John Cochrane is the Rose-Marie and Jack Anderson Senior Fellow in Economics at the Hoover Institution and the author of a new book, The Fiscal Theory of the Price Level. In this wide-ranging conversation, Cochrane discusses the root causes of inflation, what we can (and can’t) do about it, the economists who influenced his thinking, and how his father inspired him to become an academic.
To view the full transcript of this episode, read below:
Peter Robinson: The inflation rate last year, eight percent. That meant we paid more at the gas pump. It meant we paid more at the grocery store. It ate away at our savings. And inflation is still with us now, running at about six... Between six and seven percent as we shoot this show. Where does inflation come from and what can we do about it? Economist, John Cochrane on Uncommon Knowledge now.
Peter Robinson: Welcome to Uncommon Knowledge. I'm Peter Robinson. With an undergraduate degree in physics from MIT and a doctorate in economics from the University of California at Berkeley, John Cochrane served on the staff of the Council of Economic Advisors in the Reagan White House. Dr. Cochrane then began his academic career proper, joining the storied Economics Department at the University of Chicago, and then the faculty of the Booth Business School, also at Chicago. For some seven years now, Dr. Cochrane has been a fellow here at the Hoover Institution at Stanford. Now, John Cochrane has published his magnum opus, "The Fiscal Theory of the Price Level." The Fiscal Theory contains a lot of equations. "Fear not," John writes in the introduction, "one really doesn't need anymore economics or math "than is covered in a good undergraduate economics course "to understand it all." We're about to put that to the test. John, welcome.
John Cochrane: Thank you. It's a pleasure to be here.
Peter Robinson: All right, your new book, a couple of quotations. Milton Friedman in 1963, "Inflation is always and everywhere "a monetary phenomenon, "in the sense that it is "and can be produced only "by a more rapid increase in the quantity "of money than an output." John Cochrane in The Fiscal Theory of The Price Level, "In this book, I argue that the fiscal theory is "a genuinely new theory "that unseats its predecessors "at the foundation of monetary economics." That's pretty bold, John. And you started your career in the economics department at the University of Chicago, where Milton Friedman made his career. George Stigler, Gary Becker, all these great economists who gave us the monetary school, this enormous burst of creativity within the discipline of economics in the middle of the last century, and now you are coming along and saying they were mistaken. What are you saying? What's your contention?
John Cochrane: Boy, I get excited when I'm behind the keyboard, don't I? They were 90% right. And you can see, actually, the wonders of academic cross fertilization 'cause I am a lot Chicago, and I'm so lucky to be there 'cause my instincts are so Chicago. But I also picked up a lot while I was at Berkeley, and a certain skepticism of monetarism. So let's get right to it. Where are they right and what am I saying that's a little bit different? I would agree, fiscal theory agrees, with standard monetary theory. In Milton's famous words, "If you drop money from helicopters, "you're going to get inflation." In fact, our government did just drop money essentially from helicopters and lo and behold, we get inflation. Now, on this experiment, we agree entirely. That is gonna cause inflation. Good thing, because we observe things like that in the world. The fiscal theory, however, emphasizes overall government debt relative to the amount that our people believe our government will repay. So if you drop government debt from helicopters, you will get inflation, and money is just another form of government debt. So now we're agreeing.
Peter Robinson: Ah, money is a special case of some... Okay, all right, I think I'm actually following you.
John Cochrane: Money is, if I may be technical for a minute, it is very short term non-interest paying government debt. And actually, most money right now, reserves at the Fed, are interest paying overnight government debt. There is no big difference between money and government debt. So where might Milton and I disagree? If only we could bring him back and have him here, it would be an even better show. The central question is an exchange of money for bonds. So if we dump money, people will spend it and you'll get inflation. If we dump bonds, people will spend it and we'll get inflation. But the central monetarist idea is suppose that I give you money, but I take back the same amount of government bonds. Now, are you gonna go run out and spend? I could give you 10 grand, you'd quit the show and go spend it. But if I give you 10 grand and take back 10 grand of government bonds, you have more money, but you don't have any more wealth. Now, are you gonna run out and spend it? Aha! That is the crucial, decisive conceptual experiment. I would say to first order, absent all the frictions and second order stuff that matter in the real world, that would have no effect on inflation. Whereas a true monetarist says, "Yes, giving you the money, "but taking back the bonds is exactly the same "as giving you the money."
Peter Robinson:"Is exactly..." Okay, keep going, keep going. So the monetarists--
John Cochrane: I was trying to be short for once in my life.
Peter Robinson: No, no, no, no, bec... No, I'm a little surprised because I think I'm actually following this. I was prepared, in this conversation, to let a certain amount just go over my head, John.
John Cochrane: Never!
Peter Robinson:So Milton would say there is a distinction... There must be. You can't write a book as weighty as this on a mere question of semantics. There has to be something more going on than defining money in slightly different ways.
John Cochrane: Oh yes, tremendously. It's the underlying economics is very different. In one case, it's what we call a "composition effect." The problem is you have too much money and not enough bonds, and so you go to try to fix that, and that's standard monetary theory. In my case, what matters is the total amount of money plus bonds overall. So a wealth effect versus a portfolio composition effect. It's fundamentally different economics, it's not semantics.
Peter Robinson: Not semantics, okay. So...
John Cochrane: I'll give you another example.
Peter Robinson: Please, no, no, keep going, keep going. No, no, no.
John Cochrane: Do bank deposits matter? So the fiscal theory says we look at money in government debt, they are like stock in the federal government. And so, what matters is the amount that they've issued relative to the taxes minus spending that the government can use to pay back that money in debt. Now, in that view, all that matters is the government money. If the government has issued money and people believe in it, whether I lend you, I write an IOU, I owe you, Peter, I give that to you, That's what's called inside money. The government has nothing to do with it. I've just lent it to you. I've created a liquid asset. Does that cause inflation? So a monetarist would say yes.
Peter Robinson: It should, shouldn't it? All right, I'm--
John Cochrane: Well, it is not... If I write you an IOU, I'm just gonna write you an IOU, right? I owe you $1, right? I have just, in the standard view, I have created money, and you can go give that to someone else, and that helps you to make transactions. That's inflationary in the standard Milton Friedman view. Whereas in the fiscal theory view, again, in the simplest possible view of things, that's like an option, that's like a private contract on something else, but the government doesn't have to take that for taxes. That is not a liability of the government, that's a liability of me. That's not backed by the government surpluses so it doesn't have any effect on the price level. So there's another big distinction. Does the government have to stop and monitor the quantity of these inside liquid assets that we all see hanging around? Do those cause inflation? And I would just add quick, before you add another question, this is what makes fiscal theory appropriate for today. And monetarism and may well have been just right for 1935, or even 1964, but we have a financial system that is awash in stuff like this. Overnight repurchase agreements, liquid assets of all sorts.
Peter Robinson: Is this where crypto fits in?
John Cochrane: Crypto is a prime example. The government, our Fed, makes no effort to control the quantity of inside money. There's no reserve requirements anymore. M2 is whatever people want it to be. So the idea... It's fortunate that we don't count on limiting this stuff to limit inflation 'cause the Fed isn't limiting it. We need a theory that corresponds to today's institutional reality. One of them, interest rate targets. Our government does not limit the quantity of money, it sets an interest rate target. Milton Friedman says an interest rate target will fall apart, you can't do it. Gotta limit the quantity of money. They don't limit the quantity money. And they don't limit the amount of inside money. So we don't live in the preconditions where monetarism can work.
