In a recent webinar hosted by ECIPE, John Cochrane, a leading economist and the Rose-Marie and Jack Anderson Senior Fellow at Stanford University’s Hoover Institution, discussed pressing economic issues, including inflation, deficits, and the outlook for economic policies under a potential second Trump administration. Cochrane’s insights, rooted in his extensive research and his book, The Fiscal Theory of the Price Level, provided a compelling critique of traditional economic models and a fresh perspective on fiscal and monetary policy.
The conversation began with a reflection on inflation, a topic that has dominated economic discourse over the past few years. Cochrane criticised the prevailing economic theories that have guided central bank policies. He highlighted the limitations of monetarism and New Keynesian models in explaining inflationary trends.
According to Cochrane, central banks have long operated under the assumption that adjusting interest rates can control inflation. However, he argued that this approach overlooks a fundamental issue: central banks don’t directly control the money supply. Instead, they set interest rate targets, which, according to Cochrane, is insufficient to manage inflation effectively.
He also pointed out that traditional monetarist theories have been put to the test in recent years, particularly during the COVID-19 pandemic. Governments across the world handed out trillions in stimulus payments without clear plans to pay back the resulting deficits. “If you hand up $5 trillion worth of stimulus payments, you’re going to get inflation,” Cochrane stated emphatically. He went on to explain that the inflation seen post-pandemic wasn’t merely a result of increased money supply but a lack of belief that governments would repay the debt in a sustainable way.
The discussion moved on to fiscal theory, which Cochrane passionately advocates. The theory posits that inflation is fundamentally tied to the value of government debt relative to expected future fiscal surpluses. Essentially, the price level adjusts so that the real value of government debt matches the present value of future fiscal surpluses. If markets believe that governments will not repay their debts, inflation will rise as people try to offload government debt, leading to increased demand for goods and services.
Cochrane provided a stark warning about the potential pitfalls of fiscal irresponsibility. He stressed that inflation spikes when deficits are perceived as unsustainable. Reflecting on recent events, he remarked, “The crucial thing that caused inflation this time around, as opposed to previous episodes, was that governments handed out massive stimulus without any credible plan to pay it back.”
Turning to the United States, Cochrane speculated on the potential economic policies of a second Trump administration. He outlined two possible paths: one characterised by protectionism and industrial policy, and another focused on deregulation and market liberalisation. The first path, he argued, could lead to stagnation, while the second offers a chance for renewed economic dynamism.
Cochrane acknowledged that protectionist impulses have gained traction in recent years, with calls for reduced globalisation and greater domestic self-sufficiency. However, he cautioned against the economic pitfalls of such policies. Globalisation, he argued, is not just about cheap goods but also about achieving the economies of scale necessary for innovation. “You can’t afford to develop an iPhone or AI unless you can sell it around the world,” he noted, emphasising the risks of retreating from global markets.
On a more optimistic note, Cochrane expressed hope that a shift towards deregulation could unleash growth. He highlighted the potential for reforms that simplify permitting processes and reduce bureaucratic hurdles, particularly in sectors like energy and technology.
The conversation also touched on Europe, with Cochrane sharing his thoughts on the euro and the European Central Bank (ECB). While he praised the euro as a unifying force, he noted ongoing issues with sovereign debt and the ECB’s role in managing crises. He argued that the EU must address its structural problems, particularly its layers of regulation, which stifle economic growth.
Cochrane cited Germany’s energy policies as a case of self-inflicted economic harm. He noted that Germany’s decision to phase out nuclear energy while relying on coal and gas imports has hurt both the economy and the environment. These policies, he argued, illustrate the need for pragmatic economic thinking that prioritises growth and innovation.
The webinar concluded with a broader reflection on the role of central banks in controlling inflation. Cochrane underscored the importance of fiscal discipline and warned that central banks’ ability to control inflation might be more constrained than previously thought. He suggested that without fiscal policy support, higher interest rates alone might not be sufficient to tame inflation. “If fiscal policy does not help, then higher interest rates can’t control inflation,” he stated.
John Cochrane’s insights offer a sobering yet hopeful message for policymakers. His critique of existing economic models and his advocacy for fiscal theory challenge conventional wisdom and call for a rethink of how governments and central banks approach economic management. As the global economy faces new challenges, his ideas provide valuable guidance on navigating an uncertain future.
You can watch the full conversation below: