As I think about the big picture, a few points stand out. Again, Brazil is experiencing 9% real interest rates, which mean 9% interest costs on the debt, which means debt to GDP grows until it all falls apart. Can the central bank lower those interest costs by lowering interest rates, and make the debt sustainable? A central issue is what happens to inflation. Conventional wisdom says that inflation will rise. That would help the fiscal situation in the short run by inflating away some debt and lowering interest costs. But Brazil understands that inflation does not end well. A pure neo-Fisherian would say inflation will fall. That would be nice on its own, but would leave the real interest rate alone. So the bet is that inflation goes nowhere, and the lower nominal rate mans a lower real rate. The idea is based on a diagnosis that the high real interest rate is just due to the central bank holding nominal rates high, and nothing else would change with lower real interest rates. Maybe, indeed, greater non-inflationary growth.

More importantly, the central bank has to be able to permanently lower the real interest rate. Debt sustainability is about decades of interest costs. So there is a whiff of multiple equilibrium to the idea: that pushing down interest costs for a year or two would help the fiscal situation, and then the lower interest rates would stick on their own.

A crucial issue then is whether debt would be sustainable at lower interest rates. The other equilibrium has to be viable too. Here I expressed some doubts, and hence today’s post.

Before we get going, first I’ll point you to a previous post on Brazil, covering its long history of monetary and fiscal reforms and covering the excellent Monetary and Fiscal History of Brazil, 1960-2016 by Joao Ayres, Marcio Garcia, Diogo Guillén, and Patrick Kehoe. Brazil has been here before.

Second, this matters for the US. Brazil has 4.5% inflation, 80% debt to GDP, small primary deficits, and a lot of baked in social spending that they can’t really afford. The US has 3.7% inflation, 100% debt to GDP, slightly larger primary deficits, and a lot of baked in social spending that we can’t really afford. Study Brazil.

Following Fisher and Resende in Brazil, a reporter asked

We currently have a fiscal rule called the fiscal framework. Real growth in federal primary spending is limited to 70% of real revenue growth, and must stay between 0.6% and 2.5% a year. It also sets annual primary balance targets with a tolerance band. If the government misses the lower bound of the target, spending growth the following year is capped at 50% of revenue growth instead of 70%. Why do you think markets don't see that as a credible fiscal compromise?

My first thought was, uh oh. Here I have commented on a country I don’t know that much about. Does Brazil have a credible fiscal rule that ought to make debt sustainable? (The US has nothing like this!)

The rest of my correspondents however, don’t think this will work, largely because of baked in high levels of social spending, and little chance of drastic cuts.

From Emilio Ocampo’s substack

Since 2002 Brazil has had by far the highest primary government spending ratio among the five major Latin American floaters. According to IMF data, it is projected to reach 40.9% of GDP in 2026, compared with 31.3% in Colombia, 25.5% in Chile, 23.2% in Mexico, and 19.5% in Peru. The contrast is even starker when compared to other comparable emerging market economies: Brazil’s ratio of primary government expenditure to GDP doubles that of the ASEAN-5 economies.

Another correspondent:

Net of social security transfers, the operational side of the State is in surplus by about 5% of GDP. But the financial social security deficit, about 5% of GDP today, heads towards 9.5% by 2050 under rules already legislated. Even with a zero real cost of debt, explicit debt still rises from 86% of GDP to about 134% in 2050 and 175% in 2060, and keeps accelerating. The curvature is actuarial and legally contracted, so lower rates alone cannot remove it.

Another:

Brazil faces an extremely difficult fiscal situation, largely because of how rigid the federal budget has become. According to the Brazilian Chamber of Deputies, of the R$2.6 trillion in primary spending approved for 2026, roughly R$2.35 trillion (90.2%) is mandatory. That leaves just R$256 billion (9.8%) in discretionary spending, which includes parliamentary amendments and is therefore not entirely under the executive’s control. Social security alone accounts for approximately R$1.1 trillion.

To make matters worse, a significant share of mandatory spending is indexed to the minimum wage, which has been rising faster than inflation and, at times, economic growth. Constitutional requirements for healthcare and education add further rigidity. And much of what remains in the discretionary budget is needed simply to keep the government running. There is very little room left to adjust spending without tackling politically difficult structural reforms.

Another correspondent notes previous efforts:

In the early 2010s, the Brazilian central bank made a bet by sharply cutting the nominal interest rate, while, at the same time, the government stepped up the pace of spending, generating successive deficits. This was accompanied by a rise in inflation.

In 2016, after the impeachment of President Dilma Rousseff (Lula’s successor at the time), the following government passed a simple and credible reform through a constitutional amendment that froze real federal public spending for 20 years. This allowed the central bank to cut the interest rate from 13% to 7% in one year.

Using the simple rule of the debt-stabilizing primary surplus and the actual primary balance, we had the following picture:

Later, the Bolsonaro government started bypassing the spending cap because of the pandemic, and the Lula government ended the cap and replaced it with a much more complex fiscal rule, the so-called “fiscal framework” (arcabouço fiscal), [noted above] whose targets have only been met on paper, thanks to a growing list of expenditures excluded from the accounting.

…It seems to me that Brazil already has a solution to the problem at hand, and one that has already worked here.

Another correspondent looks harder at proposed fiscal reforms:

I agree that separating current expenditures from public investment, as Lara Resende proposes, would be useful for transparency. But I doubt it would change market expectations very much.

• Most of Brazil’s primary expenditure is mandatory or politically difficult to adjust.

• Evaluating public investment as if it were a private equity portfolio sounds appealing, but it requires a level of institutional credibility that I don’t think Brazil currently enjoys.

• Even good public investments do not necessarily generate enough fiscal revenue to pay for themselves.

Without addressing these issues, I don’t see why investors would suddenly become more confident about future primary surpluses.

I hear often that “well surely more debt to finance infrastructure is a good idea.” To which I answer: California High Speed Rail.

A final correspondent puts the same points with grumpy bluntness:

- 90% of the federal primary budget contains mandatory expenses. Payments to social security and pension is number 1, by far. They can only be altered by changes to the constitution, which is viable but too costly politically. Big payments to the judiciary branch is another big problem. The 10% discretionary expenses include provisions to education and public health, which President Lula does not want to touch either. Also social programs for the poor.

Raising taxes is nearly impossible. The middle class already complains loudly for getting almost nothing back for what is already paid for (public health is not so bad, but public education is, especially prior to college. we all need to pay big bucks for private schooling).

Other correspondents have pointed to very large amounts of private debt in Brazil, which I don’t know quite how to fit in to the picture.

Bottom line, I feel a bit better about my uneducated sense that the long-run fiscal picture cannot be good.

However, a durable fiscal reform might have a multiplier effect: Diagnosing high real interest rates as a premium for possible inflation, default, and devaluation, a durable fiscal reform could bring rates down, which in turn would add 5% of GDP or more fiscal space.

Thanks to all my correspondents!

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Disclaimer: I don’t know much about Brazil, the Brazilian economy, and even less about Brazilian politics. I’ll focus on general principles.

The situation

Brazil has an interesting fiscal and monetary situation. The primary deficit is not large, currently under 1% of GDP. Debt to GDP is large, about 80%. Interest rates are high. The overnight rate (selic) rate targeted by the central bank is 13.75%. The 10-Year government bond yield is 15.4%. Current inflation is 4.5%, with a 3% target. Real GDP growth is moderate, 2.5% and forecast to decline.

Resende:

The core of the fiscal problem lies in debt servicing. Everything else is secondary.

Yes. If inflation remains 4.5%, that means that real interest rates, and thus real interest costs once debt rolls over, are around 9%-11%. Times 80% debt/GDP, that means 8% of GDP deficit from interest payments alone. With even 3% real GDP growth, debt/GDP will grow 5% per year in the absence of any deficit at all. So much for r<g. In Brazil, r>>g.

It doesn't take much analysis to conclude that the situation is unsustainable. The explosive trajectory of debt in relation to GDP must be stopped as soon as possible.

In some ways, Brazil is one step ahead of the rest of us as interest costs start to consume the budget.

Lower interest rates alone, with no change in primary deficit, would indeed substantially improve Brazil’s fiscal situation. The key question is whether the central bank can make that happen just by lowering the interest rate target. The obvious complaint is that lowering interest rates might make inflation zoom up again.

Many politicians including our own President Trump have wished for a magic wand to lower interest costs on the debt. Is the central bank that magic wand? One’s instinct is no — you can’t wave a wand and lower your grocery prices, and you can’t wave a wand and lower your borrowing costs. But it is, in fact, not so obvious.

The proposal

Resende’s proposal:

A new National Fiscal and Monetary Council (CFMN) would set fiscal and monetary targets for a period of four to five years….Inflation targets would be announced jointly with targets for the basic interest rate. The central bank would commit to maintaining the basic rate within a range between the inflation target (3.0%) and the potential nominal growth rate, that is, the inflation target plus the potential real growth, which would currently be around 5.5% per year (3% inflation plus 2.5% growth). Only in exceptional cases, authorized by the CFMN, could the basic rate be below the floor – the inflation target – or above the ceiling – the potential GDP nominal growth – of the range.

To initiate the new fiscal and monetary regime, the Central Bank would announce a gradual reduction in the basic interest rate over approximately 12 months, to the potential nominal growth rate plus a temporary safety spread of 2%, that is, close to 7.5% per year. This safety spread would be periodically reassessed and gradually reduced until it is eliminated

(There is more on exchange rates, which I’ll get to later.)

Theory and experience

Some theory and historical analogies suggest it might work. Other mechanisms and experiences caution that it might not. As always in economics, just what is (and can be) held constant matters.

It certainly seems plausible, and I have written, that higher interest rates without a fiscal tightening to pay interest costs can cause higher inflation, or at least challenge the central bank’s inflation-fighting abilities. When the underlying inflation comes from fiscal problems, higher interest costs add fuel to the fiscal inflationary fire.

(The fiscal tightening need not happen right away. If the government can commit to repay the interest costs with even larger subsequent surpluses, the immediate interest costs are not inflationary. Thus, this mechanism is most important when fiscal inflation is already the problem because that fiscal space is absent.)

Well, logically, then lower interest rates without a fiscal loosening (that part is important) ought to lower inflation.

Eduardo Loyo famously interpreted previous Brazilian inflation experience in this way. In a time of high inflation and big deficits, higher interest rates with no fiscal change added to interest costs on the debt, and made inflation worse.

Well, if you like Loyo’s story (and I do), this is the same story with the opposite sign.

Even in classic “old Keynesian” adaptive expectations models, higher interest rates do not lower inflation unless fiscal policy tightens to pay interest costs, and vice versa.

Many economists subscribe to the multiple-equilibrium or unstable-equilibrium view of sovereign debt crises. Debts that are “sustainable” at low interest rates are “unsustainable” at high interest rates. So if investors get worried and demand a higher interest rate, the probability of default or inflation rises even more, and the interest rate goes higher still. Rate rises due to crisis fears can be a self-fulfilling prophecy. Conversely, intervention such as Mario Draghi’s “whatever it takes” can supposedly tip the economy back to the low-rate "sustainable” equilibrium.

Well, if lower rates alone can restore sustainability when Draghi is in charge, then they can do so for Brazil. (I don’t think this is what actually happened in Greece, but the point is the theoretical possibility. “Whatever it takes” came with some important reforms.)