Peter Robinson: And they don't try to monitor... This so-called inside money, they don't try to monitor the amount and so forth because they can't or because they're not...
John Cochrane: Please.
Peter Robinson: No, no. I don't even wanna... I'll just leave it... In other words, is it a technical problem? They just can't do it so they're not going to expend resources trying?
John Cochrane: I think they could at tremendous cost to the economy. So our economy it's tremendously beneficial that we are awash in liquid assets that help us to make transactions, that there's all this financial innovation. That's making our economy great. They could try to clamp down on this stuff if they had to. I think they've discovered they don't have to and that the cost to the economy would be so large if they did.
Peter Robinson: Okay, one more question at the theoretical le... It's not at the theoretical level, it's a question about your theory. I'm quoting you from the book, John. "Economists too often give a clever name to a puzzle, "proclaim that no standard economic model can explain it, "and invent a new theory. "But fiscal theory is much in the Chicago tradition." we're trying to get a beat on you, John. half of you is this sandal-wearing Berkeley kid who got his doctorate in the what? In the late 70s?
John Cochrane: No, no. Mid-80s, please.
Peter Robinson: Mid-80s. Oh, so you went to the Reagan White House, you were a child when you went to the--
John Cochrane: I was a research assistant.
Peter Robinson: Okay, all right. All right, all right, all right. And then, we've got the buttoned down Chicago man. "Economists too often give a clever name to a puzzle, "proclaim that no standard economic model can explain it, "and invent a new theory. "But fiscal theory is much in the Chicago tradition. "It allows a less-is-more approach, "in which a little bit of "hard supply and demand work takes you further "than you might have thought." What do you mean... Get that through my skull. Takes you further, a little bit of hard supply and demand work?
John Cochrane: So I am very much a Chicago-style economics. I wanna advertise, the theory does not require that approach. You could take this to Cambridge and it would work just fine, and add all the Cambridge-style bells and whistles, but it also fits a Chicago approach. And I hope, again, if we could bring back Milton's ghost and say, "Milton, we loved your monetary theory. "I loved it for years. "But we live in a world awash in liquid financial assets, "and the Federal reserve is setting interest rates "and not controlling the money supply. "What are you gonna do?" And I hope I could sell a young Milton on this, that this would be the Chicago of Chicago, as the monetarism of today, because it is so simple. It doesn't have the bells, and whistles, and epicycles of every macroeconomic model that you've ever seen. It's very easy, it's Chicago supply and demand. And that, of course, is the hallmark of Chicago economics. Everybody looks at something that doesn't make sense and they say, "Oh, people are irrational. "Oh, there's a monopoly. "Oh, there's some complicated sociological explanation." And then, the Gary Becker, the Milton Friedman, the Gene Fama, they just count a little harder, they go home, they work harder. They got their simple supply and demand curves, and they say, "Aha, "this actually makes sense in a very simple model." So fiscal theory allows that approach. I take it in that direction. Whereas otherwise, monetary theory, or even in Milton's monetary theory, you got this big thing that money is different from bonds. This big "something's wrong "with the financial system." We remove all that. You don't need money at all. It works in a completely frictionless Chicago supply and demand. You can add the frictions if you need to--
Peter Robinson: But how would you rewrite Milton's famous line, "Inflation is always and everywhere a monetary phenomenon." And you would say "Inflation is always and everywhere "a phenomenon of government obligations."
John Cochrane: Yes.
Peter Robinson: It's as simple as that?
John Cochrane: Well, it is the "fiscal" theory of the price level, a fiscal phenomenon. There are situations in which the Fed cannot control inflation, so it's not always and everywhere monetary phenomenon. And there are... At bottom, it is not about money as a special asset distinct from bonds. It is about the value of government liabilities. It is, "What is this stuff worth "in terms of something real?" Not just, "There's something very special "about special stuff that we use "to make transactions."
Peter Robinson: And so, it's as... Now, I think I'm achieving a little intuitive breakthrough here. The argument then moves in this direction. If the government takes on more and more debt, and people begin to develop a certain skepticism, a certain realism, you could use either word, about the government's willingness and/or ability over time to repay all of that debt, then that debt becomes not worthless, but worth less. And you get what... This book used to cost five chunks of debt, and as people become more skeptical about the government's willingness to repay debt, it begins to cost seven chunks of debt. Is this the intuitive gra... Am I grasping something real here?
John Cochrane: You got it exactly.
Peter Robinson: Okay.
John Cochrane: It is total amount of debt--
Peter Robinson: I'm tempted to say "Stop here. "Thank you, John. "It's been lovely to--"
John Cochrane: Well, no, but I'm gonna expand a little bit. Central amount is the... We start with... The simple version, the Chicago version, the undergraduate version. We start with the total amount of debt relative to how much the government, you think the government, will be willing and able to repay, and how does that work? Suppose that we look at the debt, we think, "Hmm, this is getting kind of chancey here". What do you do if you're sitting on government bonds and you start to think, "This is not gonna get repaid"?
Peter Robinson: Dump them.
John Cochrane: You dump them. Now, you might try to dump them to me, but then I dump them. We can't collectively dump them. So you might dump them in return for, I don't know, some stocks, but eventually, we're gonna dump them in return for trying to buy goods and services. So as opposed to too much money chasing too few goods, it's too much debt chasing too few goods. But how much debt is too much relative to what we think the government will repay? Now, this is what makes it hard, because people jump to, "Oh, deficits matter!" And our government can borrow an enormous amount of money if people are convinced that over 20, 30 years, it will repay that money. You know, World War II. If there's a plan for repayments, solid long-term finances, you can have big deficits. So it's not about this year's deficit, and curing this year's deficit won't do it. It's about that long-term phase. Just money is like stock. One of my early papers, I thought the title was great, "Money is stock." It's stock in the government and for the same reason, it's the same mechanism. If you think a stock isn't gonna pay dividends 20 years from now, you dump it, the price goes down. So lemme just finish on that, and this is very important 'cause people jump to, "Well, there's countries with lots of debts "but no inflation." Yes, if people think those debts can be repaid, there's no inflation, so that makes it harder too. Milton Friedman had MV equals PY on his license plate, and a whole book where he just looked at the quantity of money and said "inflation." Well, since you have to do debt and deficits relative to this expected long repayment, it's hard The same way valuing a stock is hard. There's nothing new about being hard. If you sit down with the books of Tesla and you say, "Well, Peter, what do you think this is worth?" It's awfully hard to make sense of market values. Well, unfortunately, that's where we are, but that's the idea. Just regard debt like stock in the government.
Peter Robinson: Okay, so let's take you back in time to you're starting your career in the Reagan White House, let's go through inflation in the Reagan years, January 1981, Ronald Reagan succeeds Jimmy Carter and inflation is running at about 12%, not quite 12%, and where were you in 1981? Were you at... Still at MIT, probably.
John Cochrane: No, let's say, I was a graduate student at Berkeley TRIAD, and wondering about "I need a year off "and what might be a fun thing to do?"
