Economic Growth, Macro-Models, and a Move to the Hoover Institution

Jon Hartley:

This is the Capitalism and Freedom in the Twenty-First Century podcast where we talk about economics, markets and public policy. I'm John Hartley, our host. Today my guest is John Cochrane, who is the Rose-Marie and Jack Anderson Senior Fellow at the Hoover Institution and is the co-chair of the Hoover Economic Policy Working Group. John is a prior guest on the show, but this time we're going to do something a little bit different. We have something of an announcement to make, that being that the Capitalism and Freedom in the Twenty-First Century podcast is becoming the official economics podcast of the Hoover Institution Economic Policy Working Group.

It's very fitting that the Capitalism and Freedom in the Twenty-First Century podcast become a part of Hoover. This podcast gets its name from the 1962 book, Capitalism and Freedom by Milton Friedman. Hoover is where Milton Friedman called home from after he left the University of Chicago after winning the Nobel Prize in the late 1970s to his death in 2006. Hoover has also been the home of many luminaries, including Thomas Sowell, George Shultz, John Taylor, and of course John Cochrane. John's going to explain a little bit more about Hoover's Economic Policy Working Group and what this means for the podcast, and interview me a bit as well and introduce me to the Hoover audience here.

John Cochrane:

Thanks. Yes. To our devoted listeners, half of the purpose of this show is to introduce the Economic Policy Working Group angle to Jon's already faithful listeners, but the other half is to introduce Jon and the podcast to the Hoover community where this podcast will now be hosted.

Jon, let me ask you... You get to introduce yourself a little bit after I introduce you. Jon is currently a graduate student at the Stanford Economics Department, I'd like to say star graduate student. I'm going to embarrass you a little Jon. Jon is one of the smartest economists I know as well as remarkable for being interested in public policy and public outreach at an age when most economic graduate students are simply sitting in the bowels of the library working on equations. Jon runs this podcast, he's incredibly well-connected. Everybody I know seems to already know Jon Hartley, and you're only in grad school. At some point on this show, I'm going to ask you how you do it.

Jon Hartley:

[inaudible 00:02:34].

John Cochrane:

Jon has a background at University of Chicago, a little time at Goldman Sachs. Tell the Hoover audience just a little bit of your background, Jon, and then a little bit about what you've done with what the philosophy of the Capitalism and Freedom Podcast has been, and we'll talk about what it's going to be in the future.

Jon Hartley:

That's very kind, John. A very, very kind introduction. Perhaps I should be spending more time working on research in those same libraries and basements where various graduate students are. For those who aren't familiar with this podcast, these are one-on-one interviews with experienced economists, policymakers, people in financial markets. We usually ask questions about their careers, their main ideas and contributions. We like to focus on a lot of long-term trends rather than the news of the day. But the idea is to really just focus on a lot of the key ideas, many of which were actually mentioned in Milton Friedman's nineteen-sixty-two book Capitalism and Freedom. He talked about a lot of things in that book that I think were quite prescient and quite relevant to today. Whether these are topics like occupational licensing, universal school choice, these are topics that have been sweeping the nation in recent years or sweeping the United States.

We've spoken with former Arizona governor Doug Ducey, who's the first governor to pass these policies in the US. We spoke with Morris Kleiner, who's the world's leading expert on occupational licensing. We've also had really amazing discussions with academics over some of their key contributions, and some who've represented key transformations in economics. One being Steve Levitt, for example, who co-authored the book Freakonomics. He actually announced his retirement on this podcast a few weeks ago, after which the podcast kind of exploded in popularity. It's been quite amazing to go to economics conferences and talk to people who I've never met before saying that, "Well, I listened to your podcast." It's a pretty amazing experience.

To give just a little bit of background about myself, as John mentioned, I'm an economics PhD student at Stanford. I've had a good number of policy stints in a number of places. Most of my research is focused on, one stream is focused on business cycle, macro and finance, so many of the same topics that John works on. Then another stream is working on economic growth and regulation, so things like zoning, occupational licensing, things that are wholly macro or might be causing growth. Things like management being a factor of production or antitrust policy to what degree can that hurt or help growth? Those are some of the topics that I work on. But in terms of some of the topics that I think are really interesting and have been a real theme of this podcast, including some of our discussions that we've had, John, are topics like DSGE models.

One theme for those who aren't as familiar with what a dynamic stochastic general equilibrium model is, they're kind of what is often called the workhorse macroeconomic business cycle model that places like central banks use like the Federal Reserve and such models. They're maintained by central banks around the world and economists like myself and John have to write them down on our papers. But I think sometimes we're a bit skeptical of how useful they really are. We've spoken with Larry Summers on this podcast and we've talked about some of his original debates with Ed Prescott, who is sort of one of the key figures in starting DSGE real business cycle models. But I think John and I are both a little bit skeptical whether any central bankers out there actually moved their dots based on what's coming out of the house DSGE model compared to say BAR's. I'm going to probably pass this back to you, John.