The “neo-Fisherian” prediction of modern macroeconomic theory is, as Resende notes, pretty robust. Higher interest rates must go with higher inflation in the long run (neutrality) and forward-looking expectations mean that the economy is stable in the long run, so inflation must converge to the nominal interest rate plus a moderate real rate. This is not so much a fiscal-theory prediction as a forward-looking expectations prediction, and it occurs in Mike Woodford’s justly famous but decidedly non-fiscal-theory new-Keynesian models.

Lower interest rates might still raise inflation in the short run (Resende summarizes nicely). Governments might have to wait out a short-run surge, which is difficult. However, the main model of that negative effect relies on long-term debt and a sudden announcement that changes long-term bond prices. Resende points out that Brazil (like many countries on the fiscal edge) borrows heavily in short-term floating-rate debt, so the mechanism will be weak. He also prescribes a well-preannounced, slow and steady interest rate reduction which will not sharply raise long-term bond prices.

more than half of the debt is in LFTs, securities with returns linked to the Selic, the daily basic interest rate, and therefore with a very short “duration.”…if the debt is all indexed to the overnight rate – exactly as in the case of LFTs – reducing the interest rate does not increase the present value of the debt, so it does not cause an increase in inflation in the short run. Inflation immediately begins to converge to a lower level given by the interest rate.

This structure nicely avoids the long-term debt mechanism for a negative short run effect. I worry that there are other mechanisms. Maybe I’m just too unsure of myself to discard the doctrine that lower rates can raise inflation too quickly. Policy advice must peer into the fog of models we don’t have yet but suspect might be out there.

On the other hand, many governments have tried to hold down interest costs in the face of fiscal problems, and it usually does not work. War finance is the classic example. In wars, governments borrow, print, and spend a lot of money. Central banks hold down interest costs directly. They they force banks and others to hold government bonds at low rates, impose capital controls, and finally price controls. If inflation does not surge right away, it surges when price controls are lifted, or when the government makes the decision after the war not to fully repay the debt — for example, whether to return at parity after WWI and the Civil war. Covid was fought about the same way, with the same result. Milton Friedman, in his famous 1968 address, cited the experience of postwar interest-rate pegs in Europe, that fell apart in an inflationary surge. But those interest-rate pegs were put in place to lower interest costs on the debt, in a situation of intractable fiscal deficits. Turkey tried it too.

Put another way, when does lowering interest rates to lower real interest costs, which might work, spill over into financial repression to lower real interest costs, which won’t?

In the face of this evidence, I have always been leery of the proposition that one could exploit the Fisherian properties of rational expectations models, and lower inflation by lowering interest rates. The proposition requires solvent fiscal policy, and especially requires that the government does not raise spending, diverting the saved interest costs to other areas.

Resende’s argument is more subtle however. Since inflation at 4.5% is not a huge problem, by Brazilian standards, his main goal is not to lower inflation, but simply to put debt back on a sustainable path without raising inflation.

A stronger fiscal side is needed

My main worry concerns the fiscal side. Our theory says “holding surpluses constant,” and really “holding expectations of future surpluses constant.” To work, people must really have faith that, absent higher interest costs, Brazil would reliably pay down its debt with reliable years and decades of small primary surpluses — even if a crisis or recession comes in which Brazil needs to borrow more. But do people really trust that to last — and to turn in to surpluses someday?

Resende only notes that current primary deficits are small, 1% of GDP. Restoring the ellipsis above, the fiscal part of the proposal is

A new National Fiscal and Monetary Council (CFMN) would set fiscal and monetary targets for a period of four to five years. The fiscal targets would be based on rationalizing and simplifying revenue collection and operating and investment expenditures. Inflation targets …

Well, “targets” are nice. Politicians make them all the time. Then stuff happens. “Rationalizing and simplifying” would be great, along with eliminating waste fraud and abuse. When I think of the kinds of fundamental, institutional, fiscal reforms that stop inflations and resolve exploding debts, though, they are more durable, especially given Brazil’s history.

What can Brazil do to really commit itself to debt repayment? A constitutional debt brake works in Switzerland, but the Swiss are pathologically thrifty. The inflation-targeting reforms that successfully lowered inflation and helped government finances in the 1990s included fiscal and growth-oriented microeconomic reforms that were much more institutionalized than just “targets.” I think a more fleshed out version of fiscal and pro-growth reform would give this proposal a much better chance of working. Why is Brazil only growing 2.5%? It should be rapidly catching up to the US. (GDP per capita is $12,000 or $24,000 at PPP. It’s $90,000 in the US.) That would solve the fiscal problem quickly.

In all the ends of inflations, as in Milei’s in Argentina, fundamental fiscal and microeconomic reforms led or came with monetary changes. Fix fiscal policy and interest rates fall. The collapse of interest costs can have a “multiplier” effect on fiscal reforms.

I do not know of a good successful historical precedent for the Resende proposal. There is plenty of precedent for a package of reforms in which inflation stops, debt is paid, and interest rates collapse. But all three come together. That doesn’t mean Resende is wrong, it just means it relies more on theory than more traditional policies.

He [me] makes a crucial observation: deficits and debts are only inflationary if associated with expectations that they may not be honored…everything depends on expectations, on trust in institutions.

Yes. Let’s get those institutions going.

Market doubts and fiscal worries

You can see fiscal doubts. The Real dropped by nearly 10% on the day of the election, not a sign of fiscal confidence

The 10-Year Government bond yield at 15.4% is higher than the 13.75% central bank rate despite forecasts of lower central bank rates. Some of that reflects inflation or default fears. The 5 year credit default swap is 141 bp, indicating (per Gemini) a 2.35% implied probability of explicit default, and larger if one factors in some recovery. (This applies to dollar-denominated debt.) S&P rates Brazilian debt BB. That Brazil is forced to borrow so much at floating rates indicates markets skittish about lending for longer periods, a classic sign of low faith.

Now, Resende might say, “my point exactly.” If the only reason to fear default or inflation is that high interest costs make debt unsustainable, then lowering the interest rate makes the debt sustainable. The currency will appreciate, long-term bond prices and CDS will crater, inflation will fall away, and all will be well.

Another way to put my worry, suppose that Brazil gains a gargantuan 8% of GDP budget breathing room from lower interest rates Will Brazil really not spend one Real more, or tax one Real less? My current model of government finances is that they, like ordinary people, respond to interest costs. The US and EU went on a spending spree of borrowed money when real interest costs went to about zero. It’s easy to say in theory “holding fiscal policy constant,” but for policy analysis you have to worry if that will be true.

Interest rate worries

A second worry is whether, in fact, the central bank can lower interest costs on the debt. Interest costs are real, and the central bank controls the nominal rate. Indeed, here Resende counts on interest rates not being Fisherian! Suppose a 5 percentage point lower nominal interest rate (from 13.5% to 8.5%) results instantly in 5 percentage point lower inflation — from 4.5% to -0.5%— holding the real rate constant. Well, then the real rate is constant, and interest rates on the debt have not fallen at all! Resende is counting not just that lower interest rates will not cause inflation, but that it will only cause a little bit of disinflation. Is less inflation that sticky?

More deeply, what are the determinants of Brazil’s real rate of interest? Is the current very high 9% (13.75% overnight rate - 4.5% inflation) real rates really just due to unimaginable tightening by the central bank, in the face of a “natural” rate of 2.5% or so? Or does the current real rate of interest also reflect a risk or default premium that will not so easily go away. Again, Resende’s Rule:

The central bank would commit to maintaining the basic rate within a range between the inflation target (3.0%)…plus the potential real growth, which would currently be around 5.5% per year (3% inflation plus 2.5% growth).

That rule presumes that the underlying real rate equals the real GDP growth rate (not worth a quibble here) but no default or inflation premium.

More deeply, can the central bank really make huge changes that will percolate across the term structure and allow the government to borrow at low rates more than overnight?

It is not disputed that the basic interest rate is set by the Central Bank…. The Central Bank announces and fully controls the basic interest rate, which is the main determinant of the cost of debt. It is the parameter that guides the entire term structure of debt. Other factors, such as uncertainty about its future trajectory, inflation expectations, and the political risk of debt, also influence price formation, especially for longer-term securities, but the basic rate is the main determinant of the cost of debt.

Well, maybe. That is the crux of the argument. Can the central bank really and durably set the real rate of interest?

The International element of the proposal is also interesting.

It [the central bank] would also announce that, if necessary, it will intervene in the exchange rate to mitigate any sharper depreciation, due to the possible reduction in the volume of carry-trade of speculative capital. With international reserves of more than US$350 billion, the Central Bank has ample ammunition for this. The two channels through which the reduction in the interest rate could put pressure on inflation in the short term are thus neutralized in Brazil: the fiscal channel, due to the short-term debt; the exchange rate channel, due to the reserves.

This makes less sense to me. Yes, currency depreciation leads to inflation, as imported goods cost more. But propping up the currency has a long and not very successful history in Latin America. The attempt must be a “sterilized intervention,” imagining that the central bank has two independent tools. If lower interest rates really are going to lead to lower interest costs, greater debt sustainability, and less inflation, the currency should go up, not down. (All the doubts that modern theory expresses about whether lower interest rates without fiscal changes raise or lower inflation have an exact counterpart whether lower interest rates without fiscal changes raise or lower the value of the currency.) If the exchange rate goes down, that’s a sign the policy not working. “Speculative capital” is a bit outside the model. This all reads that Resende is a little bit unsure, as I am.

Bottom line

Overall, the basic question remains whether it is lowering interest rates in free domestic and open capital markets, which novel economics uncovers as a possibility, or whether it is old fashioned financial repression which ends up exploding. I would rather see a coordinated fiscal, monetary, and microeconomic reform, which has worked many times in the past. And growth-oriented microeconomic reform is the most important policy anyway.

You may be frustrated that I don’t offer either a ringing endorsement or a stern disavowal. Policy advice is hard. You have to jump outside the model and think about what might be wrong or not held constant as you think. And I don’t like to give advice for countries that I don’t know too much about. Moreover, ideas are like children. They have to find their own way.

Note: This post will likely get updated as I learn more.

Update:

A final thought. Those 9% real rates bother me. Why are US hedge and global macro funds not rushing to invest in Brazil? The answer must be a 6% expected inflation/devaluation, which is really a smaller probability of a much larger catastrophe. This thought leads me to suspect that the 9% real rate is not just a conventional real rate of interest.

Many governments have faced the conundrum. The market charges a substantial premium for sudden inflation/default/devaluation. The government does not intend to inflate/default/devalue. So the government feels it’s being overcharged. And, if the government successfully avoids inflation/default/devaluation, it is. It’s a big insurance premium for an event that didn’t happen.

The world may be Fisherian — lower rates lower inflation. But just about the whole policy world and financial markets think otherwise, that lower rates mechanically raise inflation. That may be the reason Resende worries about short-term currency and bond movements. It does make the immaculate disinflation change in regime much harder. On the other hand pretty much everyone recognizes what a fiscal stabilization would do.

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“Personalized pricing” is in the news. Companies use big data to figure out what you’re willing to pay and charge accordingly. Politicians are already passing laws to ban it and the Federal Trade Commission is threatening action, as usual, before understanding the phenomenon. Economists call it “price discrimination.”

Here is one of the hardest-to-swallow theorems in economics: Perfect price discrimination is efficient. And price discrimination is necessary to pay fixed costs.

Suppose an ice cream shop can charge each of us the maximum that we are willing to pay. Want a chocolate Sundae? The store peers in to your data, and figures out you’ll pay $7.53. You pay $7.53. They know I came in yesterday, so they can only charge me $5.22. I pay that. Suppose the marginal cost is $2.72 — just the store’s cost of ice cream. When someone walks just willing to pay $2.73, he gets that price.