Peter Robinson: Okay, all right. By 1985, inflation has fallen to under four percent, and it would remain low for many, many years. The Fiscal Theory of the Price Level: "The conventional story of this episode focuses "on monetary policy." Monetary policy, you argue, was too loo... This conventional story argues is too loose during the 1970s, in part to accommodate the oil price shocks. Then, I'm quoting you again, "Inflation was conquered in the early 1980s "by persistently high real interest rates." In other words, Paul Volcker, Fed chairman, slams down on the money supply, drives up interest rates and rings inflation out of the economy, and that is indeed the conventional story. If we go to the financial district of Manhattan and tap anybody over 50 on the shoulder, that's the story they'll tell us. And John Cochrane says, "Oh no, no, no, no. "Inflation was not conquered in the 1980s "by monetary policy alone." Okay, so I know the conventional story, now I'm about to hear your story.
John Cochrane: So this is story, okay? So let me emphasize what... I'm gonna be scholarly for a minute, this is a book of theory. I have told a number of stories, which I think, "at least, let's get to the range "of there's a plausible story." And then, the next step of course is to make plausible stories concrete with numbers and so forth, and that's... So where we are is I'm gonna tell you a plausible story, but not the be-all-and-end-all test. But at least, let's get to "there's a plausible thing" when everybody else thinks it isn't. Now, also, the theory here does not say the Fed is completely unimportant, and it's all in the Treasury Department. There is, in fact, a very strong role for monetary policy in the fiscal theory of the price level. By setting interest rates, the Fed has a very strong impact on where inflation goes. So inflation is a... If you wanna call that monetary, the Fed setting interest rates really doesn't have anything to do with money anymore, but we call it monetary policy. Maybe a better word would be "interest rate policy." Still matters a lot for where does inflation go? So the Fed raised interest rates. There's the model in about page 372 here, which will show you that the Fed, by raising interest rates, can help to reduce inflation. That's important. The Fed remains important. But fiscal policy is a central part of the story. I can't get away from the equations that say that too. And I can make that real for you. When the Fed raises interest rates, that raises interest costs on the debt. Who's gonna pay for those? When the Fed brings down inflation, that is going to be a boon to bond holders. If you bought bonds... You're a little older than than me, so you probably bought some bonds in 1980 at 15%. And you got 15% interest in an environment of three or 4% inflation. You made a killing, courtesy of the American taxpayer. Somebody paid for that. So there's fiscal requirements for the Fed to be able to help. And in fact, when we look at the debt and deficits that followed the 1980s, by the mid-1990s, the US government was awash in surpluses. So at least with ex post wisdom, it was exactly right for inflation to go down for fiscal reasons. Now, what happened in the 1980s? I'll tell you my story. In the '82 and '86 tax reforms, they cut marginal rates from 70 to 28%. You wanna talk about incentives to work, save, and invest. They also closed up a bunch of loopholes. Capital gains tax receipts went up immediately. They deregulated. They did a big social security reform, which is very good on the... We're talking about long run expectations. The economy took off. Well, maybe the economy took off for other reasons. Tax revenues start pouring in when the economy takes off. So this was a joint monetary-fiscal stabilization, if there ever was one, and the fiscal part is important. The fiscal part is important as a matter of accounting. And when we look around the world, central banks can do that and do that often. They did that twice in the 70s. They can tighten the monetary screws, bring inflation down for a while. But especially, go hang out Latin America, wait six months or a year, boom! Off we go again, 'cause they haven't solved the underlying fiscal problem. The underlying long-term fiscal problem. And so, what I think was really important in the early 1980s was the Schulz memo, the stay-the-course memo. The idea that America was on a better long run trajectory. It's not about people... People in their kitchens didn't say, "Aha, I've worked out the numbers, honey. "In 1997, the deficit's gonna be down to only two percent." No, that's not how it works. What you need is faith that this is a serious country that will repay its debts, that's growing strongly, the government isn't gonna be in trouble. Those government bonds are a good investment. And I think the 0... That faith came back in the 1980s for good reason. That's the story part, the fact part is if you tighten monetary policy and you don't fix the fiscal problem, inflation comes back. We've seen that over and over again. When you fix monetary and fiscal policies together, inflation goes away, and often painlessly. So Tom Sargent has this wonderful, famous paper.
Peter Robinson: Tom Sergeant is our colleague here at the Hoover Institution.
John Cochrane: Nobel Prize winner, wonderful economist. He showed that the ends of the hyperinflations in World War I... That's the worst inflation you can imagine. I mean, we're talking 10 to the X inflations. How did they end? Did they end by monetary tightening? No, they solved the fiscal problem. The reparations due to the Allies, the massive deficits. The inflation stopped immediately with no recession, no high interest rates, no reduction in money supply. So fiscal and monetary policy working together is always what ends big inflations, and I think that's also true of the US in the 1980s.
Peter Robinson: Okay. From Reagan to George W. Bush, I'm gonna put this a little bit crudely but it's not entirely unfair, during the administration of George W. Bush, the president or those advising him, persuade him... Basically, they make a decision. We've got a Congress that wants to spend and we've got a war to pursue against terrorism. It's expensive to go into Afghanistan, and it's expensive to go into Iraq. We'll let Congress spend what it wants to domestically as long as they fund this imperative of pursuing these wars, Dick Cheney says to Treasury Secretary, Paul O'Neal, in 2002, this is a quotation, "Reagan proved deficits don't matter." "Reagan proved deficits don't matter." And indeed, federal debt rose during the Reagan years from 31 to 49% of GDP. So where does that fit into your fiscal theory?
John Cochrane: Deficits don't matter, indeed, if people have the confidence of the economy's ability to pay it back, the government's ability to pay it back over the long run. So that's right. And I think where Cheney got the wrong impression is in that deficits don't matter at all. And in fact, the whole economy, everyone, got the wrong impression.
Peter Robinson: This, I just don't remember. I didn't pull this together, because this thought is occurring to me now. I didn't pull the numbers together in time to get them in the script. This increase in the federal debt from 31 to 49% of GDP during the Reagan years, as I recall, that represented an increase of some single digit trillions. And during the Reagan years, the total asset value in the United States, everything, houses, other forms of real properties, stocks, bonds, the total asset value increased by some double digit trillions. So the argument there would be that was a reasonable, or at least an acceptable, debt to take on because we got something for it. The economy grew. It grew more than enough to justify the debt. Is that kind of the argument we're making here?
John Cochrane: Well, yes, especially because a growing economy, the government can tax all that asset value.
Peter Robinson: Right, right, right.
John Cochrane: The economic growth is the way out of all debt problems, really. If you try to raise tax rates, that's like going up a sand dune. Every time you raise the tax rate, the base shrinks and you come back a little bit. Economic growth is what sends the surpluses rolling in. I would say, also, the Reagan deficits, most... There's an analysis of the Reagan deficits in here. When we look at the Reagan deficits, they look tiny by current standards.
Peter Robinson: They certainly do by current standards.
John Cochrane: "What were we worrying about?" They were largely not... Let me make a distinction between primary deficits and total deficits, which include interest payments on the debt. The primary deficit is taxes minus spending, and then total deficits add the interest payments on the debt. What happened to Reagan is, first of all, there's a huge recession. So we always go into... We get less taxes and more spending in a recession. But the primary deficits in the Reagan years were not at all unusual for that stage of recession. They were smaller than 1975. What happened to Reagan was, of course, if interest rates go to 20%, the interest costs of the debt is what explodes, and that actually is the secondary. That doesn't really matter so much relative to... It was not a case of spending enormous amounts. And indeed, military spending is... We're proud of two to 3% of GDP. The government takes in 20% of GDP. Government overall spends 40% of GDP. So what the issue is, is really entitlement spending and social programs. Everything else is really small. But you are right, 2000 is where you should start. That's where our next story comes up because my story of wonderful surpluses ends abruptly in the year 2000.