John Cochrane:

Let's come back to that one. I want to do a little more intro first. The Hoover institution, those of you don't know it, combines scholarship and policy and outreach. Most of us senior fellows have been academics and now work for Hoover and continue academic work, but also try to do things in the policy space as well. The economics policy working group is sort of the bureaucratic institutional structure that brings together everything we do at Hoover in the economic policy space. It includes a whole list of interesting people who you will get to know over time. Because one thing I think we're going to do is have Jon interview interesting people associated with what we do. We have a seminar series which brings in more interesting people that Jon will get to talk about. We have our conferences. There's an annual monetary policy conference, which is getting more and more successful I think, and various other things going on.

A range of topics, not just macro Taylor Rule money that we've been talking about here, but healthcare, health insurance, energy, climate, state and local. All the zoning regulation stuff that Jon mentioned are prime concerns. And we are not just banging on the wonders of the free market, the challenge of course today is that those of us of free market bent like Jon and I at the ghost of Milton Friedman who lives in this office. The challenges of course on the left, the advance of the progressive state and on the right, economic nationalism and those other trends that we need to think about and deal with. Those are kind of the broad things of the Economic Policy Working Group.I think it's going to be wonderful to bring Jon's great interview style together with the people and the topics that we cover in the Economic Policy Working Group, so you'll never get bored.

Jon Hartley:

Well, that's very kind of you to say, John. Really excited, one, to be working with all the wonderful Swedish scholars that Hoover has and really excited to... One, I will say we've actually interviewed quite a few people at Hoover already, but there's many still to interview, and so I'm very excited for those discussions.

John Cochrane:

Wonderful. Okay, well as long as we've got some time left, Jon, why don't we talk about economics a little bit?

Jon Hartley:

Let's do that.

John Cochrane:

What have you been working on this summer?

Jon Hartley:

It's funny you ask, one topic that I've been working on quite a bit, it's also a topic that you've been working on quite a bit for the past few years, and that being the fiscal theory of the price level. Really trying to understand to what degree we can test the fiscal theory of the price level. It's at least the key equilibrium condition in the fiscal theory is one that you can empirically test because like MV equals PQ or the monetary base velocity prices and quantities, you can see all those. Similarly with FTPL, you can observe debt, money, prices, and with a lot of history you can look at the future path of surpluses and you can discount them back. One thing I think I've been a bit surprised about is actually I think how well the fiscal theory actually works. I don't think it works perfectly, but I think it works actually a bit better than at least that I expected it to.

John Cochrane:

Let's back up just a second and explain to our listeners who... I am sure everybody knows exactly what the fiscal theory of the price level is, of course. So the fiscal theory of the price level states that the fundamental determinant of inflation in our economy is not so much money, not so much interest rates, those matter, but the fundamental question is, is there more government debt than people think our government has the will or ability to repay? When that happens, people try to get rid of government debt quick before it becomes worthless, and in doing so they drive up inflation. That's the basic concept of the fiscal theory of the price level.

Now I'm glad Jon, you're taking up this challenge. Because the basic idea is just like prices present value of dividends, it's the theory of asset pricing applied to government finances. When people think that there aren't going to be any dividends, they try to dump the stock, the price goes down. When people think the government isn't going to be able to raise taxes over what it spends, they try to dump the government debt and that price level goes up. Same mechanism. But we've been asked trying to test prices present value dividends for 40, 50 years and it's still contentious. You still say the word efficient market, basically that statement, and people go bananas, but of course it's not efficient.

Now of there's all sorts of false steps. The whole thing is kind of vacuous. If you let the prices expect present value dividends, well who's expected, who's discounted? Once you put those things in, the usual criticism is that it's vacuous. How are you dealing with this central problem which permeates all of asset pricing that take into its full generality, it's very hard to test. Because you don't know what the expected dividends are and you don't know what the discount rate to take the present value is.

Jon Hartley:

Well, I think that's one central challenge. One thing that we can do is, we can make some assumptions. With the benefit of hindsight, we have hundreds of years of fiscal data that's been compiled by great economists like Carmen Reinhart, Ken Rogoff, among many others, others that have compiled data on interest rates. What you can do is, you can go back to say 1800 and you can, with the benefit of knowing what the future fiscal history will be or what the future path of surpluses will be, you can discount those future surpluses back using a long-term discount rate of what it was in 1800. You can repeat that and iterate forward and recalculate that, and you can compare that present discounted value to the real value of government debt or your debt to GDP ratio.

This is something that others have done, yourself have done in different ways. There's a paper by Hanno Lustig and co-authors that's forthcoming in Econometrica, that there's a sort of a similar government debt valuation exercise. I would say it's a little more complicated and it's not exactly testing fiscal theory of the price level exactly either, but it's the same idea. Trying to take seriously this idea that the real value of government debt, you can compare it to the present discounted value of future surpluses.

John Cochrane:

Let me put in a plug here for what you're doing in the larger scheme of things, especially if any young researchers are listening. We've got a brand new theory, it says that basically prices present value explains inflation in a way people haven't really thought about before. We have 50 years of accumulated methodology on how you apply that insight to stocks and bonds, and is simple low-hanging fruit to apply that methodology to government debt and inflation questions. Now, low-hanging fruit is not always as easy to eat as it seems, because there's hundreds of little puzzles to work out ways to implement it. But the the big picture of how we would go about to do this is fairly straightforward. I think this is a very exciting research area and I'm glad to see you doing it.