The store sells the same amount of ice cream as they would if they charged everyone $2.73, the same as perfect competition. That’s economic efficiency. The amount of ice cream sold is not “distorted” by monopoly. Pricing power is only economically inefficient if the store restricts output to raise the price.

It seems massively unfair, doesn’t it? The store has sucked all the value — all the “consumer surplus” — out of the transaction. Still, “fair” is a squishy concept. If the store doesn’t charge someone more than marginal cost, the store can’t pay rent, taxes, advertising, employees, benefits, R&D, and all the other fixed costs. There wouldn’t be a store at all. Isn’t it fair that those of us who really like ice cream should pitch in a little more to keep the store in business?

Personalized pricing raises profits, sure. But you and I are stockholders too, though our pension funds and corporate taxes if not directly. Profits come back to us. They are at worst a transfer to those with more stocks. But if you’ve been following my rants at all, you know that economics says, don’t transfer income—especially tiny amounts of income—by mucking with efficient prices.

Fixed costs pervade today’s economy. Software is free after billions of development costs. Drugs and electronics are close to it. Filling an empty airline seat is nearly free. But nobody wants to pay the fixed costs. So, much of our economy and our politics are a big haggle over who pays inflated prices to cover fixed costs, and who gets to negotiate (or coerce, in the case of government) a lower price and make someone else pay more.

Now two limits. First, we only need enough price discrimination to pay the fixed costs, and to give discounts to those only willing to pay small amounts. The basic economy ticket at marginal cost matters for efficiency, not how much each seat in business class costs. Additional price discrimination is just more profit — not distorting, but not beneficial either.

Second, price discrimination is only efficient if it is costless. Most of our economy is instead one giant game of price discrimination by needless complexity, or “signaling.” You get a lower price by wasting time and effort to signal that you’re the low-value consumer. Credit cards, frequent flyer miles, airline tickets, hotels, cell phone contracts, prescription drugs, health insurance, discounts, sales, loyalty programs all seem one big trip back to a 1950s Chevy dealer. All that haggling is a waste. So the optimum is some messy middle ground where price discrimination is enough to pay the fixed costs, consumers still get a lot of benefit, and we don’t overdo the haggling costs.

The insane complexity of taxes and social programs is part of the game. To really want to squeeze tax revenue, then hit harder those not willing to devote time and effort to avoiding taxes. Filling out lots of forms and standing in line selects for those who really need help.

There is then a theoretical argument for regulation, though I doubt our regulators are competent to sort this out. And everyone hates it so much, firms have a pretty good incentive not to overdo it. Notice that shopping for cars has gotten easier over time (Carmax), haggling at stores has disappeared, and sellers avoid the appearance of price-gouging.

In that context, though, personalized pricing by AI and big data could be a lot more efficient than all the games we go through now, since it’s basically costless. Maybe regulators should encourage it!

I hate it all. I’m the lazy shopper who ends up paying high prices. Still, as an economist, I have to admit there is a reason for it. Economics is sometimes hard to swallow.

In the meantime, crank up your AI agents, VPN, and anonymous browser to fight against the personalized pricing software. Or like me, curse, pay the bill, and get back to enjoying your life.

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Updates:

Yes, I left out a lot. Price discrimination is not perfectly efficient in general equilibrium. I left out time, incentives for others to innovate, the product quality ladder, and that fixed costs aren’t really fixed in the long run.

Willingness to haggle is also not really the same thing as inelastic demand.

A correspondent writes: “In health care there is a big war of attrition between hospitals trying to code to get the most and insurance companies resisting. Doesn’t AI risk much more war of attrition?” Yes, absolutely. I hinted at that with my last comment about AI agents. The vision of costless (to firms) and unavoidable (to consumers) price discrimination which could be more efficient than haggling is not likely to happen. Instead, the war of attrition moves online. Firm to firm transactions will clearly get more of that. On the other hand, that knowledge is also nonrival, so you could set up companies and services that help people get better prices. And the Carmax strategy will remain attractive too.

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In policy analysis, one must balance blue-sky and short-run approaches. We can ask, what is the right answer, unconstrained by the current situation and political reality? We can also ask, what little changes might one make to improve the current mess, given some view of political appeal and constraints?

One needs both. Here, I focus on blue-sky approaches for taxation and spending. Sure, they might not pass in this Congress. But if we do not ask what the promised land looks like, we will surely never get there. Moreover, when momentum for reform comes it comes quickly, and needs a library of clear ideas.

Since my colleagues in the Commons project have done such a splendid job of analyzing how much we tax and spend, I’ll focus on how we tax and spend.

Two principles help. First, how can we avoid the partisan shouting match? One side says, “You’ll bankrupt the government!” The other cries, “You’ll starve the poor!” Most people analyze taxes this way: who pays more, who pays less. Economics offers a way out: Pay attention to incentives! We can make the political pie bigger too, and both can get a lot of what they want.

Second: State the question. Disagreements about answers often come from different implied questions. Stating the question helps us to converge on common answers.

Slaying the tax code monster

For taxes, let’s start with this question: How should the government raise revenue while doing the least economic damage?

The answer is simple: Disincentives come from the marginal rate. If you earn an extra dollar, how much additional consumption can you obtain? So, lower that marginal rate. To make up revenue, broaden the base. Then you get economic magic: lower tax rates, and greater tax revenue.

The US tax code achieves about the opposite. The top marginal rate starts with a federal 42 percent. But another oft-forgotten principle: Disincentives come from all taxes taken together. Add state income tax, 13.5 percent if you live in California. Then 10 percent sales tax, property tax, personal property tax, estate tax, excise taxes, tariffs, your share of corporate taxes, and more. I guesstimate around 70 percent. Greg Mankiw once computed his marginal tax rate at 90 percent.

Yet federal revenue is only 17 percent of GDP, and overall government revenue is about 30 percent of GDP. Why? First, the United States has one of the most progressive tax systems in the world, if not the most. If people earning lower incomes pay a rate below 30 percent, people with higher incomes must pay a higher rate. Second, there is a Swiss cheese of complex deductions, exclusions, and special deals. The tax code, regulations, interpretations, and so forth add up to 70,000 pages. And those distort: Wealth management and corporate organization are organized around tax avoidance.

The damage is not just economic. People have a sense that the wealthy with fancy lawyers and lobbyists get away with a lot, a politically corrosive reality. Getting rid of the monstrous, complex, and cronyist tax code in favor of a simple and fair tax system is, in my view, even more important than getting the headline rates right.

So, the answer is simple: Eliminate the income, corporate, estate, excise, tariff, wealth, and all other taxes. Tax consumption instead. (Payroll taxes for social programs are almost the same as a consumption tax, so can remain if one wishes.)

When you tax something, you get less of it. So, tax things that people will buy or produce even if they have to pay taxes. Consumption is fairly unavoidable. By contrast, if you tax the returns to investment, people save less, and you end up with a lot less capital: fewer businesses, less equipment, fewer factories.

More deeply, if people invest and reinvest their income in businesses, directly or indirectly by holding stocks and bonds, and those businesses hire others and make great products for the rest of us, why is this a problem? Wealth and income are ways of providing for future consumption. Be patient. Tax the final consumption, not the work and investment that made it possible.

Income has little economic meaning. Consumption does. A future CEO is “low income” just after graduating college. You’re “high income” the year you sell your house. Corporate income taxes make even less sense. Every dollar of corporate tax is paid by people, either consumers through higher prices, workers through lower wages, or investors through lower returns. Tax the people, not the conduit.

Why do we tax income, anyway? In 1913, when the 16th Amendment gave Congress the constitutional power to collect an income tax, the US government did not have the technology to collect consumption taxes. Now we do. But taxing income was the original sin. If the government taxes labor income, people can incorporate, so the government has to tax corporate income. If the government properly declines to tax interest and capital gains, people can shift labor income to that form. Patch, patch, patch, and the mess results.

The blue-sky answer

Pretty much every blue-sky tax analysis ends up with a broad-based, low marginal-rate tax system emphasizing consumption. Bob Hall and Alvin Rabushka advanced a comprehensive flat tax proposal. Ken Judd, author of an early proof that zero capital taxes are optimal, updates it to “Flat Tax +45.”David Bradford introduced an “X tax” that basically implements a progressive consumption tax. The “destination-based cashflow tax” does the same from the corporate side. Many countries have a large (typically 25 percent) value-added tax (VAT), which is basically a sales tax collected at each stage of production, though on top of—not instead of—payroll, income, and corporate taxes. A “Fair Tax” proposal to replace the federal income tax with a national sales tax was actually introduced in the US Congress. It’s closer to “politically feasible” than you think!

Most tax reforms move toward a consumption tax, though in the habitually clunky way, while preserving the complexity and favoritism of the current code. To a degree, the government realizes that taxing saving and investment is a bad idea, so the tax code combines high headline rates of investment taxation with a smorgasbord of carve-outs, including 401(k), 526(b), IRA, Roth IRA, and more. Investment expensing for corporations tries to reduce their disincentive to invest. The estate tax combines a 40 percent statutory rate with enough complex ways to avoid it that the wealthy end up paying very little. The tax code is a lot like airline mile programs and credit card rewards. It taxes the unwary.

Of these implementations, I slightly prefer a value-added tax, closely followed by a sales tax. The VAT is a bit more self-enforcing.

I think eliminating the income tax rather than trying to reform it is centrally important. How do we get rid of the home interest deduction, the health insurance deduction, energy credits, politicized “nonprofits,” and thousands more? If you try to reform the income tax, you fight with each constituency. Our government seems unable to reform even the basics, like indexing capital gains for inflation. But if you remove the income tax, all go away instantly.

Crucially, the consumption tax must be one rate on everything, and for everyone. No lower tax on tacos than on steaks, on food and medicine than on yachts, for domestic vs. foreign goods. No lower taxes for nonprofits, universities, strategic industries, and so on. No more transferring income by distorting prices.

Granted, optimal tax theory prescribes a different tax on each good. Tax each good in proportion to how little its production and consumption decline after taxes. Tax dialysis machines, which you’ll pay anything for if you need one, not yachts. We tax in about the opposite pattern, for some good (insurance) and some bad (redistribution via price distortion) reasons. Mostly, however, if we open the door to good-specific taxes, the lobbying bonanza for special favors will open up and we’ll be right back where we started. Optimal capital tax theory also prescribes a surprise one-time, absolutely-never-again wealth tax, justifying it by saying the investment has already been made. A lot of academic literature focuses on this possibility, and the proposed California wealth tax imitates it. In my view, the “one time” and “never again” parts make this completely impractical, and “surprise” is hard in a democracy.

You may object, won’t that consumption tax need a high rate? Well, yes. If the government spends 40 percent of GDP, in the end the average tax rate must be 40 percent. And the less some people and activities pay, the more the rest must pay. But whatever the rate, that’s what you’re paying now. Putting it in one place is healthier, as you can see it.

You may object that a value-added tax or similar consumption tax will too easily raise a lot of revenue, especially if it is imposed on top of current taxes, and that Congress will respond by spending even more. Starve the beast. This is an interesting political-economy view, with some merit. However, our current huge debt and deficits have had very little restraining effect on spending as it is. The starving beast seems to just borrow. This view posits that our government operates always at the revenue-maximizing point of the Laffer curve given the structure of the tax code. In other words, the government sets tax rates just at the point that any higher rate will so reduce economic activity that it produces less revenue. It posits that the government is incapable of any restraint.