Peter Robinson: Okay, so let me, let me set that up. This takes a moment to set up, but I think that this will be... This will be time well spent. I'll go into debt here on the time, but you'll repay it. Up to the financial crisis of 2000... The Fed's balance sheet stands at less than 1 trillion. Then comes the crisis of 2008. Fed injects vast amounts of liquidity into the economy, balance sheet goes to 4 trillion. 2020, we get the COVID crisis, once again, the Fed floods the economy with liquidity. Now, the Fed's balance sheet rises to 7 trillion. Instead of leveling or reducing the balance sheet as the economy reopens, the Fed adds even more, in part to accommodate the Biden Administration's 2021 American Rescue Plan, which cost almost 2 trillion. So we now have, by early last year, the Fed's balance sheet stands at just under 9 trillion. 1 trillion to 9 trillion federal debt from... I'm not going back to 2000. I'm not going back far enough for you, John, but you can correct me. The general vectors here are what's important. Before the financial crisis of 2008, federal debt stands at 64% of GDP. Today, it's 120% of GDP. Inflation.... And this is the first question. Inflation doesn't really appear until about late 2020 or early 2021. So before we get to the inflation that has taken place, tell me about the inflation that didn't take place. And let me give you a quotation from Alan Meltzer. Alan Meltzer, the late Alan Meltzer, esteemed economist, spent some time here at the Hoover Institution. He was a monetarist's monetarist and he wrote, in 2014, a long time ago, "Never in history has a country "that financed big budget deficits "with large amounts of central bank money avoided inflation. "Yet the US has been printing money, "and in a reckless fashion, for years." Alan Meltzer went to his grave without seeing the inflation that he predicted. Why didn't it take place?
John Cochrane: So you asked two great questions here. Brace yourself here and stay awake. The first question that I want to get at is this balance sheet question. The Fed, and maybe we'll ex... Can I explain a little bit what the balance sheet is?
Peter Robinson: Sure, yes, yes, yes.
John Cochrane: So here's how the Fed operates. It has assets, and typically... Let's make it simple, treasury wheels. They have a little more mortgage-backed securities, but let's just think mostly in terms of treasury assets. So they buy treasuries, they print up money, and they create money in return for treasuries. Except now, the money that they print up is interest paying reserves. There's some cash out there, that doesn't really matter for our discussion. Especially since interest rates are close to zero, so cash is the same as bonds, really. So the Fed holds a bunch of treasuries and issues interest paying reserves, which are overnight debt. The Fed is nothing but a gigantic mutual fund... Money market fund, really. It's a money market fund 'cause they're fixed assets. It holds treasuries and it gives you a bank, an account, that pays interest on those treasuries. You can't do that, but you can hold Vanguard's money market fund that holds treasuries and is an account that pays interest. That's all this massive balance sheet is. Instead of you holding treasuries directly, the Fed buys 'em from you, and now you hold a money market fund that holds treasuries. How much do you really care whether you have a brokerage account? Actually, you personally might already have a money market account through, say, Vanguard or Fidelity that holds treasuries. Do you really care if that money market account sells those to the Fed and instead holds interest paying reserves at the Fed?
Peter Robinson: I care about the interest rate on my statement and about nothing else.
John Cochrane: Okay, then in that case, it makes no difference whatsoever. The Fed buying those treasuries and giving you overnight reserves is just like you holding... The private sector, instead of holding treasuries directly, holds a money market fund that holds the treasuries.
Peter Robinson: So what's the limiting principle then? Why shouldn't it run up its balance sheet to infinity?
John Cochrane: It's much as people want, why not? It's a pretty good system. In fact, Milton Friedman, let's bring back the ghost of Milton, Milton once said that the ideal monetary system... He had this paper called "The Optimum Quantity of Money," where he said the interest rate should always be zero so cash and bonds would be perfect substitutes. Why didn't he argue for that? Because he believed that would be unstable and blow up. But fiscal theory actually allows that. Or by extension, that money should pay the same interest as bonds. Why should you artificially have to go to the bank every often to keep money? Just use your bonds. So we live with a big balance sheet. I think the big balance sheet's a wonderful thing, from an economics perspective. There's some political problems with the big balance sheet. But the idea of having lots of short term government debt that we can use to make transactions is just wonderful.
Peter Robinson: So this huge run up in the balance sheet of the Fed doesn't bother you at all?
John Cochrane: To first order. Now, it bothers me for political reasons because Congress doesn't seem to understand that this is not a kitty that they can go raid, and I think it would be better... It says there's a big problem. The Treasury should be issuing fixed value overnight interest rate electronically transferrable debt, 'cause that's what we want. Instead, what happens is the treasury issues debt, the Fed buys that, and then Fed gives you what you want in exchange. But no, to first order, on the issues of inflation, recession, and so forth fiscal theory says--
Peter Robinson: Don't worry about it.
John Cochrane: Buying US treasuries and giving you, in return, overnight US treasuries, that's what reserves are, doesn't make any difference at all, on the way up or on the way down. Now, you asked a second question. We have to answer the second question.
Peter Robinson: Why didn't we have inflation?
John Cochrane: This one is harder. Now, I have to remind you--
Peter Robinson: I had a long cup of coffee with Alan Meltzer, about 2014, and he had me scared stiff t hat inflation was going to come back the day after tomorrow, and it just never happened.
John Cochrane: Yes, now--
Peter Robinson: And he knew a lot. We're not talking about a foolish man. He was a distinguished economist.
John Cochrane: I view the period from 2010 to 2021, and actually for another reason, the period since then, as remarkable confirmation of the fiscal theory of the price level in view of the other theories. So if the interest rate just stays pegged at zero, the traditional Keynesian view says you get deflation spirals. remember all the worries about "Deflation spirals, "it's gonna happen"? It never happened. Interest rates stuck at zero, inflation went nowhere. That's exactly what fiscal theory says it would do. No deflation spiral. Similarly, the monetarists say, "Reserves used to be 10 billion." That's the basic quantity of money. They are now what? 9,000 trillion? That is an atom bomb of money. If you ever wanted an experiment, monetarist doctrine says "Fed buys treasuries, "gives you money. "That's inflationary." We did that from 10 to 9,000. That should have set off... We'd leave Zimbabwe in Argentina back in the dust. It didn't happen. Well, good thing, wouldn't it be nice to have a theory that is perfectly consistent with infla--
Peter Robinson: With reality.
John Cochrane: With inflation is constant no matter, no matter how much the Fed does of this stuff. So that one, I'll chalk up as as a victory. The harder question is there were big deficits in 2008, and those did not cause inflation. And there were big deficits in 2021, and those did cause inflation. So we've gotta come up with a story for how those are different. I'll try to give you the short version of the story. I think there are stories--
Peter Robinson: So what you're addressing now is you've told me why inflation didn't take place. Now, we're in 2021, inflation suddenly appears, and climbs to quite a high level, not Reagan-level, or Jimmy Carter-level to be a little fairer about it, but pretty high. Eight percent after a couple of decades of very low inflation is a very big shock. And you're now going to tell us why... You've told us why it didn't happen then, and you're now going to tell us why it did happen last year, correct?
John Cochrane: Yes.
Peter Robinson: Okay.