So let me shift the conversation a little. I want to ask you about our other big issue. Which this is one of the things that's been on my mind, and I just finished a paper called Expectations in the Neutrality of Interest Rates, which talks about this, but part of why it's on my mind. But your listeners may have seen there's an Atlantic article, nobody knows how the Fed actually does things. There's a Scott Sumner blog post, nobody knows how interest rates actually work. The point of my article was really to look at the very basics and to realize that there is a standard doctrine of monetary policy that says higher interest rates, lower spending makes the economy worse, and through the magic of the Phillips curve that lowers inflation.

But there is no faintly respectable modern economic model that embodies that doctrine. It simply doesn't exist. Of course, even the pieces of the doctrine, the verbal doctrine, people are starting to notice that the Fed did raise interest rates. Inflation did come down, not clear whether the Fed just jumped in front of the party or not, jumped in front of the parade or not, I happen to think it did. But nonetheless, the prime mechanism, the Fed didn't have to induce a recession. Now people can spin epicycles on this, "Oh, the Fed changed expectations." Well, the Fed's been giving speeches to try to change expectations for 30 years, it's the first time it's actually worked. But there is no respectable model. That of higher interest rates lower future inflation.

Now that contrasts with what goes on in the bowels of a policy world and in much of academia where people write incredibly complicated multi-equation models and people in the policy world and the central bank and the international organizations, they write these new Keynesian DSGE models. They're beautiful models, but they don't work the way the words say we think monetary policy works. They do not produce... Higher interest rates, do not produce steadily lower future inflation. That's just not how the equations and the predictions of the model work. I'm curious, and if you want, we can go into exactly why this doesn't work, but in your contact with the policy world, how has this cognitive dissonance, how has this schizophrenia that's been going on for 30 years get patched over?

Jon Hartley:

Well, it's a great question. My sense is this, and this may certainly offend certain sensibilities of people that have spent their entire careers on DSGE models. But my experience working in various policy organizations and having talked to a lot of people who have worked very closely with central bankers or have been former central bankers themselves, is that there's basically a bifurcation that goes on. I would kind of put it this way, central banks are essentially the biggest subsidizer of DSGE research. And DSGE research broadly speaking, is actually lost a lot of, I would say, interest in broader academia, broadly speaking. If you look at the number of macro companies, the number of people just working on DSGE models, or just say macro models in general in economics departments, has declined really significantly, especially since the 1990s or so.

Largely they've been replaced by applied economists, people that are working on largely applied micro topics but with really good identification. What happened I think in tandem in the 1980s beginning with Kittleman and Prescott and the rise of real business cycle DSGE models, is that macro-economists were more focused on theory and less focused on very good reduced form empirics. We have a lot of central bankers, increasingly fewer who have PhDs. There's a great Financial Times article that was written by Ron Wigglesworth a few weeks ago that said and made this observation that now only 50% of FOMC members have PhDs compared to say 75% say a decade or two ago. I think what's in part going on, and the reality is, that central bankers don't really pay attention to DSGE models.

I think that they use VARs to forecast big macro-economic variables like inflation and growth and those sorts of things. But at the end of the day, most central bankers will not change their, I say their dot or their monetary policy reaction function based on some wisdom that's coming out of the DSGE framework, or coming out of the DSGE model, say like FRB/US that's estimated by the economists at the Fed staff in DC. Now that said, there's some insight from DSGE models that are used, things like aggregate demand slopes down, maybe this idea that higher interest rates can slow down inflation. That's not something that's necessarily exclusive to a DSGE model, I think at some level, I think more policymakers have like an ISLM kind of model at the back of their minds rather than a highly technical 100 page DSGE macro model.

But I do think that there really are a lot of empirical examples in the past, think the Volcker disinflation and what happened there, or the observation that Milton Friedman and Anna Schwartz made in the monetary history of the United States. That money supply that its contraction contributed to how deep the Great Depression is. In my mind, at least in terms of the best way forward, is really to improve our empirics. I'm a big fan of a good identification. I'm a bit of an empirical or contra macro-economist myself, and I think that the way forward for macro in my opinion, which is probably a bit different than yours, John, is that I think we need better empirics, better identification.

That's not easy given that so many things are endogenous in macro and perhaps impossible, but to me I think that's a better way forward and perhaps a better way to get policymakers thinking about research. Because to be honest, I don't think that people on the FOMC are reading new a hundred plus page macro papers that they get released on the NBR working papers series on a weekly basis. That's just my view on things. Again, I fully agree with you that I think theory is broken in that sense, but I guess the question is, do you need a better model to beat a model in the words of Bernanke and many others or should we really just follow the data and see what we can glean from that? And have some [inaudible 00:22:25]-

John Cochrane:

You said several multiples here. Well, let me react to you about, again, I've got a list of the eight things you said that I wanted to react to here. My view is actually, the models might be right. The bottom line where I come to is a combination of New-Keynesian DSGE with the fiscal theory of the price level, repairs the most outstanding obvious problem of the DSGE models. That most outstanding problem is an assumption that inherently there are multiple equilibrium and the Fed acts by making everybody jump to an equilibrium that the Fed likes by threatening to blow up the economy if we don't do it. Literally that's in there. You got to be kidding. But that's easy to fix with fiscal theory of the price level.