While I am sympathetic, most economists find that tax rates, especially on middle-income voters, are substantially lower than that amount. Most of all, however, I do not believe it is right to shade my economic answer to the question, how to structure taxes to raise revenue with least economic damage, and to hide a better option, in order to secretly steer the government toward my preferences for lower spending. People who do that sort of thing—and many do—soon lose credibility. And if our political and constitutional order is so broken that it is incapable of taxing and spending less than the maximum it can squeeze out of the economy, we have far worse problems than the nature of the tax code.

Focus on the whole system

You may object that a consumption tax is “regressive.” Everyone pays the same share of their consumption. I answer, wait: Now you’re asking a different question. We were raising revenue for the government. Now you’re asking how to transfer income.

Well, again, if we wish to answer that question, we must look at the whole system, not each element in isolation. If a flat tax funds Bernie Sanders’ spending, the whole government can be as progressive as you like. Also, if you believe the trope that rich people don’t pay income taxes, then you have to admit they will pay more with a consumption tax. You’ll get them at the yacht dealer, not the tax accountant’s office.

But if we must, a consumption tax can be progressive. Most proposals to shift the income tax system to a consumption tax maintain the income tax’s progressivity—along with its Swiss cheese of deductions, exclusions, subsidies, and cronyist special deals. A VAT or sales tax can also be progressive. For instance, everyone could get a card that pays the first $10,000 of VAT or sales taxes.

However, you cannot escape basic math. For every person who pays a lower rate, someone else must pay a higher rate, and thereby worsen the economy. (The damage of taxation is roughly proportional to the square of the tax rate.)

Despite clear economic advice against it, wealth taxes are again politically popular, even among Nobel Prize winners, many of whom wrote contradictory academic articles. As Hoover senior fellow Josh Rauh persuasively computes, wealth taxes won’t raise much if any revenue. Again, look at the estate tax. They necessarily shift the economy from productive capital to consumption, just as everyone wants to raise investment, whether in AI, green tech, chips, or ship building.

Why pursue a wealth tax? When you drill just a little deeper, again, its proponents ask a different question. It’s not about raising revenue. They believe that billionaires have too much political power, and that by taxing away billionaires’ wealth they can reappropriate some of that power back to politicians. Well, if that’s the question, all sorts of answers appear. I would start by recommending a more limited government, whose power is thereby less attractive to wealthy private and corporate interests. And I might point out that France today adds to the long experience that confiscatory wealth taxation and redistribution do not guarantee social and political harmony.

You may object that you want to support housing, health insurance, nonprofits, green energy, sports stadiums, and so on. Or, that their constituencies will block any tax reform that removes these preferences. Well, now you’re asking a different question again: How should the government subsidize? And I offer the obvious answer: Write them checks. Annually appropriated, in the budget process, voted on. If you want to subsidize charitable contributions, home mortgages, and health insurance for Palo Alto millionaires via a 55 percent match from taxpayers, fine, cut them a check—out in the open where voters can see it, not hidden in tax code. (Tax deductions are remarkably regressive!)

Similarly, spend wisely. If we focus less on the amount of spending but rather on its gross inefficiency, we can achieve better results at less cost. Again, pay attention to the whole system, and pay attention to the incentives.

Streamline and control social spending

Americans with low incomes face some of the highest all-in marginal tax rates. Each means-tested program or credit may have only a 30 percent phaseout, but they add up to 100 percent or more marginal tax rate from $0-60,000, with many cliffs.

Earn an extra dollar, and you can lose food benefits (SNAP, WIC), Social Security disability benefits, earned-income and child tax credits, TANF and CalWORKs cash, section 8 rent vouchers or “affordable” rentals, health insurance, Medicaid or ObamaCare subsidies, Pell grants and other financial aid, all the way to low-income bus passes and library cards. (Estimates vary a lot, in part because many people participate in far fewer programs than they are eligible for.) The sharp decline in labor-force participation among people with low incomes is a natural result.

So, put social programs all in one place, where people can get the help they need, but we can make sure nobody faces more than, say a 50 percent marginal tax rate. (Paul Ryan is advocating this in a RISE program). Indeed a “nobody shall face an all-in marginal tax rate greater than x” (50%? 70%) might be a great guiding principle.

Much of our social spending now goes to fund nonprofits, with much less oversight than if the government spends directly. That’s how you spend $100,000 per homeless person per year, and only get more homeless. Bring back actual government employees. Even funding the DMV is a better bet than giving money to a driving safety advocacy organization. And federal money handed to states for Medicare, schools, and so forth creates little incentive for the states to spend wisely.

Health care and insurance

Finally, a note on health spending, perhaps the maximally inefficient rathole of our government. (Well, next to the California high-speed train, but health spending is a lot bigger.) What’s the question? Is it to provide health care for poor and homeless? There is no reason that your and my health care and insurance needs to be so screwed up to achieve that goal.

A system with essentially no economic regulation, and brutally competitive markets, will work fine, and that includes pre-existing conditions and information asymmetry. For the poor, elderly, and so forth, here’s a $10,000 voucher—or whatever our democratic system decides it wishes to spend. Buy yourself some health insurance.

I think a question that motivates our current health mess is how to provide some charity care without it showing up on the budget. The government forces doctors and hospitals to provide care below cost to some, but allows them a protected monopoly to make up the difference on you and me. As in the rest of this essay, my root recommendation is political transparency. Don’t hide a subsidy in the tax code or with a regulation. Charge taxes, spend money, on budget. Taxing and spending are damaging, yes, but visible and politically accountable taxing and spending are far better than the same thing hiding in economic regulation and complex tax deductions and credits.

A Hopeful Note

There is a chance for good economic policy analysis to have a great impact. Few in the political and policy arena think about the incentives and the system as a whole. They think about who gains and who loses, with each policy in isolation. Most start with an answer and look for the question. Stating the question and thinking about the best answer is far more productive. Doing so, the United States and other governments can raise needed revenue with less economic damage, and help people who need it at lower cost.

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*****

This conference is devoted to the question, how to save the welfare state? This is the wrong question. The question is how to save our countries from the welfare state.

France’s debt is in the news. France’s government spends 57% of GDP. 57%. That means the average tax rate in France must be 57%. And for everyone who pays less, now or later, someone else must pay more. For much of Europe the number is only slightly less, around a half. The US is not far behind.

Europe’s crying economic problem is economic stagnation. Marginal tax rates well above a half are deep in the range of undeniable disincentives to work, save, innovate, start and grow businesses, invest in education, and so on. Add extreme business protection and over-regulation, pay people not to work, and you have all the ingredients of stagnation.

What to do? Tax even more? Cut benefits to needy people? Economics offers a way out: Focus on the incentives. In the United States people lose about $1 of benefits for each dollar they earn from 0 to $60,000, with many cliffs along the way. Many retirement and disability schemes make work essentially impossible. You don’t have to force people to work, you just have to let them keep some of the money. And grow, which needs mostly a big dose of get-out-of-the-way.

Beyond debt and growth, our societies are failing the most basic biological commandment, to reproduce. When the average woman has one child, the population falls by half every 30 years. A pay-as-you-go welfare state cannot survive that. And it is doubtful that our highly specialized economies can survive population decimation either.

In the old days, people had children in part to support them when they got old, sick, or unlucky. In a welfare state, other people’s children take care of you when you get old or sick or unlucky.

Margaret Thatcher said socialism ends when you run out of other people’s money. Here we are. The welfare state ends when you run out of other people’s children. Here we are.

For better or worse, the regulated welfare state substitutes a personal, individual relationship with the central government for the insurance once provided by family, markets, savings, community, church, charity, and local government. But incentives matter. Children are now just an expensive luxury consumption good. The welfare state is at least part of the plummeting fertility that undermines the welfare state.

Don’t save the welfare state. The welfare state is killing our prosperity. End, or at least deeply reform, the welfare state. Focus government efforts on the truly needy and unfortunate. Leave the average person to the glorious incentives, rewards, and protections of the competitive market.

Update:

I was more politely received than you might think. But perhaps that’s because this sort of thing is so completely unsaid. Even among trained and prominent economists, the dominant tendency is to assume the government has to do everything, and add policies to “solve problems,” without stopping to think that maybe said problems are the result of past policies.

I also ended up the butt of “buying cheap cars from China isn’t so bad” conversations. Several said things like, “If China is better than us at everything there will be nothing for us to do,” so we need tariffs and protections so our industries can become efficient. Comparative vs. absolute advantage anyone? Exchange rates adjust? How did 50 years of tariffs and protections work out for Fiat, Renault, Citroen… and GM, Ford and Chrysler?

From my point of view, basic simple supply and demand, equilibrium adjustment, has gotten lost in the professional activity of writing models and getting papers published. What they made of the crazy free-marketer from California is another story.

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Inflation Dynamics with a Generalized Lucas Phillips Curve

New-Keynesian Inflation Control is Equilibrium Selection

The question: How do central banks lower inflation by raising interest rates? Or can they? In particular, how can a central bank lower inflation all alone — without coincident tighter fiscal policy? (“Active” or “passive”.) And how can today’s interest rate lower future inflation?

I’m looking for the simplest, explainable, understandable benchmark model of inflation and interest rates (and maybe a bit of output), not a big calibrated black box.

In light of this year’s Nobels, this is also a good time to comment. Though the basic new Keynesian model dates from the 1990s and Mike Woodford’s book was published in 2003, there is plenty to do following up on these basic ideas as you’ll see.

Equilibrium selection

You might say, “Duh, the standard three-equation new-Keynesian model answers that question.” “Equilibrium selection” puts together exactly why that isn’t the case.

The model is the standard IS (intertemporal substitution) and Phillips curve,

with x = output, i = nominal interest rate, pi = inflation, r is the steady state real rate, and sigma and kappa are parameters. This is the continuous-time version of the more familiar

I leave out the expectations to study the response to a shock. I’m going to completely follow the NK philosophy here; no fiscal theory funny business.

Eliminating output and solving the second-order differential equation for inflation, the solutions are

Inflation is a two-sided moving average of the nominal interest rate, with positive coefficients. Higher interest rates on their own raise inflation. There is also an exponentially-decaying transient, indexed by the constant C or by initial inflation. The NK model needs to add something else, not just the path of interest rates, to fully determine what happens to inflation. The different possibilities are “multiple equilibria” so we need an “equilibrium selection” policy in addition to an interest-rate policy. And the only way to get inflation to decline at all in the presence of higher nominal interest rates is to choose a lower C. Inflation control comes from equilibrium selection. And not from higher rates.

Here is a graph. I suppose the Fed raises interest rates, with a pattern following the blue line. (This is an AR(1), or exponential decay.) Then inflation follows one of these paths, corresponding to different values of C or inflation at time 0. Only the choices with a negative downward inflation jump at time 0 show any decline in inflation at all.

The conventional calculation picks the “u AR(1)” equilibrium. To get that result, you add a Taylor rule for the interest rate

and you specify that the disturbance ut follows an AR(1). Then any but the indicated equilibrium blows up. The Fed selects equilibria by threatening to blow up the economy.

But even granting this blow-up threat, it turns out that there are lots of Taylor rule disturbances ut that produce exactly the same path of interest rates, but produce different inflation paths. They are easy to reverse-engineer: Pick any equilibrium in the first graph, compute ut = it - phi pit, and you have a Taylor rule disturbance that produces the same interest rate path but a different inflation path. These generically follow AR(2), or the sum of two AR(1), the sum of two exponential paths.

