological Problems, but it’s the little peasants out there.
That's the deepest one, which is of course markets, that's an argument we can have because people are allowed to express their views. Future generations, of course, aren't allowed to express their view because they're not born yet and they don't get to buy and sell stuff. Now we do it on their behalf. To some extent, future generations are represented.
I'm mostly saving for my unborn great-grandchildren because my kids have enough money. So in that sense, are caring for them privately, if it's not distorted by estate taxes. It's weird, your ethicists want us to care about future generations, and then they want to tax us 50 % once a year to stop doing the one thing we could do for future generations, which is to leave them some money.
Sounds like they want to be in charge of our money to save it for future generations. Now I want to point out that economic growth is like the most important thing ever. And it's the last thing we ever talk about, the most important one there is. And if the economy grows on per capita terms, 2 % a year, within a hundred years, our great-grandchildren will be seven times better off than we are now.
Do we need to leave them more money? Once AI and biotech come along, they're going to be seven times more productive. They're not going to get diseases that we get. They're going to live long and happy lives in a pollution-free, equitable society. And why should we leave that more money? That argument for the social discount rate, I think, forgets about the magic of economic growth.
And I think the one thing we could do for our children and grandchildren is not to lower the discount rate and invest. Us not consuming and not investing in stuff we need now. Most of Africa needs investment right now, but instead low productivity savings for our children. What we should do for our children, and grandchildren is ramp up economic growth.
And if we could get our growth back from 2 % to 4% which it was back in the 20th century before, in my view, regulation and taxes turned us into sloths. If Europe could start growing at all, Europe stopped growing in about 2010, and it used to be growing fantastically per year.
And of course, India, China still, Africa, there's parts of the world we, in the U.S., it's about 60, 000 a year GDP per capita. Europe's about 40, 000. Europe's still substantially behind the U. S. So there's 20, 000 there to catch up. India, I think, is around 5 to 10, 000. China's 20, 000. Sub-Saharan Africa's in the thousands. So the catching up, which means spectacular rates of growth to our standard of living, is way more important than anything else.
This argument, people, there's just the behavioral thing I like. There's this idea people just focus on one thing, ignoring the other things. They say, oh, maybe we should be saving more because our children aren't represented in debt markets and they wouldn't like us. The best thing we could do for our children is to keep Western civilization alive, to keep innovation going, and to get economic growth going back again, allowing that to be spread to the parts of the world that desperately want it.
That's the best thing we can do for our children. So yes, invest in good institutions that foster economic growth. That's what we should be doing for our grandchildren.
Rasheed: John, thank you very much for coming on the podcast today.
John: This was wonderful. You are well prepared and you ask great questions. Thank you.