John Cochrane: Let's take a deep breath. So what have we talked about? Why, with interest rates stuck at zero, did we not have a spiral of deflation the way Keynesians said it would? Well, because there was... Of all the things, you look at fiscal policy in the United States, running huge surpluses does not look like fiscal policy in the United States. So we're perfectly consistent with the absence of the deflation spiral. Money was printed on an enormous scale, why did that not cause inflation? Because most money in return for bonds. So we're doing great on the zero bound era. Now the next puzzle, deficits. Do deficits cause inflation. And they didn't in 2008, and they did in 2021. In fact, can I tell a little story?
Peter Robinson: Of course.
John Cochrane: We need to lighten this up a little bit. I turned in the draft of this manu... I've been working on this question since 1980. And I turned in the draft of the manuscript to Princeton University Press. And the introduction said... This is before inflation. It said, "We haven't seen inflation in 40 years, "nobody cares about inflation. "But I've been thinking about this "my whole professional life, so here it is. "And maybe someday you'll need it. "Take it down off the bookshelf and dust it." I am the luckiest economist in the world that the Trump and Biden administrations saw fit to drop $5 trillion of money from helicopters and do exactly what this said would cause inflation between then and when it came out. But there is a d... Now, back to your question. The 2021 inflation is very clear. They dropped three... They literally created new money and wrote 3 trillion of checks, which they sent to people. And borrowed another 2 trillion and sent people checks. And I don't think... If I just tell you the word, "fiscal theory at the price level," you know that's gonna cause some inflation. 2008, however, we had a 800 billion stimulus and that seemed not to cause inflation. People were happy to hold it. Now, this is, perhaps you'd say, too easy to weasel out of, but there are differences between the episodes. Again, you can borrow an immense amount if people think that there is a chance you'll pay that... That people think government will pay it back.
Peter Robinson: This is the point to which we're always returning.
John Cochrane: We're always returning. It's not today's deficit. "Do you trust the government?"
Peter Robinson: "Do you trust the feds?" Essentially.
John Cochrane: The government got enormously lucky after 2008. The other thing that happened is interest rates went to zero. Now, suppose you bought a too expensive house in Palo Alto, but suppose interest rates, your mortgage... You have an adjustable rate mortgage, and the adjustable rate goes down to effectively zero. You can sit on that house for a long time, and that's essentially how we didn't get in. That's one of the most important reasons we didn't get into trouble after 2008. And here, I'll give you a big picture too. Again, like all of us, I am the sum of things that smart people have told me over the years. In my time as a finance professor, I learned the great discovery of the late 80s and early 90s in finance, that if you account for stock market values, it's really not about changes in dividends. It's about changes in expected returns, changes in discount rates, changes in risk premiums, changes... Those are the things that account for stock valuations. Well, the same is true for the government. That it's not really that much about the expected surpluses, it's the expected discounted surpluses. And the fact that you get to have a very low interest cost on the debt for a decade, that makes it very easy to sustain debt.
Peter Robinson: John, I'm a little nervous now that circularity is entering in. Expectations are unprovable, unknowable. Unless you have some very clear objective criteria, not you personally, but one can slide into the form of argument, "Well, see? "X happened because expectations changed." "And how do you know expectations changed?" "Why, expectations must have changed "because X happened." Okay, you see the... Obviously, you see it. But when you put your... Good lord, you put this whole book on expectations, and that's pretty slippery ground, isn't it? This will have occurred to you. Go ahead.
John Cochrane: This has occurred to me and I wish it were different. I will argue only that it is no better or worse than anywhere else in economics, right? So let's take the theory of finance, which has been, I would say, a grand success, the most successful theory in economics of the last gosh knows how long. And where does it start? Price is expected discounted value of dividends. What are the expectations? Why did people change their minds about Tesla's expected dividends or the discount rate they wanna apply to? Well, now, it gets hard. So what do you do? You do the same thing we do, in that, horrendously, that is the theory, right? You find as many predictions as you can. You try to plausibly interpret historical episodes as best as you can. But if I am no worse than the entire rest of the theory of economics, which also depends on expectations, it's not bad. Now, there's important lessons that we should learn here. It has been a fool's errand in finance to... You and me go out, take analyst forecast of dividends, say, "Here's what we think Tesla should be worth," and try to explain Tesla stock price. That just doesn't work. So trying the same approach is not gonna be useful for fiscal theory. There's plenty that you can do though. Expectations, so you want me to be testable and scientific?
Peter Robinson: I'd like it.
John Cochrane: Yes. Expectations, We don't know what they are, in any individual case, but good expectations, if people are not too dumb, they should be right on average. So we can look and, and I have, if you look at periods of time with high inflation, what do we see on average afterwards? I can't tell you what people were expecting in a particular episode, right? But I can say many times that look like that, on average, we saw either high required returns, or low surpluses, and so forth, and that checks out nicely. So certainly, the on average. And we can look at historical episodes and say, "what makes sense of the zero bound era? "Why did we not get a deflation spiral? "What happened in 1933 "when they went off the gold standard? "Why was Bretton Woods a difficulty?" At least you can create a plausible, consistent story of these things, and that's how we do what we can in all of economics.
Peter Robinson: Okay, now, that actually is very reassuring to this layman because I was slightly concerned that you're moving off towards string theory, which is based on no physical evidence whatsoever, of course. It's purely theoretical, as far as I understand it. I was a little worried that this all exists on the chalkboard, but actually you go back and check known event... You are moving back and forth constantly between the chalkboard and history.
John Cochrane: Yes.
Peter Robinson: Got it. I feel much better knowing that, John.
John Cochrane: What I do... This is... Many of my referees on paper say, "give me a test. "Is this a testable theory?" And I write back, "Look, we do what we can, "but that's not how the history of science ever worked." Monetarism versus Keynesianism, that went on for 60 years. It's still going on today, I would say. Was that ever decided by someone... Did someone say to Milton Friedman, "show us the test of your theory"? Well, he said, "Well, there's this episode, "and then in the Great Depression, "look what the Fed did and how terrible that was." He organized history and that was persuasive. No one ever tested monetarism versus Keynesianism. Finance; efficient markets versus behavioral finance, well, they've been at that one for 70 years. Did anyone solve that by writing down some formal statistical test, "Aha, the T statistic is 2.1, I win"? No. We assemble the evidence, we assemble the historical episodes, we see, "does it work in that average sense?" We do the tests that we can. Is it at all plausible that things work? That's how you assemble evidence on all scientific theories.
Peter Robinson: Okay, okay. Oh my goodness, this is... I wish I'd gone to Booth Business School. I think if I'd encountered you, I might've understood a few things much better than I did. All right, so let us now shift from John Cochrane fleshing out a new theory that comports better with reality than previous theories, that's the argument...
John Cochrane: That's whose assumptions... I'll make three. The assumptions comport with current reality. I didn't want to jump to, "Oh, it makes predictions that are clearly better." I think it does. The assumptions fit better with current reality, namely that our Fed sets interest rate targets and does not limit the quantity of inside money. That's just a fact. And if your theory says the Fed is controlling the money supply, I'm sorry, I love that theory, it's just not true of today's economy. Second, it's a internally consistent economic theory, which we actually don't have for interest rates. So how does the Fed set interest rates and that leads to inflation? I give you a complete theory with economics into it that answers that question. And it does, I think, it certainly com... There's a plausible answer to historical questions. And I actually went out on a limb last summer in some discussions with John Taylor and others.