So, this standard NK model also makes two, separate specifications of monetary policy: The interest rate follows the path shown in blue, and the Taylor rule disturbance is an AR(1). If we allow AR(2) disturbances, all of the other lines are possible while producing the same path of interest rates. Inflation control is still equilibrium selection. It’s just a lot more buried than following my equivalent approach.

In the standard specification, fiscal policy adapts “passively.” Notice the long period of interest rates above inflation. Interest costs of the debt are high. Who pays those? Fiscal policy must raise taxes or cut spending. So the “equilibrium selection” policy also has a fiscal consequence.

The fiscal theorist, of course, views it the other way around: Fiscal policy “selects equilibria,” or, better, completes the specification of the government policies that determine inflation. You need both the interest rate path and the change (or not) in surpluses to determine inflation.

But you don’t have to take a stand on FTPL. Even with a pure passive fiscal approach, the fiscal tightening must happen. This is not a pure monetary policy change. It is a monetary and fiscal policy change, and the equilibrium selection + fiscal tightening is doing all the work of lowering inflation.

These days, I think it’s important to ask “what if Congress refuses?” And for economic understanding it’s important to ask what is really the effect of interest rates, separate from the effect of Fed-induced fiscal tightening.

The red line marked “s=0” plots an equilibrium that does not require any fiscal change. You could phrase this as a constraint on the time-series process of the Taylor rule disturbance that the Fed may choose, among those that produce the given intrest rate path. You can see that the period of interest rate above inflation is matched by a period of interest rate below inflation, so interest costs net out to zero. And inflation rises throughout. An interest rate rise without fiscal support raises inflation.

This proposition holds more generally. In “expectations and the neutrality of interest rates” I show that even in an old-Keynesian adaptive expectations model, that otherwise well captures standard doctrines, higher interest rates cannot durably lower inflation without a fiscal tightening to pay interest costs on the debt. Intuitively, in that model, higher real interest rates drive inflation down and lower real interest rates raise inflation. So, if the Fed drives inflation down with higher rates, the stock of debt rises due to interest costs. If fiscal policy does not tighten to pay the interest costs or the resulting debt, the Fed must then lower real interest rates for a while to lower interest costs and bring down the debt. That brings inflation right back up again. Let’s call it unpleasant Keynesian arithmetic. Without fiscal tightening, the Fed can only lower inflation at the cost of higher inflation later.

There is a way out, marked “s=0, long.” If I add long-term debt, then the “stepping on a rake” or “unpleasant interest rate arithmetic” mechanism kicks in. Now a persistently higher interest rate lowers long-term bond prices. Since surpluses have not changed (by assumption), that’s a deflationary force. Now we can get the initial jump down in inflation without asking Congress do to anything. And now there is a reason for central banks to raise interest rates. Otherwise, they get even lower inflation with the equilibrium selection policy alone, as higher interest rates raise inflation.

This is the best I have been able to do to produce lower inflation from an interest rate rise without a simultaneous fiscal tightening in the standard new-Keynesian economic framework. I encourage you to find some better simple mechanism that achieves a similar result.

But the resulting model has nothing to do with the standard old-Keynesian intuition, that higher real rates lower aggregate demand, which lowers employment and through the Phillips curve lowers inflation, all going forward. Inflation only goes down from equilibrium selection/fiscal policy. You can see all of this even more clearly in the flexible price model with just interest rate = expected inflation. (See the paper.)

New Keynesian inflation control is equilibrium selection. This is just a fact about the model, and not criticism. This is the model we have. Let’s see how it works, and how to make it work better. The only thing to be critical about is the continued habit of plastering old-Keynesian ISLM intuition, introductions, conclusions, policy implications, and executive summaries on these equations. I tell the joke that new-Keynesians went hunting for a horse — microfoundations of ISLM. They came back with a zebra, and naturally said “look at our fine horse.” Well, that was ok for a while, but now we know that we have a zebra. Celebrate its novelty and let’s see how it works, but stop pretending it is micro-foundations for a horse.

We have made some progress. But inflation still jumps down on the day of the interstate-rate rise. We would like to find a model in which higher interest rates lower inflation going forward. And we would like a simple, robust, and explainable model. Simply saying “prices can’t change for a year,” and adding a smorgasbord of other frictions is unsatisfactory for such a basic idea. Do we really want to say that inflation naturally would jump down and then rise absent some smorgasbord of frictions? Simply alluding to '“long and variable lags” doesn’t work. In today’s macro, dynamics must come from the model.

Generalized Lucas Phillips curve

That brings me to the second of the two papers. Equilibrium selection is, honestly, not that novel. I’ve made the point scattered around many writings before, and I’m getting to be like the stereotype American tourist, who, when locals don’t understand him, just shouts louder. I think I did express it a lot better and all in one place, so maybe this time it will catch on.

The “Generalized Lucas Phillips curve” goes after the central problem of how to get an interest rate rise to lower inflation going forward. Here, I build on the analysis of “Expectations and the neutrality of interest rates.” Standard old-Keyensian (and Friedman 1968 monetarist) adaptive expectations models are unstable. Higher interest rates set off a deflation spiral. That’s how higher rates lower inflation going forward. Rational expectations new-Keynesian models are stable and long-run neutral. Higher interest rates must eventually raise inflation. And we saw above that stability kicks in right away. You can only get lower inflation by an instant downward jump, but then the Fisherian attraction of higher rates starts immediately. But perhaps we can have a model that is unstable in the short run — higher interest rates set off a deflation spiral — but reverts to the stability and neutrality that rational expectations demands in the long run? There is:

This is the best graph in the paper. Surpluses are constant — this is the counterpart of the “s=0,long” graph above. Start with the solid lines. The interest rate rises persistently, following the usual AR(1) pattern. There is still a small downward jump in inflation, due to the long-term debt mechanism. But then inflation is initially unstable. The initial jump downward gets amplified. It looks old-Keyenesian. After a while, however, new-Keynesian rational expectations take over, and inflation is stable and neutral. That may surprise observers, but most practical people have not seen a lot of long runs where the Fed doesn’t keep moving interest rates around and Congress doesn’t move fiscal policy around.

The model is very simple. I replaced the above Phillips curve with a version of Bob Lucas’ curve,

pt is today’s price level. Output is higher when firms are surprised by inflation, but each firm learns the aggregate price level with a different lag. Alphaj is the number of firms that learn the aggregate with a j period lag. It’s an obvious generalization of Lucas’ curve

I didn’t know this would lead to instability followed by stability. I noticed in “expectations and the neutrality of interest rates” that macro has just basically pushed the index of inflation expectations forward. Adaptive expectations references the Phillips curve to past inflation. New Keynesian economics references the Phillips curve to expected future inflation. How about unexpected current inflation? Might that give the best of both? It turned out to do so. I got lucky.

So the model is just the standard intertemporal IS curve, plus this slightly generalized Lucas Phillips curve. Another plus: It’s trivially easy to solve. I won’t belabor a blog post with it, but the analytic solutions are even easier than the second order differential equation I solved above for the standard NK model. The idea is quite similar to Mankiw and Reis’ “sticky information” Phillips curve, but that one was much harder to solve.

The dashed lines are even better. Again, the long-term debt mechanism still underlies this response, by giving the initial downward jump without a tighter fiscal policy. The key of that mechanism is lowering long-term bond prices. So expectations of future interest rates are the central deflationary force, not the current interest rate. The dashed lines follow a different interest rate policy, an announcement of a future tightening. This has the same deflationary effect, though interest rates do not rise at all in the short run.

This is an important observation for several reasons. Central banks don’t usually raise rates and then let them fall away, like the standard AR(1) exercise. (Maybe that’s been bothering you all along. It should.) Central banks wishing to control inflation usually start on a protracted tightening cycle, like the one in the dashed lines. But in the standard calculation, with the usual Phillips curve and a Taylor rule, such persistent interest rate rises choose an equilibrium in which inflation goes up right away.

Central banks also follow a lot of “forward guidance” — or at least they used to. The standard NK analysis of forward guidance is a bit looney — it says promises further in the future have larger effects today. This is an alternative in which forward guidance is important.

We plot the AR(1) interest-rate exercise because it’s easy, and also because the tiny shocks that “identified” VARs isolate seem to fall away quickly with that pattern. They also seem to have very little effect on inflation. We don’t measure the protracted tightening cycles that we see in history via VARs because those movements are usually responses to other events, like galloping inflation, and hence not “exogenous.” This is a classic case that the “exogenous” identified shock does not isolate the relevant policy question.

This is the best I can do so far, to produce a simple, transparent, easy to solve, baseline model in which higher interest rates lower inflation without fiscal help. It could (and I think should!) take over from the standard Calvo Phillips curve. (Nobody ever accused me of intellectual modesty!)

The paper takes on a lot of the what ifs and what about that are surely troubling you. Habits produce a hump shape in output, but no hump shape in prices. Lagged inflation in the Phillips curve doesn’t work either.

I wish for a better mechanism than long-term debt. Perhaps the next place to look is the IS curve. Interest rates work through capital, investment, and housing, perhaps better than through the usual first order condition. I wish for empirical analysis of the long-term debt mechanism. (I don’t know how to find shocks orthogonal to fiscal policy, reasonably exogenous, and giving rise to persistent interest rate movements. Maybe we have to move past VARs.)

Also, I hold surpluses constant because I think that’s the intellectually interesting question to ask of monetary policy —what can it do alone? If you want to analyze policy and forecast its effects, you should include endogenous surpluses, both from economic effects (more GDP, more tax revenue) and political effects (Gongress does respond to interest costs on the debt). But you should also recognize, as NK economics did not for a long time, when the entire effect is coming from induced fiscal policy and the higher interest rates are, on their own, counterproductive!

There is lots to do! The basic IS/Phillips structure is up for revision, now that we understand the weaknesses of the three equation model and we can handle the fiscal underpinnings of monetary policy. This post is in the end suggestions for future research.

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Today I’m going to follow up on affordability, sparked by a remarkable Wall Street Journal poll in which large majorities, left and right, support populist economic policies.

“The rent is too damn high.” So, people respond, pass rent control, subsidize rents, force builders to construct and rent out so-called “affordable units,” or have the government build and provide housing. They give the same answers for childcare, health care, prescription drugs, and energy.

Why are people so enamored of policies that have failed time and again, over centuries? Why are simple cause-and effect truths seemingly so hard to understand?

“Don’t transfer income by distorting prices” is a bedrock economic principle. If a government wants to tax landlords, and send the results to current tenants, giving more money to wealthy people who pay higher rents, let it do so: Tax the landlords, and send the renters a check, whether they stay or leave. Don’t get in the way of who values which apartment more, who should stay, who should move, which apartment should get fixed up, and which should be left alone and rented cheaply.

“Transfer income first of all by distorting prices” is the political reality. Why? Partly, this is a way for politicians to favor a constituency without the visibility of taxing landlords and sending checks to current renters. But, we’re here to understand public opinion, which should be outraged by that transfer.

When you’re negotiating rent, the price is an income transfer. That’s the point. The income transfer is the whole incentive for you to shop. If the government could force this landlord to charge you a lower rent, you’d be better off. So it’s natural to feel that if the government would just force all landlords to charge all tenants lower rent, we’d all be better off.

Similarly, if you get a rent subsidy, you’re better off. You don’t see that giving lots of people subsidies just drives the price up even more.

