How Government Spending Fuels Inflation

When debt grows so much that people don’t believe the Treasury will pay it, they sell their bonds and buy other things, sending prices through the roof.

By Tunku Varadarajan. Interview with John Cochrane. Excerpts:

"Starting in March 2020, “the Treasury issued $3 trillion of new debt, which the Fed quickly bought in return for $3 trillion of new reserves.” The Treasury then sent checks to people and businesses, later borrowing another $2 trillion and sending more checks. Overall federal debt rose nearly 30%. “Is it at all a surprise,” Mr. Cochrane asks, “that a year later inflation breaks out?”

He likens this $5 trillion in checks to a “classic parable” of Milton Friedman (1912-2006), the great monetarist at the University of Chicago, where Mr. Cochrane was a professor for 30 years before moving to Stanford in 2015. “Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community,” Friedman wrote in “The Optimum Quantity of Money” (1969). If they spent the money, inflation would result.

The Covid checks, Mr. Cochrane says, were “an immense fiscal helicopter drop. People are spending the money, driving prices up.”

Why didn’t the Fed see that this massive stimulus would cause inflation? Mr. Cochrane sees a “big blind spot” in the institution and its “large circle of policy commentators.” The Fed’s “modeling and understanding of ‘supply’ constraints is very simplistic,” he says. It focuses only on unemployment “as a measure of slack in the economy. There is no group of analysts at the Fed measuring how many containers can get through the ports.” More deeply, he says, “the Fed and its larger intellectual circle don’t think about supply at all. All variation in the economy is more or less demand.”

This “intellectual failing” showed up first in the recession that followed Covid. “The economy didn’t need demand-side stimulus,” Mr. Cochrane says. “It’s not 1933 again and again. A pandemic is, to the economy, like a huge snowstorm. Sending people money won’t get them out to closed bars, restaurants, airlines and businesses.”

The government did have to act “as a sort of insurer, making sure there wasn’t a wave of bankruptcy and helping people really hurt by the recession.” But it should have been obvious that supply constraints would lead to inflation after the recession ended. “The Fed being surprised by supply shocks is as excusable as the Army losing a battle because its leaders are surprised the enemy might attack,” Mr. Cochrane says.

He notes that even Lawrence Summers, who served as Bill Clinton’s Treasury secretary and Barack Obama’s director of the National Economic Council, foresaw inflation as early as February 2021 (in a column in the Washington Post). “Summers, who’d argued for big deficits and loose monetary policy to combat low inflation and ‘secular stagnation’ for a decade, saw inflation coming, and saw its source in the massive fiscal stimulus of the Covid recession. So why didn’t the Fed?”"

"The new theory holds that when the overall amount of government debt is more than people expect the government to repay, we see inflation. The price of everything goes up, and the value of the dollar declines.

How does this work? “The U.S. government has $20 trillion of debt outstanding,” Mr. Cochrane says. “That means, over the long run, people must expect taxes to exceed spending by $20 trillion to repay the debt.” But if they think the government will be able to pay back only $10 trillion in today’s money, “people will try to get rid of their government debt fast, before it is worth less. They try to sell it in order to buy other things,” driving up the price of everything else. “That keeps going until all prices have doubled—until the $20 trillion promise is only worth $10 trillion at today’s prices.”"

"'Mr. Cochrane believes that “we overstate the Fed’s power” to respond: “The Fed likes to say it has ‘the tools’ to contain inflation, but never dares to say just what those tools are.” In recent historical experience, “its tool is to replay 1980,” the year when inflation peaked at 14.8%. That means “20% interest rates, a bruising recession that hurts the disadvantaged, with the medicine applied for as long as it takes."

"In any case, Mr. Cochrane says, raising rates is a “crude tool to fight inflation, especially when the source is fiscal policy.” He likens the situation to a car going too fast. “Fiscal policy is the accelerator; monetary policy controls the oil. OK, if fiscal policy has floored it, you can slow the car down by draining oil, but that’s not a terribly good way to drive.” Fiscal policy sends checks, stoking inflation; monetary policy raises interest rates to discourage borrowing or encourage savers to hold the extra Treasury debt. To change the analogy slightly, the driver is accelerating and braking at the same time.

To overcome inflation, fiscal constraints on monetary policy will need to play a large role, Mr. Cochrane says: “The Fed is merely a copilot.” He notes that in 1980, the ratio of debt to gross domestic product was 25%. Today it is 100% and rising: “Fiscal constraints on monetary policy are four times larger today.” So for a rise in interest rates to lower inflation, “fiscal policy must tighten as well. Without that fiscal cooperation, monetary policy cannot lower inflation.”

An additional complication is that any increase in interest rates raises interest costs of servicing the debt. “The government must pay those higher interest costs by raising tax revenues and cutting spending, or by credibly promising to do so in the future.” At 100% debt to GDP, he says, “5% higher interest rates mean an additional deficit of 5% of GDP, or $1 trillion, for every year that high interest rates continue.” This consideration is especially relevant if fiscal policy is at the root of the inflation."

"When people fundamentally distrust the government to repay debt, interest-rate policies and quantitative easing have limited power. So “the bottom line” is to ensure that people have faith in the government as debtor, and that comes “from solid growth, and transparent, responsible, durable institutions.” There’s no way out without “regulatory reform, tax reform, entitlement reform, as well as clear-eyed monetary policy that works on the narrow things it actually understands.”"