Peter Robinson: John Taylor at the Hoover Insti... Economist at the Hoover Institution.
John Cochrane: Was it necessary for the Fed to raise interest rates more than inflation to bring inflation down? And while inflation was still going up, I, for the first time in my life, went out and said, "Okay, I'm gonna put that on-paper prediction. "I think the models in here say no, "this inflation can go away, "even though the Fed doesn't raise interest rates "more than the current inflation rate," and it seems to be going away. So I think I'm doing good on all three grounds.
Peter Robinson: Then let's ask you to do more of this. Jerome Powell, Joe Biden, new Speaker of the House, Kevin McCarthy, here's the pickle that it seems to this layman that we're in. What was it? We have economists, Reinhart and Rogoff, 2008 paper, which, as far as I know, was quite famous. At least, it got mentioned in the Wall Street Journal, which is what I read. And they claim that economic growth decreases one to two percentage points when public debt exceeds 90% of GDP. And this is not a law, it's not a theory, this is observed. And our federal debt now stands at 120%. As we mentioned, 120% of GDP. So we are in the zone where we are depressing our own economic growth, according to what they would predict. And inflation remains again at seven percent. And this, apart from anything else, there's a political problem in that people begin to feel, "Well, no, this isn't just a political problem, "this feeds right into your theory." Because your theory is, the question we return to again and again and again is, fundamentally, do people trust the feds? And inflation, what inflation does, among other things, is inject mistrust, and suspicion, and queasiness, and "who's in charge?" and who's... All right, so we have inflation that's still running at a pretty high level. What do we do? What does this book tell us to do?
Peter Robinson: Solve the long run fiscal problem to get the economy to grow again. No, I'm gonna give you a longer answer. You knew I couldn't stop at that. Much as I love Reinhart and Rogoff, let's analyze what they actually said, which is to point out a correlation. And the number one problem in all of economics is correlation is not causation. Rich guys smoke cigars, smoke on a cigar isn't gonna get you rich. And in fact, it's--
John Cochrane: And I've tried, by the way.
Peter Robinson: And does it work?
John Cochrane: Doesn't.
Peter Robinson: Oh. The problem with that correlation is that, of course, who racks up a lot of debt? If countries get into a growth problem, they start borrowing and they rack up a lot of debt. And in fact, that's why in economics... That's why theory is important. In economics, you need to understand a mechanism to make any correlation plausible. And what we know about long run growth, long run growth comes from productivity growth, which comes from work, saving, investing, the ability to get a permit to rehab a house without too much trouble, we were talking about that earlier, the sand and the gears and so forth. So debt itself is not a problem. Debt can, if an economy has sand in the gears, the government's gonna start borrowing money and you'll see debt. But the fundamental mechanism for long run growth is microeconomics. An economy that's growing should borrow. If you are an economy that's booming growth, private people should be borrowing to invest in future opportunities, and it's fine for the government to borrow because it's gonna be just rolling in tax revenue in the place. So it's always debt relative to long run fiscal stability, which is primarily long run growth. So in the end, I'm a micro economist, we need to get back to long run supply side growth is the main answer.
John Cochrane: Okay, so another couple of questions here. And now, I'm doing something that makes me... This is the sort of thing that makes me more nervous than anything else, which is throwing away the script and just going with a couple of questions that occur to me here. It felt to me as though after the crisis... Beginning with the crisis of 2008, President Bush famously said, I will now misquote him but this is a close paraphrase, at least, that "we are departing from free market principles "in this emergency to save capitalism." Something happened there, where the government began injecting huge amounts of liquidity, there were bailouts, and it seemed... I'm now talking about economics as a profession, as a discipline, as a field. And I know a lot of economists, but I'm not an economist so I may be wrong about this, but it felt to me as though very quickly, surprisingly quickly, all the progress that had been made in the field from the middle of the last century on, the understanding of the ne.. Well, the understanding of how to promote economic growth. I mean, one way of telling the story of the Reagan Administration is to look at the Board of economic advisors he had to come into the White House once a quarter to talk over the economy with him. Milton Friedman, Arthur Burns, George Shultz, people with whom you studied. And they understood a version, at least, of what you're saying. We need productivity growth, that means low taxes, small g... All right. And it seems as though all that... It seems as though within two months, it was as if Milton Friedman had never been born and John Maynard Keynes never died. That the economics as a profession embraced a sudden surge of big government with really an unseemly enthusiasm, instead of in a manner that was intellectually rigorous. Am I just wrong about that?
Peter Robinson: Well, economics, as a profession, has always embraced big government with unseemly enthusiasm. Most people are not--
John Cochrane: Because it puts the economists in charge. It's just the power urge. Is it as simple as that?
Peter Robinson: Nah, young people go into it who want to save the world. There's the free market Chicago Minnesota School is a small, curmudgeonly branch... Small, and smaller every day, curmudgeonly branch of economics, as free market incentive-associated people, like you and I, are a small curmudgeonly branch of our political spectrum. 2008 did... I think 2008 was very important. And the lesson I took from 2008 is not that Keynes was right all along, but that financial crises matter. So when you blow up the financial plumbing of the economy, you're gonna get a recession. I mean, finally in 2008, a good thing about it is we know why we had a recession, because there was a huge financial crisis, and maybe we'll have another Uncommon Knowledge on the proper lessons and the wrong ones learned about the financial crisis. I don't wanna get too far there. You are right that many people took that as an indication of, "Oh, Keynes was all right." Threw out Chicago and so forth. Now, just to make the case, what was the problem in 2008? Was it that people had animal spirits and didn't feel like spending enough, or was it that the financial system had blown up and people were scared about risk? Clearly, the latter, right? So what I think we learned, the proper lesson, is that risk premiums matter, back to asset pricing, and that the financial structure matters. But you are right, the mainstream profession who believed this all along took this as a victory lap to say, "We just need more Keynesian stimulus. And we spent the 2010s hearing about secular stagnation, and hysteresis, and modern monetary theory--
Peter Robinson: And the so-called "new normal."
John Cochrane: The new normal, but the new problem that our economy... It was true our economy grew very slowly, right? Slow long run growth is the economic problem since 2000. Our growth rate has cut in half. And a lot of people said, "Well, look, it's just not enough aggregate demand. "What you need to do is borrow a lot of money "and throw it from helicopters "and the economy will recover." Now, it's not so much monetarism on the other side, but I'll call it supply side, that the economy is doing as well as it can, but it's hobbled by all sorts of taxes, and regulations, and problems, and so forth. That was my view, but it wasn't a very popular view in the 2010s. Inflation is a wonderful slap in the face. This has brought... Inflation, that we just observed, changes everything. And I think it's gonna be very hard for our friends on the left to recognize that fact. It turns out we were pretty close to the edge of the cliff all along because what they said is, "all the government needs to do, "borrow money, give it to people, "the magic of the multiplier, "and we will start growing again." We finally did it, and what did we get? Inflation. It turns out that supply limit of the economy, that the best we can do was right pretty darn close to where we were all along. So inflation right now just throws that all out the window. Demand is not the problem, it's increasing supply. Increasing the productive capacity of the economy is where all of economic policy has to be right now. And these habits, 10 years of "every problem you have, "just throw money at it." I forget who you quoted saying, "Oh, deficits don't matter," boom!
Peter Robinson: Dick Cheney, Dick Cheney.