“Prices allocate resources” we say looking at the market overall. But “prices are an income transfer” to the people in the market. People naturally generalize their experience. Good public policy thinks about how the whole system responds.

We are also hard-wired to zero-sum thinking. If rich people got rich, people surmise that they must have taken it from someone else. Well, that was true for thousands of years. It still is true in many autocratic regimes. That our billionaires got rich by inventing new products and companies and making all of us fabulously better off too, is outside most human experience. And everything is zero sum in the short run. If a Tesla were $10 cheaper, Elon Musk would get less and you’d get more. You get more eggs if you carve up the golden goose. Abundance takes patience.

People are by nature tribal moralizers. They view the world as a battle between good and evil, our tribe vs. their tribe. If we can just quash the evil people and force them to be less greedy all would be well with the world. Adam Smith’s vision, how greedy self-interest serves the public good is unnatural.

People think in simple stereotypes. The large landlord can surely “afford” to lower rents for the struggling “working family.” The market accommodates unimaginable variety. Some landlords are hard-scrabble immigrants who saved a lifetime to run an apartment building. Some rent-controlled tenants are well-connected trust-funders who moved in decades ago.

People also don’t see the unseen. We see the lucky family that got a break on their rent. We don’t see how immigrants, minorities, people with children or pets, anyone with sketchy credit or little cash, or those that lost the affordable-housing lottery can’t get apartments at all. We don’t see the apartments that didn’t get built.

People long for yesterday. Populist policies all try to reverse a recent change. Why be outraged by suddenly higher gas prices, but not by perpetually high caviar prices? The rest of the country is outraged at $6 gas. California has had that for ages and few complain. Bring back yesterday’s price, but by government action in place of market forces is not wise policy.

People are also nostalgic for childhood. Mom and Dad can surely set things right. But we have the government, the people who run the DMV and disastrous public schools, not Mom and Dad. Just why long experience with government does not squash relentless optimism that next time they’ll get it right is a puzzle. The founders were a lot more skeptical of government power in general.

The paradox: The market works even if nobody understands it. People just need to follow their narrow greedy self-interest. But democratic politics needs voters and their representatives to understand basic cause and effect of how the system works. We, voters in a democracy, need to set rules of the game that lead to good outcomes, not decide outcomes. People need to understand the “fallacy of composition,” that what is good for one household or business is not always good for the nation as a whole.

What’s the answer? The ideas are pretty simple. One can ask for more economic and historical education. But many economists and most textbooks are pretty weak on these basics, and if we open that Pandora’s box, well, lots of people want to indoctrinate voters with terrible ideas too. We lost the long march through the educational institutions long ago.

In the past, these questions had a simpler answer. Price and rent controls? 51% of your neighbors want to use your house for a homeless shelter? They want to seize the business you built over decades and give it away? Sorry. That’s your property, to sell as you please. The government can’t interfere. We don’t live in a pure democracy. We live in a constitutional rule-of-law republic with a sharply limited government. Those limits and traditions encode much long and hard-won wisdom of what actually works. Institutions are precommitments. Revitalizing the institutions of limited government may be more promising. And perhaps people might think a little straighter when sitting down to that task, outside of the narrow focus engendered by a recent price increase.

(PS: Credit to Steve Davis, who asked this question during a Hoover event for Phil Gramm and Don Boudreaux excellent “Triumph of economic freedom.” This is an elaboration of my attempt to answer the vital question.)

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Affordability? It does seem a bit petulant. American’s standard of living is greater than any large country, and better than ever in the past. We earn on average 40% more than Europeans, British, Japanese, and Canadians. Poverty just hit an all time low. Health indicators hit an all time high. Inequality is falling. Some things have gotten more expensive, but other things are cheaper. Real wages are rising. Is a new multi-bedroom house in a nice suburb of a hot city expensive? Yes. But ask Europeans, who live in tiny apartments. What is everyone complaining about?

Well, the level of prices, as measured by the consumer price index, is 27 percent higher than it was just before inflation hit in January 2021, and 14% higher than it would have been had inflation been 2% that whole time. Though average real wages largely kept up with inflation, that’s not true for everyone. Many people who got new jobs got raises. But many people in old jobs did not. People on fixed nominal incomes or who want to buy houses or stocks are worse off. Inflation creates a lot of churn: some gain, some lose. Anyone who held government bonds lost about 14% due to inflation, and more as long-term bond prices fell.

People hate inflation. People hate higher prices. You can lecture them all you want about real wages, about “transitory,” but people hate higher prices. That ought to be an important lesson.

Congress gave the Federal Reserve a “price stability” mandate. The Fed interpreted that mandate to mean 2% inflation forever. Prices should double every 35 years. And even that 2% is only a forward-looking aspiration. The Fed lets bygones be bygones. If inflation hits 10%, as it did in 2022, the Fed does not try to run inflation lower than 2% for a while, or even slight deflation, so that inflation will average 2% over time. The Fed does not even think of trying to bring the level of prices back to where they were. Even so-called transitory inflation means permanently higher prices.

The situation in Europe is even clearer. The ECB is given a sole mandate of “price stability.” The ECB has explicitly interpreted that mandate to mean a '“medium-term” forward-looking 2% target, with no correction for past mistakes.

But the peasants with pitchforks, also known as voters, are really mad about the level of prices.

I think the Fed, and Congress, should listen to that. What did Congress mean by “price stability?” An economic originalist would say, Congress meant a long-run steady level of prices, as had been the case for 200 years under the gold standard. The Humphrey-Hawkins act, though emphasizing employment, called for zero inflation by 1988.

Congress (and whoever is in charge in Europe) should clarify the mandate. Perhaps, “when we said price stability, we meant price stability!” If not, at least define a 2% target as a long-run average, and the Fed should correct its misses. Many inflation-targeting countries do that.

When I mentioned that sort of price stability, a prominent central banker dismissed it immediately: Nobody, the central banker said, would induce a recession just to bring back the level of prices.

Is a desire for price stability economically illiterate? I think not. I don’t think long recessions would be necessary. That’s pure Phillips curve thinking, that the only way to lower inflation is via high unemployment. Yes, unexpected deflations are associated with recessions, though causality often goes the other way, as in 2008 and 2020. But if everybody knows the Fed is committed, indeed legally bound, to slowly bring prices back to their previous level, or inflation back to a long-term average, people can fit that in their plans. The expected inflation term of the Phillips curve can move, not just the unemployment term. (The Phillips curve says that inflation equals expected inflation plus the effect of output or unemployment.)

Moreover, supply- and technologically-induced deflation, goods getting cheaper as wages stay the same, is fine. We’ve seen that in electronics, and AI may bring it more widely. Alan Greenspan reportedly favored “strategically” returning to zero inflation, and I think what he had in mind may be letting such technological deflation take its course.

In the 19th century, the US had slow steady deflation, as it brought the greenbacks back to gold parity. It was a period of strong growth. (Yes, there were some banking panics, but that’s another issue.)

Steady prices and a clear price level or average inflation mandate also implies a commitment by Congress to repay debt without inflation. In turn, that helps to remove fiscal pressures for inflation.

The people want steady prices. I think they have some centuries-old wisdom that the Fed, and Congress who gives the Fed its mandate, might remember.

Update:

A reader asks “it seems like you are advocating for a return to the gold standard as a way to control inflation. Would that be an accurate interpretation?”

Answer: No! Gold won’t work for the modern US economy. Inflation was very unstable under gold, though prices slowly came back to their original level. The price of Gold today is very volatile. That suggests that if we fix the dollar to gold, we’d get huge swings in inflation. However, since we no longer use gold coins, the tie between gold price and other prices we care about is gone. So I think pegging the dollar to gold would peg the gold price, but other prices would wander away. Finally, gold failed horribly in 1933. Gold is a good precommitment against inflation, but if deflation breaks out, the government is committed to raising taxes and cutting spending to redeem bonds in their gold value. Thus, big and undesired deflations can break out. I would like via a CPI standard to emulate the good parts of the gold standard without these defects.

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This is a great prize, honoring two superb and highly influential economists.

What their work has to do with Keynesian stabilization is more of a head scratcher. This prize lives a lot more in the shadow of Milton Friedman and Bob Lucas than Keynes.

Hall’s most famous paper (my review here) was a brilliant extension and test of Milton Friedman’s permanent income model of consumption, which undercut the whole Keynesian fiscal stimulus business. Hall’s approach is also the cornerstone of all subsequent macroeconomics. Keynesian economics thinks about each year in isolation. In modern economics people think about the future in deciding what to do today. That is also a central part in Bob Lucas and Ed Prescott’s justly famous Nobel contributions. And Woodford.

Woodford’s monumental work (Interest and Prices is a capstone) was centrally about monetary policy, what the Fed can and should do. Keynesian economics famously said monetary policy is ineffective so the government should pursue fiscal stimulus. There isn’t much fiscal stimulus in Woodford’s book, and what little there is in subsequent work has very little to do with the Keynesian story. Again, this is the shadow of Friedman, not Keynes. But Friedman needed the money supply. The Fed sets interest rates and ignores money supply. Woodford shows how the Fed can affect the economy by setting interest rates. The core proposition is John Taylor’s rule: the Fed should aggressively raise interest rates to tame inflation. Woodford credits the idea to Wicksell and Taylor, and the Fed discovered on its own in the 1980s. But if you don’t have equations you don’t really know anything, and that’s what Woodford (leading a pack of many others) did.

I have been a little critical of new-Keynesian economics. But mostly as I see unfinished business. I think FTPL repairs a hole in new-Keynesian economics, and finishes the job. (“Expectations and the neutrality of interest rates” sums that up best.) Indeed, my main criticism is that Woodford went through contortions to leave out fiscal policy and inflationary fiscal stimulus, and give the Fed too much (complete) power over the economy.

Even Brad de Long called new Keynesians the “triumph of monetarism.” So, really, this is one more prize for Milton Friedman and Bob Lucas, not Keynes. Woodford set out to do something “Keynesian,” but by Lucas rules: people optimize in their behavior, they can’t be fooled systematically, and we write a proper model based on people and firms and budget constraints and markets that clear. (Woodford has been looking at more complex expectations recently, but not in the original work.) Policy consists of rules, either explicit or inferred from repeated behavior, not actions. I think that Woodford and other new-Keynesians set out to rewrite “Keynesian” economics under Lucas rules. But when you read the actual equations of what they came back with, it has very little to do with Keynes. (A recent article making that point.) The equations of NK models scream that higher interest rates raise inflation. That’s only now becoming clear. And it’s a bit weird for the committee to be impressed with central bank stabilization policy in the wake of 10% inflation here, in Europe, and the UK. This was a systematic failure of ideas—though largely old- rather than new-Keynesian ideas.

Hall ranges broadly over labor, investment, money, and many parts of macroeconomics. He is always innovative. I had given up hope of a Nobel for him, because he’s not the type who bangs away on one idea. I am glad to be wrong.

Reporters have asked “who else?” This has been a very productive few decades for macroeconomics, and there are a dozen or so economists who could easily have shared this prize. There isn’t that much common between Mike and Bob’s work, actually, so it’s really a generic prize for macroeconomics. I would hate to be on the committee that has to pick just two or three per year. Perhaps more macro prizes will come.

Two short personal stories: When I was on the job market long ago, a senior economist asked me who my favorite economist was. I answered Bob Hall, because he worked on so many issues and his papers were always so innovative. I nearly lost the job. Bob has also been a great colleague here at Hoover. For example, he asked a crucial question while walking back from a seminar that sent me on the whole s-shaped surplus quest that makes fiscal theory work.