Then you get what I think is quite sensible, which is a view of the economy, which is the way we think it works. There's production and there's workers and there's markets and there's various kind of shocks and interest rates do and do their thing. I'm not against the models and in fact, what I said was, I said something very careful, we don't have a model that encompasses standard doctrine. Now it's not obvious that the doctrine is right and the models is wrong rather than the models are right and the doctrines wrong, because that doctrine really just comes from stories that are repeated over and over again. The doctrine again, that there is interest rates that cools the economy and then the magic of the Phillips curve lowers inflation. The latter part is especially troublesome.

Now you also made fun of a hundred-page models, and that's not really where the trouble is. There's a one-page version of the model, that doesn't work either. The famous three-equation model. Which includes there's something like price stickiness, that's a crucial part of why this monetary policy... Although we don't really know what that is. This is not about overly complicated models. This is about models that even boil down to their essence don't work the way you think. I don't want to get too deep into models, but there's a clear intuition for why. Suppose the Fed raises the interest rate, the nominal interest rate. Now, normally we think of a bottom line that real things remain the same. If you measure something in feet or meters, that doesn't change it. So the Fed can raise the interest rate, but then the puzzle is, "Well, why doesn't then next year's inflation rise so that the real interest rate remains the same? Why does next year's inflation go down?" That's the fundamental puzzle, because in the models, there is no model where next year's inflation goes down when the Fed raises it this year.

The verbal doctrine is a static, you said ISLM. This is a static view, a view that eliminates time. The central thing, what I meant by a respectable model, is one that treats time correctly. The intuition people have says, "Well, higher interest rates, that's going to lower output and lowering output somehow is going to lower prices." Then they jump from that to, not prices go down today, but prices slowly go down tomorrow. You have sort of a verbal, an adjustment mechanism to a static model produces dynamics, but that's not how you do respectable economics. Respectable economics today is intertemporal, it's today versus the future. When they raise the interest rate, that's going to typically raise tomorrow, that's the kind of fundamental problem. It's not about being overly complicated, it's about just sort of fundamental economics that might be right but does not comport with the standard story people.

Now you also said... I'm sorry, I got a laundry list here so I got to go through it. People aren't... In graduate school your compatriots are not working on macro and inflation, they're all doing difference in difference empirical things, trying to find tiny, tiny little exogenous causal changes in the sea of endogenous facts that we have. But it's really weird. When we went through a financial crisis, there was an outpouring of what caused the financial crisis, and then we had the sovereign debt crisis and there was an outpouring of what caused the sovereign debt crisis. We've just had an inflation that we haven't seen since the Reagan era, and you would think there would be an outpouring of what caused this inflation. The answer is no. People would just, "Oh, it was a supply shock or greed or shrinkflation or whatever. Can we get back to work on doing a difference in difference of whether green ties or yellow ties raise your GDP by 0.001%.

Now you said empirical, and of course the problem with macro is that those tools don't work. They don't work because you don't have natural experiments. This central problem of causation versus correlation is one that is not as easily solvable. The VAR, the vector autoregression tried to do it, but that I think is completely played out. It was a brilliant idea when Sims introduced it in 1980, but it requires the notion of an exogenous monetary policy shock, and there is no such thing as an exogenous monetary policy shock. The best we can find are two or three tiny movements, but measuring... And that's not even really the question. The question we want to know of monetary policy is not, "What if the Fed sneezes raises 25 basis points?" The question we want to ask in monetary policy, what happened in 1980 was not a sneeze, it was a change in the rule. The change in the rule changed the expectations.

So there's this one data point. Volcker raised interest rates, big recession, inflation came down. But you look over history, there's other totally contradictory data points. The end of the German hyperinflation, when the fiscal problem was solved, interest rates went down, there was no recession, there was an economic boom, they printed up way more money and they borrowed more money. What? Wait, that's totally opposite. That's the central problem. I think it's an exciting time for research, because our models are completely played out and we need to go back to absolute basics. Does raising interest rates lower inflation and raise the value of the currency? If so, how? That's like the most basic question you can ask. I think I know the outline on how to do it, but our current models do not do that.

And our current empirical procedures are... VARs, they're largely for forecasting, they're used just for finding correlations. For causal analysis that's completely played out and is answering the question we're not really interested in answering. And you said forecasts. How well have central bank forecasts been doing lately? They've been a complete disaster. In part has they ignore supply shocks, they ignore the whole real business cycle. They say, "Oh, we had supply shocks." And then I say, "Okay, well where's the supply shock in your model?" "Oh, we don't have any supply shocks in the model." "Well, why not, if you think it's a supply shock?"

Jon Hartley:

Forget about [inaudible 00:29:40].

John Cochrane:

The last thing I wanted to complain about is you said PhDs in central banks. It's not obvious to me that given the state of economic knowledge more PhDs in central banks is going to be a good thing rather than a bad thing. Central banks remember, never had PhDs. It was not a College of Cardinals or a theological disputation club. It had bankers that had regular people and the Fed is set up to be a representative institution. It's not obvious to me that PhDs are going to do any better, especially if they know too much of their models and not enough of the historical doctrine matters. Doing policy is very different from doing research. Doing research, your job is to have a hundred crazy ideas before breakfast on the hope that one of them works out. Doing policy is about not screwing up. The loss function is entirely different. Loss function for academia is, I can throw away my bad ideas. Loss function for policy is, don't screw up even once.