John Cochrane: Dick Cheney of all... Well, there's historic... Dick Cheney, I'm sure, is looking out the window at inflation saying, "Well, now deficits matter." The program of just throw money at it, and that will be stimulus... And this matters everywhere. I'm thinking of, say, the Green New Deal, which was advertised as, "it'll give you 20 million new jobs." Well, maybe that's an argument if there's 20 million people sitting around with nothing to do all day, but there's a massive labor shortage going on. We have inflation. We don't have 20 million people free to go put up solar panels 'cause they're all driving trucks or doing something else. The supply side constraints... This is what inflation... The wonderful news of inflation is to wake us up that, in fact, the supply side matters.
Peter Robinson: Okay, can I ask another couple? We're running a little long here, but--
John Cochrane: And I wanna go back to monetary policy.
Peter Robinson: I promise I'll get you there in about three questions. That'll be--
John Cochrane: Save me one for... Because I never answered your Powell and "how do things look going forward?"
Peter Robinson: No, no, I'll get to that, I'll get to that. But let me get you there because now we're on... Now, we're on basic stuff that a layman like me can understand.
John Cochrane: Well, this is really all basic, so don't worry about it.
Peter Robinson: So let me ask you a couple questions about contrasts. China. Here's the whole question about China. The whole question is, "have they invented some new way "of achieving long-term economic growth "that we didn't understand?" Milton would say, and John Cochrane, his intellectual legatee, would say, "No, no, no, here's what you need. "You need freedom for innovation. "You need freedom for risk taking and investment. "You need limited government. "Modest but reliable regulatory bodies." And the Chinese say, "No, no, no, here's what you need. :You need a communist party "that says we're going to invest in this industry "and we're going to invest in that industry. "We will brook no dissent, "and the economy will grow and grow and grow." Okay, two quotations here. Peter Thiel, this is in 2014, He publishes Zero to One: "The Chinese have been straightforwardly copying "everything that has worked in the developed world. "Railroads, air conditioning, "even entire cities. "They might skip a few steps along the way, "going straight to wireless "without installing landlines, "but they're copying all the same. "That's the secret to their economic growth." All they're doing is copying what we have. Here's Eric Schmidt, second quotation, former CEO of Google. "Unless trends change, "by the 2030s, we will be competing "with a country," China, "We will be competing with a country "that has a bigger economy, "more research and development investments, "better research, "wider deployment of new technologies "and stronger computing infrastructure." So who's right? My little mind can almost get what an authoritarian government can do is command various persons over whom it has authority to copy what's going on over there. That, I can sort of see that as a way to rapid economic growth, and that could explain China to my little mind. But Eric Schmidt is saying, "No, no, no, no. "They may have copied for a long time, "but now they're in the business of innovation. "They're leapfrogging over ahead of us" and I can't come up with any economic understanding under which an authoritarian regime should be able to pull that off.
John Cochrane: Okay, the China question. Mao tried the strategy of copying. "Everybody go out and make steel in your backyard," that did not work out. The North Koreans tried that. Authoritarians is not the story of China. China started incredibly poor and is still barely a middle income country. I may me get my numbers wrong. US GDP per capita is about 60,000. Chinese GDP per capita is about 20,000. So they are still quite a ways behind us on average. What they are doing is called "catch up growth," and it was clearly from the liberalization of the Deng era. The private companies, allowing a market. They have a market that exists. Private companies, markets, that's the part of China--
Peter Robinson: So it was to the extent that they embraced freedom free markets. The bit of the copying that paid off for them was copying our economic system.
John Cochrane: Well, first, they allowed the copying of the economic system, and yes, of course they copied. Now, remind you how the US got to where we were. The UK had wonderful... They had wonderful machinery and looms that they didn't want us... That was their intellectual property. And some smart Americans went over and remembered exactly how it worked, went to Lowell, Massachusetts, and copied it.
Peter Robinson: John, that's called "Yankee ingenuity."
John Cochrane: We want them to copy our systems, the ways of doing it. Let's not get into the intellectual property debate about it. But that's exactly right. They, to a small extent, copied the free market system. Chinese entrepreneurs got to set up shops, got to start businesses. Who do you think is sending you co... I bet these are from China.
Peter Robinson: I bet they are.
John Cochrane: Coffee cups from China? This isn't some Chinese central planner who decided this is the industrial policy. This is some smart guy who probably grew up on some miserable farm, went to a city, figured out how to start a factory, figured out how to send it on Amazon to Hoover, and is sending us great, nicely done cheap cups. That was all the private sector. So this catch up growth, this join civilized way of doing things, that's how China made its big growth. China's now stuck at the middle income trap. So the great direction of the party, that's only very late. This is after the big growth happened. And they're trying to reign in the Jack Mas. Jack Ma wasn't a state owned company. Alibaba wasn't a state owned company. It is now, and we'll see how well it does.
Peter Robinson: So to the extent that they reassert communist control, or broaden communist control, over what had been, for the last two decades, free-ish markets, to that extent, they'll get in their own way?
John Cochrane: And now they are stuck, as many countries are. And how do you... They're facing the problem that you can't have a lot of innovation, you can't have new companies, and also maintain political control. So the China of great growth--
Peter Robinson: You can't?
John Cochrane: You can't. I don't think so--
Peter Robinson: There's nothing in the recent history of China that persuades you otherwise? That's the fundamental question.
John Cochrane: The China during the period of great growth was the China of liberalization, the China of letting economics in. Now, what's gonna happen in the future? They are doing research in STEM. We'll see if you can do cutting edge research in a unfree country, but we are also shooting ourselves in the foot. It is harder and harder to do academic research in the United States. It's harder to innovate in the United States. We are not teaching our... Chinese students, they teach them math. We don't really teach math anymore for all sorts of reasons. So I think there is a definite challenge there of whether we can maintain our leadership in those fields. But trends, country after country... Remember the Japanese? Yes, you were... The Japanese, you watch... The US GDP is here, the Japanese GDP is here. They grow like crazy, why? 'Cause they're catching up. They're copying what we do, and sometimes bettering it. Toyota was better than GM. But they didn't get the idea of how to run an assembly line on their own. And they allowed innovation, they allowed competition. The trend, the trend, the trend, and then Japan stops. South Korea. Here's the US, South Korea. Oh, they open up, they allow... They have a vibrant economy. They learn our way of doing things. Catch up, catch up, catch up, . They don't pass us. And moving from catch up growth to leadership, innovation growth, that's a whole different thing. Very, very hard.
Peter Robinson: So here's the other big think sort of question; Red and blue. For a couple decades now, we've been conducting an experiment here at home: the blue state model and the red state model. And the blue states have enacted very high taxes, and lots and lots of regulation, and they've permitted teachers unions to retain total control over public education. And the red states have, by and large, cut taxes. And there are a number of red states; Texas, Florida has become a red state. Of course, blue means Democratic and red means Republican, but I'm trying to avoid the partisan nature here to get to the underlying economics or policy question. And a number of red states don't even have an income tax. And the red states tend to be where they've been making experiments in charter schools, and voucher school systems, and so forth. And the results of this experiment are in, blue states are shrinking. Last year, for the first time in history, the population of California shrank. Even on net, even net of immigration. Texas, Arizona, Florida, the red states grow. Today, California has a deficit of over $20 billion, and Texas has a surplus of over $30 billion. One model works and the other model doesn't. So of course, what we see is the political systems responding. No, we don't, and this is the question. Here in California, the state, the party of big government and high taxes, remains in total control. Likewise in New York, likewise in Illinois, there's no adjustment taking place. I mean, who knows? You can't run controlled experiments and set up an alternative California. But if there's adjustment taking place, it sure is subtle. It's too subtle for me to detect. Why is that?