Mike was a crucial spur on my path to the fiscal theory. While we were both at the University of Chicago, I mentioned my struggles with monetarism. He mentioned that I should read a recent paper of his, an early draft of “price level determinacy without control of a monetary aggregate.” Woodford papers aren’t easy, but knowing that the nugget I wanted was in there proved the spur. Woodford left the true faith (fiscal theory) behind, for reasons I need to ask him someday, but that paper and interaction was crucial for me.

Later, I wrote a paper (“Determinacy and Identification”) somewhat critical of some loose ends in Woodford’s book. The JPE asked Mike to referee it. Mike wrote a detailed 20 page single-spaced report, detailing every objection. He didn’t squash it or dismiss it as others might have done. I spent a few months addressing each point and much improved the paper. I don’t think I convinced Mike, but this is how scholars interact. We can disagree on fundamental matters, with detailed and careful arguments, but remain colleagues and friends. I’ve had the pleasure of returning the favor.

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“Affordability” is in the news. People left and right want the government to “do something.”

I’ve been gently ignoring most of this economic nonsense, but a Wall Street Journal survey brought it to my attention. Populist policies are hugely popular among democrats, republicans and independents.

• “Cap credit card interest rates at 10%?” 78% D, 83% R, 76% I.

• “Limit rent increases to 5% above the rate of inflation?” 65% overall.

• “Raise the minimum wage to $20 per hour?” 57% overall.

As you probably know, price, wage and rent controls have led to rationing, lines, black markets, and corruption every time they’ve been tried.

• “Require health insurance companies to cover services and medicines prescribed by doctors?” 96%, 82% and 86% are for it.

Because, of course, there is a magic pot of money out there and said companies wouldn’t possibly just raise premiums.

• “Restrict large institutional investors from buying large numbers of single-family homes?” 77%, 77%, 69%.

Because, of course they just love to buy houses and leave them empty? Let’s get rid of used-car dealers, stock brokers, and all of Ebay while we’re at it. And large institutional homebuilders.

• “Cap child care costs for working families?” 90%, 61%, 67%.

Even the question invokes magic. Who does the capping and how? The choice is massive subsidies or price controls. And then how do you get child-care workers to show up?

• “Run a government website that offers discounted prices for prescription drugs?” 76%, 75%, 63%.

Oh, like the wonderful Obamacare website. And remember how student loans cut out the middleman and lowered costs?

More bad ideas abound. Export controls, price controls, and subsidies are in vogue. Does anyone remember the charming 1970s?

The only clunkers:

• “Open government-run grocery stores that sell food at discounted prices”. 37%.

It seems people do remember their last trip to the DMV.

• “Send Americans $5,000 checks if Republicans maintain control of Congress” 23% in favor.

As I hope you know, the government cannot, by taxing, spending, borrowing or regulating, make anything “more affordable” overall. All it can do is try to make someone else pay, and then often to give you something you don’t want that much and lose half the money along the way. Subsidies against fixed supply, like energy and housing, just drive prices up more.

The $5,000 checks are interesting. It is a terrible idea overall, and simple enough that Americans can see that the money has to come from somewhere. But it is a whole lot better than all these other ideas. If you want to give Americans $5000 more purchasing power, it’s a lot better to just give them cash than to put in price controls or subsidies for particular goods. The current vogue, giving money to “nonprofit” advocacy organizations to “provide services” with precious little oversight, is even worse. Even Milton Friedman advocated cash as better than provision.

What could the government do to make things more affordable? Start by getting out of the way A lot of policy and regulation deliberately makes things more expensive. The biggest price rises are education, health, and housing, exactly where the government intervenes the most. When you’re in a hole, first of all, stop digging.

Housing? Let’s get serious about zoning and permit reform. Allow portable mortgages. Remove rent controls, forever. Allow people to rent rooms. Gas? Get rid of ethanol requirements, which add about 30 cents a gallon to diesel, drive up corn prices and agricultural land prices, and do nothing for the environment. Abolish the Jones act, which restricts shipping between states to US manned and made ships, and has driven up transport costs as it has destroyed the US ship building industry. Eliminate all the tariffs. Let Americans buy Chinese cars, at about half the price of domestics. (Yes, with data controls). Washing machines assembled in Mexico do not threaten national security. Allow automated ports. Get going on environmental permit reform, used by NIMBYs to block projects in ways that do nothing for the environment. Keep deregulating business (an unsung achievement of the Trump administration. Did you know that the Department of Transportation regulates font sizes on airline websites?) End agricultural price supports and quotas. Free up labor markets. Remove unneeded occupational licensing. Stop subsidizing higher education with basically free student loans. Open up health care and insurance to competition. I could go on. As Pogo said, “We have met the enemy and he is us.” As Aesop advised, “Doctor heal thyself.”

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Central banks have assets and liabilities like any other bank. Money—cash and reserves, which are accounts banks hold at the central bank—are the liabilities. Central banks own corresponding securities as assets. The central bank can then sell assets should it ever need to soak up money and reduce its liabilities.

There is a lot of discussion of the Fed’s balance sheet, and a task force of top economists. Should the Fed hold long-term bonds or short-term bonds? Should it hold just treasury bonds or also mortgage-backed securities or other assets? Should the balance sheet be large or small? Should the Fed offer a fixed supply of reserves and corresponding fixed demand for assets, or should it offer a flat supply of reserves at the policy rate and take assets in return for new money as they are offered? Other central banks hold more or less dollars, gold, foreign vs. domestic securities, private bonds and even stocks. France is debating whether central banks need assets at all, and can France please default on their bonds held by the ECB. This is my small contribution to that larger debate.

The central idea behind my proposal, that central banks should back currency with real assets, that hold their value in case of inflation, is ancient. Central banks on the gold standard had gold reserves and issued notes. 100% backing with gold was regarded as ideal, though seldom implemented. Currency boards back the currency with enough foreign exchange reserves to soak up every note and defend an exchange rate peg. Many central banks hold foreign-currency assets, gold, or even stocks. Inflation-protected government securities seem like a good real asset for a central bank such as the Fed and especially the ECB.

At a basic level, holding real assets should help central banks to control inflation. If inflation comes along, the nominal value of the central bank’s assets will rise. It then has more resources with which it can soak up money through asset sales. For example, the Fed and ECB lost a lot on their assets after the recent inflation. Even if they had held short-term bonds, they would have lost like the rest of us through low real interest rates. If they had held inflation-indexed bonds, their assets would have been worth more, and any constraint the balance sheet put on them would have vanished. Conversely, if deflation comes along, the nominal value of the central bank’s assets falls. It then is in a hole, making it more difficult to soak up money—which is exactly what we want in that situation, to stoke inflation.

(Sadly, US TIPS only adjust upwards and not downwards. So, while I’m dreaming big dreams, imagine that the Treasury issues better TIPS, that adjust in both directions. Ideally, of course, the Treasury would issue indexed perpetuities, whose coupons adjust upward and downward with the price level. Inflation swaps could work the same way currently.)

Now, let’s think a bit more carefully. Of course, I think in terms of the fiscal theory of the price level, so I’ll start there. FTPL says that

(money+bonds)/price level = expected present value of real primary surpluses.

To create a central bank, the government carves out some of the right hand side to buy gold or issue bonds, and separates central bank and government balance sheets. Then the central bank backs money with

money/price level = central bank assets

and the rest of the government obeys

bonds/price level = expected present value of remaining surpluses.

The central bank then establishes the price level, and the government commits to finding surpluses to back its remaining bonds, or default on them. People don’t have to guess whether periodic deficits will be repaid by surpluses. They only need to know that the central bank assets back the currency, and have faith in the government’s commitment to repay debt.

The problem is, modern central banks hold mostly nominal government bonds. So liabilities = assets reads

money/price level = bonds on balance sheet / price level.

The price level cancels. If inflation breaks out, the value of liabilities (money) falls, but the value of assets (bonds) falls just as much. There is no restorative force. If the central bank held inflation-protected bonds, then the central bank balance sheet would read

money/price level = real bonds on balance sheet,

period. Now after inflation the assets are worth more, which is a disinflationary force. After deflation, assets are worth less than liabilities. The central bank is technically insolvent, a clearly inflationary force. That’s what we want!

That’s the simple basic idea. I think it is especially useful for a central bank in a common currency such as the ECB. That bank is supposed to be set up independent of member country’s fiscal policies, and with the ability to defend the price level based on its own balance sheet only. The member states are, via debt and deficit rules, expected to repay debts or default without central bank help. Well, that was the idea, at least.

The details are a bit more speculative. (Yes, I’m trying to encourage others to think about this too. It needs some formal modeling.)

If prices were perfectly flexible, the price level would be perfectly determined by this relationship. In the case of gold and currency boards, the “price” is the price of money in terms of gold or foreign currency, which can jump, and the promise to convert one to the other instantly does make this relationship hold instantly.

But prices are not perfectly flexible, and cannot jump. We want a relationship like this to hold in the long run, and describe a pressure on the price level that is expressed in gradual inflation or deflation.

The general FTPL with debt on the left and surpluses on the right adapts to sticky prices by real interest rate variation. If the price level is too low relative to expected surpluses, inflation rises without a price-level jump. With a steady nominal rate higher inflation means a low real interest rate. The lower discount rate raises the present value of surpluses to keep the valuation equation going. As the price level rises, inflation and the real rate return to normal, the price level takes over as the equilibrator.

That mechanism might work for my central bank model too. If the price level were low relative to the value of real central bank assets, the real interest rate would decline. (Money has a higher real value than real bonds, so people try to sell money to buy bonds, driving up bond prices.) That raises the market value of real bonds, and the valuation equation holds again. As before, the lower real interest rate at a constant nominal rate would mean inflation, which brings the price level back down.

Alternatively, however, central bank equity might take up the slack. The actual balance sheet is

money/price level + equity = real value of bonds on balance sheet

Central banks have equity too, the difference between the value of liabilities and the value of other assets. Inflation or deflation, and (as we have seen lately) lower values of long term bonds then can show up as changes in central bank equity.

Now, if the price level is too high, the money issued by a central bank is a claim to real bonds worth more than the money, like a stock whose dividends are more valuable than the current price. People should want more of that money, driving down the price level. Conversely, money issued by a central bank with negative equity is a dangerous deal, so people should want to sell it, driving up the price level.

But there are many flies in this ointment.

In general, central banks rebate their profits (the spread between the interest they receive on assets and the interest they pay on reserves) to the treasury. They essentially pay out the equity as a dividend. When central banks lose money, they stop rebating profits, and hope bond earnings eventually top them back up again. If not, they need eventually to ask for some more assets as a transfer from the treasury. Such automatic profit and loss sharing would completely undermine the whole idea of the proposal, turning the indexed debt back in to nominal debt. So, any repayment has to be on a fixed or real schedule, independent of inflation.

It also might be better for the central bank to hold long-term inflation-indexed bonds. In the extreme, if the central bank held overnight inflation-indexed bonds, then the assets would only be protected from inflation for a day. Holding long term bonds means that real interest rate variation will affect the value of central bank assets, however.

In sum, the conventional wisdom is that central banks should hold short-term government debt and rebate profits. Real debt seems to overturn both precepts.

It is also important that the government doesn’t default on the bonds held by the central bank. In the Greek restructuring, the ECB didn’t lose anything while private holders did. A legal restriction that central banks are senior, that “even if we default on others we don’t default on the central bank” is important. It is also possible. Of course, currency boards can be raided, central banks abolished, gold reserves taken, promises not to default abrogated. No recommitment is perfect in life, or totally immune from irresponsible fiscal policy. FTPL wins in the end! Even constitutions can be broken. They are still useful precommitments.