Jon Hartley:

Or when are you going to get tenure.

John Cochrane:

Sorry?

Jon Hartley:

I feel like in academia perhaps it creates a lot of risk-loving behavior in the sense that, not getting tenure requires you to take a lot of risks on certain ideas.

John Cochrane:

I don't know, getting tenure seems to require taking very little risks and doing exactly what AER is likely to publish without too much complaining.

Jon Hartley:

That's true.

John Cochrane:

But having influence after you get tenure and doing something important in life, which may or may not mean getting famous in economic. Getting famous in economics is about getting a thousand other people to do what you do and cite you, it's not necessarily about being right, but long-lasting influence being right. Yes, is about taking an intellectual risk. Which is not, if you do policy. Jon, you do policy someday, no more intellectual risks. You got to be very, very... I think wise policy is very conservative. Even I, I just gave you a lecture about higher interest rates, I don't know how they lower inflation. But you put me in charge of the Fed, inflation goes up, I'll tell you what I'm going to do, I'm going to raise interest rates. I don't know why it works. I don't know if it works, but until we know for certain something else works, that's what you got to do.

Jon Hartley:

Well, I think it's quite ironic that Jay Powell's idea or central idea or approach to policy, which he refers to is called the Risk Management Approach to Monetary Policy. I think that's making it innately clear. It's kind of, keep going until you break something type approach. It is definitely interesting.

John Cochrane:

I think monetary policy needs more of a risk management approach. They sort of say, "Here's the forecast and here's what we're going to do." Rather than what our military colleagues here at Hoover do, which is they teach us, you don't say, "Well, the forecast is they're coming on the left flank, so that's where we'll meet them." You go, "Well, what if it's the left flank? What if it's the right flank? What if they come down the center? What if they come around?" You got to think much more about risks than the Fed typically does.

Jon Hartley:

It's interesting. I don't know how you'd frame it in terms of risk, but I think a related problem is really just group think. You go back to, for example, October of 2021 after inflation had started to shoot up in May or April, May of 2021. At that point by October 2021, it was very clear that it wasn't just your used car prices that were driving the big jumps in CPI that we were seeing. We were starting to see things like shelter home prices or owner-occupied rent prices increase, and even still the Fed waited another six months to start raising interest rates. I think there was this idea that inflation was going to come back down on its own and wouldn't need help from the Fed.

This was just this idea that was being promoted by the media. I really think that forecasters were moving away from what their VARs would suggest, just that this supply shock was a one in a hundred-year type event. But even still, I think independent thinking is a somewhat rare thing. Another thought is, I think just on sticky prices and sticky wages, I've heard the stories of how it came back to modeling, how sticky prices and sticky wages first got inserted into macro models in the first place. My understanding is basically you had RBC models which said that there was no role for policy to have any real economic effects. A lot of the early New-Keynesian modelers basically said, "We want policy to matter and this is something that we can throw into the RBC machinery and make policy matter again." It wasn't some sort of great empirical insight necessarily that it was sticky wages that were causing massive fluctuations in unemployment history.

There was some work, written by Bewley and others afterward, but I think it's kind of funny how it was something that was inserted into models to make them work the way that such modelers wanted them to work without necessarily a ton of empirical basis. Just to push back a little bit on some of those natural experiments. I do think especially for economic historians out there, I think there are great natural experiments to look at when it comes to monetary policy. We have great instances of the money base being cut by massive amounts. For example, I think in France there's a great François Velde paper, there's the 1863 Currency Reduction Act in the Confederate United States where the money supply was contracted and it could only be contracted in one part of the confederacy, the eastern part of the Confederacy because the union forces had taken the Mississippi so the new grayback notes couldn't make their way to the western part of the Confederacy, which was like Texas and so forth.

So inflation from your [inaudible 00:36:09] back prices actually went down significantly in the Eastern part of the Confederacy versus the Western part. I think things like that are what you see in that François Velde paper in France. I think these are obviously historical episodes that the economy may look very, very different now, but I think they're interesting in [inaudible 00:36:33] exogenous identification. Some would even say some of those monetary policy shock series, whether it's from folks like Nick [inaudible 00:36:41] give you some exogenous variation, breaking an exchange rate peg or stopping UI benefits or some sort of cutoffs across states. I think these are interesting examples of good identification that can help us to answer, at least begin to answer some macro questions or identify some [inaudible 00:37:02]. Sure might be partially equilibrium, not perfect, but in my opinion gets us some answers maybe with some precision, even though they might not be global.

John Cochrane:

You've given me another laundry list here, so hold your horses. First of all, I want to violently loudly agree with you on what you just said, that I find lately historical episodes are the most convincing natural experiments we have for distinguishing macroeconomic theories, as opposed to fancy statistical analysis with a lot of assumptions and identified VAR by some identification restriction. I'll just want to point up some that I've been making lots of pay in my own writing. I regard the inflation episode that we just had, inflation came from seemingly nowhere. The Fed didn't do anything with interest rates, particularly unusual. 8% inflation, where'd that come from? Then inflation went away without repeating 1980. That's a historical episode. Well, the federal government printed up $5 trillion of cash and gave it to people and the fiscal theory of the price level does exactly that and the other theories clearly don't.

