Summary of a presentation by John H. Cochrane at conference "Fiscal Policy under Fiscal Imbalance" (November 2011). Topic: Fiscal Theory of the Price Level and its Implications for Current Policy in the US and Europe.

1. The Fiscal Theory of the Price Level and
its Implications for Current Policy in the
United States and Europe
John H. Cochrane
American University
ECON-630
Achim Braunsteffer
October 21st, 2015

2. John H. Cochrane
• Senior Fellow of the Hoover
Institution at Stanford University
• Distinguished Senior Fellow of the
University of Chicago Booth School
of Business
• Ph.D. in Economics at the University
of California at Berkeley
• Asset Pricing, dynamics in bond and
stock markets, liquidity, volatility, etc.
• Op-Eds and blog (“The Grumpy
Economist“)

3. Fiscal Policy under Fiscal Imbalance
• “There really isn’t a ‘fiscal theory’.”
• Monetary-fiscal policy coordination
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐷𝑒𝑏𝑡𝑡
𝑃𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙 𝑡
= 𝐸𝑡
𝑗=0
∞
𝑅𝑒𝑎𝑙 𝑃𝑟𝑖𝑚𝑎𝑟𝑦 𝑆𝑢𝑟𝑝𝑙𝑢𝑠𝑡+𝑗
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒𝑡+𝑗

4. No Theory other than Fiscal Theory?
1. Deflationary Spirals
 Since higher debt causes higher taxes, this will not happen
2. Inflation can come before deficits and monetization
 Future deficits can cause inflation today
 No money, no seignorage, nor central banks (in)action needed for inflation

5. 3. Maturity structure of debt matters
 Short-term debt and lower surpluses: nominal debt fixed  price level must rise
 Runs on bonds: i ↑, E ↓ and π ↑
 European „Bailout“ is misnomer: countries stepping in to roll over debt during
irrational run (however, Greece is another story…)
 Illiquidity vs. Insolvency
 Long-term debt preferable b/c market value of debt in numerator could fall
Long-term debt would buy time, be a buffer and run insurance

6. 4. Aggregate demand and interest rates
 Understanding government debt demand to understand aggregate demand
 Discount rates matter (think about asset pricing)
 “Flight to quality”, buying less goods and services
 Fiscal Theory thinking misguided? Should we think about discount rate changes
instead of changes in expected surpluses?
5. Is the Fed powerless?
 Fed absent from main equation
 Fed is powerful if and only if it can issue a signal of future fiscal policy
 Run from the dollar could not be prevented by Fed

7. 6. Europe and the US
 Euro: fiat currency divorced from sovereign debt and deficits
 ECB ultimately buying eurozone debt
 Eurozone adapting Anglo-Saxon policies
 If market value of debt falls further, either German taxpayers recapitalize ECB
or inflation kicks in
7. Dynamic Laffer curve and growth
 Growth is only way out (except default or inflation)
 Austerity of high distorting taxes in Europe hopeless b/c of dynamic Laffer
curves effects

8. 8. Europe vs. the US
 Sclerotic growth
 Bond market run in US for growth rates of 2% (obviously, not true)
 Huge prospective deficits in US are dangerous, but can be addressed
 Europe does not face these deficits, however, has to inflate, default, or pay off
 Markets trust that US problems are solveable
 Even if US inflates away debt, it faces unsustainable deficits
Deficits have to be tackled before run on debt begins

9. Critique
• Asset pricing and corporate debt view of government debt
• Is fiscal policy really superior to monetary policy?
• Differences between EU and US are manifold and beyond fiscal issues
• Predicted run on US bonds did not occur
• US deficits have improved
• No direct solutions and policy recommendations
• Fiscal Theory does not implicate changes in exchange rate
Nonetheless, Fiscal Theory useful framework for debt sustainability