John Cochrane: This is really a political question. It is lovely that the US has, to some extent, still states, So we see competition between the states. So we can see experiments before our eyes. Of course, if we were to look out a little more, the rest of the world, there are some God-given experiments. North Korea versus South Korea, right? The same culture, same country. The north used to be the industrialized, rich one. You can't ask for a controlled trial on how much governments can destroy an economy. East versus West Germany. But we have some of that here. Now, your question is a deep one. Why do local governments go into the Detroit spiral? You start--
Peter Robinson: And stay there for decades.
John Cochrane: You start with something very productive, the car industry, as here we started with the Silicon Valley, and then a rapacious political class takes over. And even as you see it falling apart, is unable to... There's too many people sucking at the trough to agree to stop it until you have what happened to Detroit. And we see this in many other countries. Why can't India... Why can't India start growing the way China did? Our Hoover colleague, Ragu Rajan, has a nice book with Luigi Zingales of Chicago, called "Saving Capitalism from the Capitalists," telling the story of India. India, it's perfectly clear what they need to do, but the people who benefit from the current system, they know they'll lose. And of course, the heads of the teachers union knows that if California becomes free market paradise, they will lose. Our country has a lot of taxpayer support for political activities, and the people who will lose are able to block things that benefit all of us. But I wanna tell... I wanna be optimistic out of this, 'cause in my thinking about growth theory, I've gotten in some debates about my view that the US, as a whole, could be growing much more than we are. That our tragedy is that from four percent growth from the end of World War II to 2000, we are now growing at two percent, and add that up over a couple decades. This is an immense tragedy and I think we could be growing at four. Now, people say, "Oh John, you're nuts!"
Peter Robinson: You do? So cab I just set this... I'm now setting up my last question, and my last question goes from young John to John today. I did not say "old John," I say John today. And here's what I mean. In the 1970s, we see stagflation. The 1970s were a catastrophe in all kinds of ways. And then, along comes the 1980s. And one way of telling the story of the 1980s is that economics as a discipline had actually gotten someplace. It had to understand the importance of productivity growth and the importance of limited government, stable dollar, cutting back regulations. And Ronald Reagan listened to George Shultz and Milton Friendman.
John Cochrane: To some economists.
Peter Robinson: To some economists.
John Cochrane: Actually, economics as a discipline hated Ronald Reagan. George Shultz, Milton Friedman.
Peter Robinson: Really? So they were always a subset? Because I thought that... I mean there was a point... By the end of the 19... By the early 2000s, no economics department was legitimate unless it had at least a couple of free market economists. Isn't that right? Wasn't there an intellectual triumph, at least a limited one, no?
John Cochrane: I'll give you a limited one, but certainly, it's always been more contentious. And it's less the eco... The economics profession is less... What Ronald Reagan did was Adam Smith could have been his advisor.
Peter Robinson: I see, okay, okay. So my question is really simple then. I withdraw, I don't know the economics profession. My question was going to be, "Is economics, as a profession, "capable of the same kind of usefulness "as it demonstrated, "or as a subset of it demonstrated, "back during the 1980s? "And does this country still retain "the capacity for renewal?"
John Cochrane: So I think, yes, and this is just pure optimism and patriotism. The point I was gonna make on the states; the differences between red and blue, I don't like the partisan association, but let's call them economically... Economic policy focused versus distributive policy focused maybe states, whatever you wanna call it. These differences are actually quite small 'cause we all live under the arm of the federal government, which is much larger. Look at your taxes. You pay, I think, more to the state of California that you'd like, but you pay a lot more to the federal government, exactly. And you look at the level of regulation, yes, there's the California Air Quality Board that wants to take away my gas stove, which I'm gonna have to take me from it violently, but that's nothing compared to the EPA. So these small differences in state policies are showing big effects in economic effects. Think what you could do if you could fix the federal policy. So that's my optimistic case that the US is capable of... Economically capable of great growth, if we can just get the--
Peter Robinson: Stop... Charlie Munger once said that he and Warren Buffett made a lot of money by not being stupid. In other words, economic renewal isn't that hard. We understand.
John Cochrane: Yes, it is not that hard as a matter of economics. Now, it's very hard as a matter of politics. And you asked me, I think the economic profession... Many people in the economic profession are following today's political fads. But there are many people remaining in the economic profession who are doing great work on the sources of long-term growth. And so, the fact that long-term growth is the most important thing. I mean, I wrote a book about inflation 'cause I have some answers about inflation and I've been thinking about it forever, but the important thing, if I--
Peter Robinson: Your next book.
John Cochrane: If I were to write a book about what matters, I would write a book about long run growth. I just don't know how it works as well. We'll let our colleague, Chad Jones, here at the business school write that.
Peter Robinson: I told a lie, that wasn't the last question. Here's the last question. Your dad was a medieval historian.
John Cochrane: Renaissance.
Peter Robinson: Renaissance historian. And you spent a lot of time as a boy in Florence.
John Cochrane: Yes.
Peter Robinson: And in fact, I know from a mutual friend of ours, who knows Italian, that your Italian is not only fluent, but you speak Italian like a Fiorentino. Your Italian is specific to certain neighborhoods in Florence.
John Cochrane: Yes.
Peter Robinson: So anybody who had known you as a boy might have said art history, renaissance... Something along the lines of his father, and you went into economics instead. How did that happen?
John Cochrane: Well, I must credit my father with some fundamental values that stuck with me. And in fact, I've always criticized myself for not being very imaginative. I kind of went into the old man's business without... Of being an academic.
Peter Robinson: I see, I see.
John Cochrane: I kind of knew I was gonna be an academic, but if you met me when I was young, my talents and interests don't lie there. I built model airplanes, I liked math, I liked science. So I took that seriousness about academic pursuits and the understanding, really, of what a wonderful life it is to spend your time thinking about things, like "where does inflation come from?" So that I got from both of my parents. But I went in an opposite direction just because... I know historians that I tremendously admire. I I hang out with Niall Ferguson, and Steve Kotkin, and the historians here. I love them 'cause they know all this stuff.
Peter Robinson: They know a lot. They do know a lot.
John Cochrane: My mind doesn't work that way. I have to organize things around a few simple ideas. And so, all of my... My previous book, "Asset Pricing," boiled all of asset pricing down to one very simple principle from which everything else follows. This book boils money inflation down to there's one equation, real value of nominal debt is present value of surpluses. Everything follows from that. So that's the mind of a physicist. That's my physics training. My proudest intellectual moment was my electricity and magnetism exam, where I started every question with the appropriate Maxwell equation, derived what I needed, and went on. I can organize things that way, and I am full of admiration for people like my father, who can basically memorize the Florentine archives and then write a beautiful book about it, or Neal, or all the others, and their ability to do that. I don't have that bit ability so you do what you like, and--
Peter Robinson: So this was your humble best?
John Cochrane: So far.
Peter Robinson: John Cochrane, author of the Fiscal Theory of the Price Level, thank you.
John Cochrane: Thank you.
Peter Robinson: For Uncommon Knowledge and the Hoover Institution, and Fox Nation, I'm Peter Robinson.