There's a historical episode that I think helps you distinguish theories. The other one, the zero bound era. When interest rates hit zero and the Fed did massive QE, our existing theories made very clear predictions about what happened. At the zero bound you have deflation spirals, in old Keynesian models you have multiple equilibria in some spots in New-Keynesian models, and when you do QE you have hyperinflation in monetarist models. The comparison of QE, which did nothing, and the Covid expenditures which caused inflation, is just crucial. For Monetarism says those two have the same effect. Fiscal theory says they don't. This is an example of historical episodes that are just screaming theory A makes a clear prediction, theory B makes a clear prediction, the episode tells us what happened, and yet nobody's paying any attention.

The problem and I love Velde's work on a Chronicle of a Deflation Foretold for your listeners that the Velde and Sargent Macroeconomics of the French Revolution, another masterpiece, their work on US fiscal and monetary theory more masterpieces. I think that's incredibly useful work. The problem right now is sort of our professional problem, it doesn't look very technical. You can't impress hiring committees and econometrics editors with all the equations you can run, you can just convince people of stuff that's right. It's like Tom Sowell's work, it doesn't have lots of regressions, it's utterly persuasive by assembling facts. Now maybe hopefully economics will at some point produce reward things that are actually producing knowledge, but I totally agree that's kind of where my own thinking is going to try to send anything out.

You said something about central banks not having independent thinking, and that's true. There is kind of this bubble where they talk to each other. It's funny because the Fed is set up so much as a responsive structure. The regional banks, the FOMC members, they're not supposed to be there to represent schools of thought, they're supposed to be there to represent communities. And again, it's just stuck. I think the greatest example is, and the disadvantage of having too many PhDs around, is just one, you mentioned one episode, but the episode earlier, the flexible average inflation targeting is a beautifully constructed New-Keynesian DSGE Maginot line against the supposed problems of deflation at the zero bound, which we cure by making promises about what we will do 10 years from now if inflation should ever come. The promise of if inflation ever comes 10 years from now we'll be slow to react will be the thing that stimulates us today. That was just New-Keynesian DSGE doctrine. It took over within the central banks and the original Maginot line, sorry, it was the wrong problem at the wrong time. It's a great example of both the kind of group think, but how the group think was affected by I would say too many PhDs and not enough people saying, "You got to be kidding about this stuff."

And last, you said sticky prices. This was a very deep thing that you said. Now sticky prices, everybody recognizes the models of sticky prices are kind of silly. This is a problem we have in economics. We're like the drunk who looks for our keys where the light is not over by the car where we drop the keys. Because we kind of sense, like the historical experience, that inflation causes output booms and deflation is sort of associated with recessions and we don't know why. So making prices sticky artificially produces models that do that kind of thing and lets you explore it. You also mentioned it helps to sell things to central banks. Here we just noticed our last two recessions have had nothing to do with monetary policy. There was a financial crisis and there was a lockdown that caused the recession. You can't ask for better real business cycle view of the world.

But you are right that telling central banks they're not very powerful is not a really good way to get yourself invited back to central banks. It is funny that the whole macro has so totally focused on monetary, but we'll kind of agree monetary policy might 1%, 2% here and there, but sort of the central things that cause big economic perturbations are not any more monetary policy. Friedman turned out to be wrong, maybe not about history, but about current events. Recessions are not caused by monetary policy mistakes. This isn't just doctrine, this is what you can see in every empirical estimate, even your VARs, monetary policy shocks just aren't that important for recessions.

In fiscal theory, the Fed on the edge is helping here and there, but fiscal policy is really important. Milton Friedman won far too much. In the fifties people thought inflation had nothing to do with central banks as wage price spirals and stuff like that. Then Milton Friedman goes, "It's all central banks," and now recessions are no longer all central banks and inflation we're starting to discover is not all central banks. It's a problem that the customer with the deepest pockets wants a theory where central banks are really powerful and it's not obvious they are. Okay, stop having so many beautiful ideas and I'll stop having such long responses.

Jon Hartley:

Well here's another, I guess the last just couple monetary policy questions. I'd love to talk to you a bit about economic growth and regulation and other growth related topics as well.

John Cochrane:

Let me just interject. Monetary policy, I do it because I think it's interesting, but economic growth is the important issue of our time. The falling in economic growth is the tragedy, is the Europe's end of economic growth is the tragedy. And it really has nothing to do with the Fed and monetary policy, it's about regulation, innovation, dynamism, all those things. So yes, that's the important question. We're off, we're the drunk looking for the car keys over where the light is and not where we dropped them, economic growth.

Jon Hartley:

Absolutely. Before I get to growth, one last question on just monetary policy. One is, you mentioned FAIT or Flexible Average Inflation Targeting. We've had just inflation targeting in the past 30 plus years, and the history behind it I think is really interesting. For those that aren't really familiar with how central banks were targeting things, there was a period of time at the height of Milton Friedman's thinking in the 1980s when central banks were trying to target monetary aggregates, they were taking MV equals PQ very seriously. Then they realized they kind of couldn't really target it or control M very well, in part because money demand is a bit unpredictable.

From there that's kind of how this New-Keynesian machinery kind of emerged, or the whole concept of targeting an interest rate as well as targeting an inflation rate emerged. It was really the central bank of New Zealand, the Reserve bank of New Zealand that began inflation targeting and chose this 2% level of targeting, and then other central banks around the world followed, the Fed started following but didn't officially declare their 2% target until actually the early 2010s. But the whole world started following this 2% idea by and large by the end of the 1990s.

What's interesting is, in those debates, if you look back, there were a number of people like for example, Paul Volcker who is very much against 2% was in favor of a 0% inflation target. Paul Volcker being president of the Fed or the chairman of the Fed for quite some period of time in killing the inflation of the 1970s, 1980s or at least being credited. But with that maybe there's more of a fiscal policy story there that you could tell. But other central bankers like John Crow who is the governor of the Bank of Canada was in favor of 0% inflation targets. I know John, you've spoken quite a bit or written quite a bit about not being as worried about inflation as we should. Let's say some recession hits the US economy in the coming years and the Fed drops interest rates back to the zero lower bound and say we start getting worried about deflation again. What would you say to those people in macro circles?

John Cochrane:

Oh gosh. Once again, there's the whole history here. Yes, central banks, there's a question of the target in the instrument. What do central banks want to control? Are we driving to Las Vegas or are we going to go to Santa Barbara? Then what do they actually is the steering wheel, the money supply or the nominal interest rate? Those are central questions that we've changed around on over the years. As you mentioned, it used to be the money supply that turned out not to work. Central banks went back to what they've always been doing, which is using the nominal interest rate to try and steer inflation where it's going.

The other question is the set of goals. Should central banks worry about one thing, inflation or a whole bunch of other things. Our official mandate in the US is inflation and employment, but there's a whole bunch of other things people want central banks to do as well, exchange rates and inclusive employment and climate and all sorts of things now. Just quick on the history of this, in the 1980s the US Fed and other central banks went back to interest rates and felt that higher interest rates was what you do to control inflation. In the early 1990s, a bunch of countries, starting with New Zealand, innovated with the idea that the central bank would not try to do five things at once, inflation, unemployment, all sorts of other things. They would just worry about inflation. I think this is very wise, the best way to raise employment within the constraints of what monetary policy can do, is to just have very stable inflation. It's when inflation goes up and down and then the Fed has to fight it all the time that you get fluctuations in employment.

By the way, it is kind of weird that the Fed is supposed to be in charge of inflation, but it can't do the one thing that creates inflation or gets rid of inflation, it can't give people money and it can't take away people's money. The Fed is supposed to worry about employment, but god forbid it should talk about tax rates, employment policies and so forth, which is actually what determines employment. Anyway within the constraints of what it can do. What happened was, New Zealand and the other countries, it was a political deal with the central banks involved, was you worry about inflation, we will evaluate you by how you do on inflation and nothing else. I think also they always included fiscal and micro economic reforms, which is actually an important part of the deal.we by the way, will pay our debts and we won't count on you to print up money to pay our debts. That was a crucial part of the deal, and we'll get rid of a bunch of regulations.

What happened was not, you mentioned the Volcker experience, high interest rates and a big recession to combat inflation. The inflation targeting countries got rid of inflation big overnight. The idea was it was supposed to insulate central banks from political pressure not to raise interest rates, so they could be tough and repeat Volcker if they had to, and they never had to. It was just instantly inflation went away, sort of like the end of the German hyperinflation. That was a big success. Through the nine formation of the Euro central banks were told, "This is beautiful, just worry about inflation, don't worry about anything else. Everything else will take care of itself if you just worry about inflation." Now we've slid back on that a lot. Central banks are now doing all sorts of other things beyond just targeting inflation. But we are left at least in the doctrine and also we're starting to realize central banks maybe don't have as much control with it.

We're left with the doctrine of exactly what do you mean by target inflation? You're right, 2% was picked out of a hat. I personally like zero, but our Fed's mandate is price stability. The European central bank's mandate is price stability. What do you think they meant when they said price stability? Do you think they meant 2% inflation forever or do you think they meant price stability? That's legalism, but then there's the economic question, which I don't know how deep you want to, I kind of like price stability, in part because I'm not that concerned about adding stimulus from the central bank. The central banks just not screw up. That's good enough.

Jon Hartley:

In the US, it's price stability and full employment-

John Cochrane:

And full employment.

Jon Hartley:

[inaudible 00:51:40].

John Cochrane:

The price stability part is interpreted as 2% inflation. Now the theory is it's the same theory as the theory that it feels good if you wear shoes that are too tight all day long, because it feels so good to take them off at night. That if it's 2% in normal times then you can have higher interest rates and lower them more. All right, maybe, maybe not. I don't think so.

Jon Hartley:

I guess the divine coincidence idea that you're just targeting inflation, you end up-

John Cochrane:

There's a even bigger question of what do we mean by this 2% inflation? This really comes up with the past inflation that we've had. If say you have a 2% inflation target, does that mean inflation is on average 2% over long periods of time? You might think yes, absolutely no. Because they always catch it in a forward-looking direction. It's 2% where mistakes are forgiven. Your impression of a 2% inflation target might mean, "Well, if it goes up 8% in one year, you got to have several years of zero or 1% to bring it back to 2% over the average." Uh-uh, central bank's interpretation of price stability is 2% inflation forever, and if we ever screw up, we just forget about it and try to get back to 2% in the future. But we bring the level of prices back to where it was. That's actually, that's the deepest part of the 2% target that I think bears some worry. So yeah, I think zero would be fine. Price stability should mean price stability. But that is that last remaining part of the debate still.

