I wrote a paper for class about the future problems of our current deficit. I figured I'd share it with you guys, hoping some of you are econ junkies, or are concerned about economics in general. It's a paper that deals with John Cochrane's 2011 paper Inflation and Debt, and my summary of it. Bear in mind this was done at the 11th hour ( 2500 word essay in 3 hours, eek! ), but it represents some of my insight of the current crisis. Comment, criticize, and enjoy!
John Cochrane’s paper, Inflation and Debt (2011), issues a stern warning concerning how our rising debt may contribute to future inflation. In Inflation and Debt, we learn and attempt to understand the approaches taken by both Keynesian and Monetarist economists to predict and prevent rapid inflation. Cochrane points out key issues that both breeds of economists miss in their evaluations of inflation, and how policy makers can have a better understanding in assessing when and why inflation can strike. The purpose of this paper is three-fold; we will first understand and summarize Cochrane’s main arguments about why Keynesian and Monetarist economists miss the mark in predicting inflation. Next, we will summarize and evaluate Cochrane’s view that government fiscal policy and risk of insolvency contribute to inflation. Lastly, we will determine whether Cochrane’s views can translate into meaningful and useful advice in future inflationary outlook.
In the first portion of Inflation and Debt, Cochrane details why inflation should be considered a serious problem that cannot be brushed aside by today’s economic minds. Cochrane argues that most economists and commentators don’t seriously consider inflation to be a concern at this moment, as inflation has remained relatively low on all historical metrics. Support for this view is that yields on long-term treasury bonds, which naturally should rise when inflation is expected to rise due to interest-rate risk ( the risk that investors take when inflation is expected to rise in the future), are at half-century lows. To further that point, Cochrane points out that the Federal Reserve issued a statement proclaiming that “…measures of underlying inflation have trended lower in recent quarters”. Cochrane notes, however, that the Fed’s view of the risk of inflation is too narrow. He views inflations as, historically, the ‘fourth horseman’ of economic apocalypse. Instead of focusing on monetary policy and price level, Cochrane points to inflation being used by governments to control the amount of debt they owe. When inflation rises, the relative price of the debt that a government holds falls. In effect, this means that the government may have incentive to increase inflation as debt becomes unmanageable. So monetarists who view inflation through the lens of money supply and Keynesians who point to interest rates to understand inflation, are missing the factor of government debt in their predictions of future inflation. Both sides, however, believe that the Fed can intervene to control inflation and that the American government can remain solvent, two ideas in which Cochrane seeks to question in Inflation and Debt.
Cochrane begins his critical analysis of current inflationary thought by detailing how Keynesian economists believe inflation in controlled by the Fed. Through changes in overnight interest rates, Keynesian economists believe that the Fed can control economic growth, as to not grow too quickly (inflation), or too slowly (recession) through monetary policy. Cochrane, however, believes that there is very little correlation between metrics of economic ‘slack ‘(unused productive assets, like cash), and inflation. If this were the case, Cochrane notes that Zimbabwe would be the richest country in the world with 11,000,000% inflation. Furthermore, he criticized the causative link that the Fed places between inflation/deflation and stack/tightness. To counter this problem, Keynesian economists point to expectations of changes in inflation to actually help cause inflation or prevent it. In this view, expectations of inflation can actually worsen it if those expectations are not grounded in reality. If, for instance, the market reacts to a short term blip in inflations as a sign of further long-term inflation the market will actually contribute to long-term inflation. However, Cochrane notes that studies, surveys, and long-term interest rates did not predict serious inflations, like in the 1970s. Regardless, Keynesians believe that to implement an ‘anchor’, or a solid prediction of future inflation, we only need the Fed to announce such a prediction for the market to respond accordingly. This course of action is proposed assuming that the Fed will respond swiftly and boldly to changes in real inflation by raising and lowering interest rates. Cochrane disagrees with this sentiment, claiming that the average person doesn’t really pay attention to the Fed’s inflationary targets. Instead, he argues that our relatively stable expectations the past 20 years may be due to sound fiscal policy, as unmanageable governmental finances are usually a precursor to rapid inflation. With this in mind, he then turns his attention on Monetarists’ misunderstanding of inflation.
Contrary to Keynesian economists, Monetarists believe inflation results in too much money in a market that has too few goods to purchase. As such, the price of the goods will increase to adjust to a true value of the good. Cochrane explains that this gives Monetarists a good reason to be concerned; the total reserves in Fed accounts amounts to a total of 1.6 trillion USD, doubling in three years. While these reserves are still deposited in the Fed, they do not contribute to inflation. However, if those funds leak out of the Fed’s accounts, then they could spark massive inflation. Cochrane doesn’t believe that money supply is the source of inflationary danger, even with this in mind. He notes that modern metrics measuring money supply of M1 and M2 do not show much of a correlation with rises of inflation. Cochrane explains that the reason Monetarists view the source of inflation improperly is because they view the demand for money as constant. This view is misguided as the demand for money can rise and fall when the demand for liquidity rises and falls; when liquidity is favored, people will demand money more, and vice versa. To further that point, since interest rates have been near zero since the financial crisis, the Fed has begun paying interest on reserves in Fed accounts. If the total yield on interest bearing bonds is equal to the yield gained from keeping reserves in a Fed account, bank managers will choose to keep those funds in the Fed accounts to enjoy the relatively more liquidity. As such, Monetarists hold the belief that the Fed can still control inflation by adjusting its interest rates on reserve accounts, and by selling bonds. Like Keynesians, monetarists assume the government to be solvent and generally disregard government deficits and debt when they analyze future inflation. It is this assumption that we now call to question.