Jon Hartley:

Well, speaking about your books, and it would be remiss not to plug your, perhaps dare I say magnum opus, The Fiscal Theory of the Price Level that came out in 2022. You're also working on a new book, a related one on my understanding is, of fiscal theory, but in the Euro area. Can you explain to just a little bit about that and the idea behind that book?

John Cochrane:

I'm very excited about this. I'm working with Klaus Masuch at the European Central Bank and Luis Garicano who is, let's see, LSE, University of Chicago and an ex-member of the European Parliament great theorist. We are working on it. We're finishing up due July 15th, a manuscript which will be available on my website for free until it gets published by Princeton in the spring, on reforming the structure of the Euro. Of course the central problem of the Euro, it was set up quite clear-headedly, really amazing the things they thought about compared to standard monetary doctrine at the time. The problem of a common currency without a fiscal union, is that of course each individual country has an incentive to borrow a lot of money and say, "Help, help, help. Print money to bail us out." So the ECB and the Euro was set up very thoughtfully to try to stop that problem.

The ECB would not buy sovereign debts. The ECB would not work to hold down spreads, and countries were supposed to follow debt and deficit limits to not get in trouble in the first place and we'd solve that problem. Well, not really. In part because when putting it together, they didn't really want to write a prenup. It would've been impolite to say, "Now if you do feel like defaulting, let me remind you that you are now just like a country you default," and to put in a bankruptcy and resolution mechanism, which they didn't do. That was a beautifully set up separation of monetary and fiscal policy, and it kind of fell apart. Now, it fell apart in the most human of all ways. Things that nobody ever imagined in fact happened. The financial crisis happened. Nobody was thinking about financial crisis. Financial crisis happened and the ECB started integrating.

The sovereign debt crisis happened, nobody thought there would be sovereign debt crisis anymore. The ECB started buying Greek bonds. QE happened, and the ECB decided, "Well, so what? We don't buy sovereign debts. We're going to buy lots of bonds and print up lots of euros." Covid happened, the ECB bought more. Step by step, we're now in a situation where every time there's a hiccup in the Italian spread, the ECB starts buying Italian debt. We're economists, it's about incentives, the incentives for countries to run good fiscal policies, for people not to expect the ECB to intervene routinely are gone. That basic structure of the Euro, the monetary and fiscal part of the Euro...

And it's banking too. By pretending sovereign debt was risk-free, it means banks are loaded up with sovereign debt, so banks are like hostages now. Because if Greece fails, all the Greek banks fail. Why? Because banks are allowed to load up on sovereign debt as if it's risk-free, in a way they can't load up [inaudible 00:56:36]. Well, that's nuts, but nobody ever got out fixing that. The book points out this beautiful structure that was set up, how it fell apart in the exigencies of four crises. If you put me in a crisis, I'm going to bail everybody out just like they're going to... You got to get through the crisis. But then nobody fixed the structure in between the crisis. They just said, "Oh great, a river of money solved it, so let's go get ready to print up another river money."

 We're at the point now where Europe needs to put that genie back in the bottle and get some structures that will get the incentives right again, not for everybody not to count on the ECB always to print money to solve every problem, because it won't always be. That's the short summary of the book and wait... Well, this probably won't come out until July 15th. July 15th the draft will be up on our website and look forward to it next year from Princeton University Press, and many more podcasts about this wonderful effort.

Jon Hartley:

Well, I'm very excited to read that. That's a super exciting development. So lastly, just want to talk about economic growth. The question I think is perhaps the most central question in the field of economics. Why are countries rich and poor? Why are countries growing or why do certain countries have levels of GDP per capita that are much higher than others?

John Cochrane:

Let's not solve all the world's problems in one podcast, Jon. I think what we've done for our listeners is tee up the many issues that we'll continue talking about. Along with tariffs, that's probably going to be in this soon. Industrial policy, that's going to be in soon. How much money should the government throw on electric vehicles, especially made in the US by union labor? We got a whole bunch of issues coming to talk about over the coming years.

Jon Hartley:

Absolutely. Well, this is really such an exciting opportunity and Hoover has such a great cater of scholars who will be appearing on the podcast soon. And of course, really wonderful to have you on, John, as always. I really want to thank you so much for joining us today and also for this wonderful collaboration between the podcast and the Hoover Economic Policy Working Group. Really excited to be part of the team and really excited to continue to engage on a lot of these same ideas that we've been talking about.

John Cochrane:

This is going to be great fun, Jon. I hope all of you tune in to the new home of Capitalism in the Twenty-First Century at the Hoover Institution, EPWG

Jon Hartley:

Wonderful. Today our guest was John Cochrane, who is the Rosemarie and Jack Anderson Senior Fellow of the Hoover Institution and the chair of the Economic Policy Working Group. This is the John Cochrane podcast, where we talk about economics, markets and public policy. I'm Jon Hartley, your host. Thanks so much for joining us.