John Cochrane’s paper, Inflation and Debt (2011), issues a stern warning concerning how our rising debt may contribute to future inflation. In Inflation and Debt, we learn and attempt to understand the approaches taken by both Keynesian and Monetarist economists to predict and prevent rapid inflation. Cochrane points out key issues that both breeds of economists miss in their evaluations of inflation, and how policy makers can have a better understanding in assessing when and why inflation can strike. The purpose of this paper is three-fold; we will first understand and summarize Cochrane’s main arguments about why Keynesian and Monetarist economists miss the mark in predicting inflation. Next, we will summarize and evaluate Cochrane’s view that government fiscal policy and risk of insolvency contribute to inflation. Lastly, we will determine whether Cochrane’s views can translate into meaningful and useful advice in future inflationary outlook.
Inflation: A Silent Assassin
In the first portion of Inflation and Debt, Cochrane details why inflation should be considered a serious problem that cannot be brushed aside by today’s economic minds. Cochrane argues that most economists and commentators don’t seriously consider inflation to be a concern at this moment, as inflation has remained relatively low on all historical metrics. Support for this view is that yields on long-term treasury bonds, which naturally should rise when inflation is expected to rise due to interest-rate risk ( the risk that investors take when inflation is expected to rise in the future), are at half-century lows. To further that point, Cochrane points out that the Federal Reserve issued a statement proclaiming that “…measures of underlying inflation have trended lower in recent quarters”. Cochrane notes, however, that the Fed’s view of the risk of inflation is too narrow. He views inflations as, historically, the ‘fourth horseman’ of economic apocalypse. Instead of focusing on monetary policy and price level, Cochrane points to inflation being used by governments to control the amount of debt they owe. When inflation rises, the relative price of the debt that a government holds falls. In effect, this means that the government may have incentive to increase inflation as debt becomes unmanageable. So monetarists who view inflation through the lens of money supply and Keynesians who point to interest rates to understand inflation, are missing the factor of government debt in their predictions of future inflation. Both sides, however, believe that the Fed can intervene to control inflation and that the American government can remain solvent, two ideas in which Cochrane seeks to question in Inflation and Debt.
Inflation: A Keynesian Approach
Cochrane begins his critical analysis of current inflationary thought by detailing how Keynesian economists believe inflation in controlled by the Fed. Through changes in overnight interest rates, Keynesian economists believe that the Fed can control economic growth, as to not grow too quickly (inflation), or too slowly (recession) through monetary policy. Cochrane, however, believes that there is very little correlation between metrics of economic ‘slack ‘(unused productive assets, like cash), and inflation. If this were the case, Cochrane notes that Zimbabwe would be the richest country in the world with 11,000,000% inflation. Furthermore, he criticized the causative link that the Fed places between inflation/deflation and stack/tightness. To counter this problem, Keynesian economists point to expectations of changes in inflation to actually help cause inflation or prevent it. In this view, expectations of inflation can actually worsen it if those expectations are not grounded in reality. If, for instance, the market reacts to a short term blip in inflations as a sign of further long-term inflation the market will actually contribute to long-term inflation. However, Cochrane notes that studies, surveys, and long-term interest rates did not predict serious inflations, like in the 1970s. Regardless, Keynesians believe that to implement an ‘anchor’, or a solid prediction of future inflation, we only need the Fed to announce such a prediction for the market to respond accordingly. This course of action is proposed assuming that the Fed will respond swiftly and boldly to changes in real inflation by raising and lowering interest rates. Cochrane disagrees with this sentiment, claiming that the average person doesn’t really pay attention to the Fed’s inflationary targets. Instead, he argues that our relatively stable expectations the past 20 years may be due to sound fiscal policy, as unmanageable governmental finances are usually a precursor to rapid inflation. With this in mind, he then turns his attention on Monetarists’ misunderstanding of inflation.
Inflation: A Monetarists Approach
Contrary to Keynesian economists, Monetarists believe inflation results in too much money in a market that has too few goods to purchase. As such, the price of the goods will increase to adjust to a true value of the good. Cochrane explains that this gives Monetarists a good reason to be concerned; the total reserves in Fed accounts amounts to a total of 1.6 trillion USD, doubling in three years. While these reserves are still deposited in the Fed, they do not contribute to inflation. However, if those funds leak out of the Fed’s accounts, then they could spark massive inflation. Cochrane doesn’t believe that money supply is the source of inflationary danger, even with this in mind. He notes that modern metrics measuring money supply of M1 and M2 do not show much of a correlation with rises of inflation. Cochrane explains that the reason Monetarists view the source of inflation improperly is because they view the demand for money as constant. This view is misguided as the demand for money can rise and fall when the demand for liquidity rises and falls; when liquidity is favored, people will demand money more, and vice versa. To further that point, since interest rates have been near zero since the financial crisis, the Fed has begun paying interest on reserves in Fed accounts. If the total yield on interest bearing bonds is equal to the yield gained from keeping reserves in a Fed account, bank managers will choose to keep those funds in the Fed accounts to enjoy the relatively more liquidity. As such, Monetarists hold the belief that the Fed can still control inflation by adjusting its interest rates on reserve accounts, and by selling bonds. Like Keynesians, monetarists assume the government to be solvent and generally disregard government deficits and debt when they analyze future inflation. It is this assumption that we now call to question.