Now, you may be scratching your head, if you even got this far. Central banks can go a long way with negative equity or ignore positive equity. Indeed, central bank balance sheets and equity don’t show up at all in most theories of inflation, and people don’t think much about them. So this starts to look like a weak force.

But in our current system, changes in central bank equity get soaked up, positive or negative, by the Treasury. In the system I envisage, changes in central bank equity pass on to money holders, and everyone knows that. People might pay a lot more attention to central bank equity if they knew that inadequate assets backing the currency must lead to inflation sooner or later. And certainly in the historic systems, people paid a lot of attention to central bank gold and foreign currency reserves.

The gold standard or an exchange rate peg also tie the value of assets and liabilities tightly, because you can exchange one for the other. A similar tie might be useful here too. Perhaps the Fed could offer a flat supply curve of reserves. You can always exchange reserves for a real bond.

A related proposal I’ve been kicking around for a while: Perhaps the central bank should target the spread between indexed and non-indexed bonds, not the level of the nominal interest rate. The spread is, directly, expected inflation. The central bank wants to control expected inflation, without having to divine the mysterious r-star, the appropriate level of the real interest rate. Why not control the thing you actually want to control? So, offer to buy and sell nominal vs real debt at a fixed premium, equal to the inflation target. To do that, it helps to have a big stock of real debt. An expected-inflation target, backed up by essentially 100% reserves, looks a lot like a gold standard backed up by 100% reserves, except it targets the thing we care about — inflation — not the thing we don’t really care about — the price of gold relative to dollars. I grant that too is an invitation to modeling. In particular it exploits the stability of the economy, that inflation will move to the Fed’s target and not spiral off.

Putting it together I know some of my readers must be a bit skeptical. Why do central bank assets matter anyway? Again, nobody has thought of central bank equity as a serious cause of inflation in countries such as the US, UK, Japan, and Europe. Central bank balance sheets do not appear in conventional new-Keynesian thinking.

But France gives us the reductio ad absurdum. If central bank assets don’t matter, then countries can freely default on their bonds held by central banks, with no inflationary consequences. Countries can borrow a lot more, sell the bonds to central banks, and then freely default, with no inflationary consequences. You know this is wrong, right? Central bank balance sheets must matter somehow. They aren’t historical relics (like gold reserves), right?

So, let’s put on our thinking hats and go back to the beginning. Find whatever reason that makes sense to you why central bank balance sheets matter to inflation control. With whatever reason you have in mind, wouldn’t it make sense for the central bank to hold real assets whose value is not influenced by inflation and deflation?

****

Update:

A correspondent has a brilliant idea regarding the conundrum of long vs short-term debt: “Variable rate in an amount equal to [interest-paying, variable-rate] reserve balances, fixed rate in an amount equal to currency (and TGA, maybe).” The Fed could also get its inflation protection from CPI swaps and not hold real interest rate risk on the balance sheet. That’s probably ideal, but more financial engineering than I want to do right now.

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But the Fed and other central banks and regulators denied us narrow banks (banks that invest deposits in reserves), segregated accounts (accounts invested in reserves, walled off from failure of the bank), money market funds with fast payment services, or useful (large-denomination, interest-paying) central bank digital currency. Interest-paying stable coins (backed 100% by short-term treasury securities) are the latest attempt to reinvent this wheel and drive around regulatory obstacles. But the Clarity Act just failed, over the question whether stablecoins can pay interest. Why not? From the Wall Street Journal,

Well, now I’m glad that’s all out in the open, and we can forget the long winded arguments about some vague threat to financial stability or the public interest. Banks don’t want competition, which would force them to pay interest on checking deposits. Plain and simple.

(Some think that banks, protected from deposit competition, turn around and offer cheaper loans out of the goodness of their hearts. Nice theory. If you want to subsidize loans, subsidize loans, don’t give an oligopoly a protected market and count on good will.)

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The Treasury is buying back long-term bonds. To some extent, the Treasury views long-term bond prices as too low and yields too high. Treasury wants to raise the prices, or at least to buy back debt at attractive prices. The Treasury says “This increase in buyback operation sizes reflects Treasury’s desire to provide greater liquidity support in longer-dated nominal sectors.” In policy circles, illiquid means low prices that can be pushed up with modest interventions.

The great canine silence comes from the Fed. Since the era of QE and then massive Covid bond-buying, when government feels that long-term treasury yields are too high, and telling stories of illiquidity and market dysfunction, the Fed (and the ECB) has stepped in to buy long-term bonds. That the Fed is not buying is significant.

I would imagine that Treasury Secretary Bessent [argh! autocorrect on original] must have called Fed Chair Warsh at some point and said, “Hey, can you buy up some of these mis-priced illiquid bonds and help us out?” If so, Warsh said no. Good for Warsh. If Bessent did not call out of respect for Fed independence, even better.

Why do I cheer? Beyond a good sign of Fed independence, a central question for Fed-Treasury accord ought to be “Who is in charge of the maturity structure of Treasury debt?” In QE, the Treasury issued long-term bonds. The Fed bought up the long bonds, issued overnight debt, and passed the interest difference back to the Treasury. In the end, it is just as if the Treasury issued overnight debt in the first place.

The maturity structure has a big impact on government finances. Long-term bonds are on average a bit more expensive. But they include insurance against interest rate rises. If the government issues short-term (as it did) and interest rates rise (as they did) then the government has to collect more taxes or cut spending (eventually) to to pay higher interest costs. The current $1 trillion a year interest costs reflect previous Treasury and Fed decisions to borrow short. The tradeoff between cost of borrowing and how much interest rate risk taxpayers shoulder should be squarely on the shoulders of the politically-accountable Treasury not the independent Fed.

I’m not sure that shortening the maturity structure is a good idea. If rates go down, Secretary Bessent will look like a genius, as lower interest costs will quickly help deficits. But if rates go up again, however, interest costs will pile on that much more quickly. I would buy the insurance. But I’m a risk-averse investor.

However, taking statements at face value, this operation was not really about maturity structure. It was about liquidity. Management of “illiquid,” “dysfunctional”, or “fragmented” markets (scare quotes because I don't think these terms make much sense, and I know for sure there is no theory or objective measurement of any of them) usually stood with the Fed. That’s not necessary but it has a long historical tradition. The Bank of England was founded in 1694 to help market government debt and keep it liquid, not to manage inflation and output by setting short-term interest rates. Still, short-term financial market intervention does not justify a permanent balance sheet of long-dated Treasurys. Warsh has also talked about wanting to reduce that balance sheet. In the new Accord, I hope that Fed and Treasury can agree to swap out long-term bonds on the Fed’s balance sheet fairly promptly, leaving maturity structure in the Treasury’s hands.

This is a longer-term operation however. Secretary Bessent is buying bonds for good. It is also aimed at “off-the-run” bonds, which are particularly illiquid. Here’s how it works: The Treasury sells a 30 year bond. There is lots of trading as the bond makes its way into portfolios, the bond-market equivalent of the day Taylor Swift tickets go on sale. But next year, it’s a 29 year bond, and the year after that a 28 year bond. Most of those bonds are sitting in institution’s proverbial sock drawers, so if people do want to sell, they are hard to trade, illiquid. And as a result their prices are typically a bit lower. Gemini made this graph for me which looks right but I can’t vouch for the source:

Higher yield is lower price. The spread is not quite enough for an arbitrageur to short the 30 year bond, buy the 29 year bond, and hold to maturity. But the Treasury can earn the spread since it doesn’t have to short anything. When people want to sell bonds early, The treasury can buy, at a discount, and pick up a few tenths of a percent on interest costs. Smart management. I’d go bigger: I’d publish a daily yield curve fit to the on-the-runs, and stand ready to buy any amount at 20 bps or so higher yield (lower price), and maybe sell any amount at 20 bps or so lower yield. This is a debt-management operation entirely and properly in the Treasury’s wheelhouse.

However, the Treasury buyback program is limited to $6 billion. There is an Austin Powers feel to the headlines. 6 billion dollars! The sky is falling! Horrible things happening! But there are $5.5 trillion — $5,500 billion — treasury bonds more than 10 year maturity outstanding. The Fed holds $1.62 trillion. The Treasury’s general account (its bank account at the Fed) is $997 billion. The Treasury borrows over $500 billion in the typical quarter. The Treasury can buy $6 billion of bonds with couch change.

I stupidly wrote most of this out before checking the number. When I did, I nearly deleted his post, and wrote instead “Who is worrying about this tiny drop in the ocean and why?” The media seem enthralled with artificial catastrophism. Still, the nature of the event is worth comment even if the magnitude is so far small, since everyone is looking, and maybe the next one won’t be so small.

I occasionally pitch old ideas in new contexts, and here I can’t resist returning to my Treasury debt reforms. If the Treasury wants to do something about illiquid off-the-run bonds, lower interest costs on the debt by offering more liquid securities, avoid occasional Treasury market illiquidity, or shorten and lengthen the maturity structure, there is a much better way to do all of this.

Simplifying a bit, the Treasury should introduce a fixed-coupon perpetuity and a fixed-value floating-rate perpetuity. These should gradually make up the bulk of government debt.

A fixed-coupon perpetuity is a security that pays a $1 forever. The Treasury auctions them, getting a lower price when interest rates are high and a higher price when rates are low. If someday we start running budget surpluses, the treasury can buy them back.

The key advantage of perpetuities: they are eternal. Last year’s perpetuity is exactly the same as this year’s perpetuity. There is no more 29 year bond vs 30 year bond. There is no off the run bond, and no off the run spread. In place of the 350-400 or so separate bonds bills and notes there can be two. You want liquidity, and associated lower yields? I give you liquidity!

(The fixed-coupon perpetuity should come in two forms, one with coupons adjusted for inflation supplanting todays TIPS, and the other with nominally fixed coupons. I also like the idea of versions in which the coupons are not taxed, so the government collects the taxes ahead of time in a higher price. More in the proposal.)

The other main security is a fixed-value floating-rate perpetuity. The rate resets every day to maintain a fixed value. It is also electronically transferable. Thus, it is functionally the same security as reserves at the Fed, except that anyone can hold them, and everyone gets the same interest rate. (The Fed pays banks more than everyone else.) It looks like a Federal money market fund to investors, though I hope with near instant settlement. I called this “treasury electronic money.” You want liquidity, here I really give you liquidity! Why should the Treasury sell an imperfect security — a smorgasbord of bills and notes — and then the Fed or money market funds transform that into the security people want, while taking a cut?

The Fed still controls the level of interest rates by controlling the interest on reserves. If the Treasury wants to do a big buyback, and the Fed doesn’t want to help, the Treasury doesn’t have to issue 1 or 3 month debt, it can go straight to issuing overnight debt.

The Treasury can control the maturity structure with these two securities. It can also offer fixed-for-floating swaps.

It’s not a new idea. Historically, perpetual government debt was more common than fixed maturity debt precisely because you didn’t have to roll it over. The Downton Abbey set held perpetuities.

The main objection I have heard is the notion that there really are important demands for specific maturity coupon debt, intermediaries that today happily create strips would somehow not be able to create coupon bonds, and the Treasury knows how to fill these demands so it can borrow at lower rates. I can’t fathom why, but I don’t object to the Treasury still selling specific securities if it can get really good prices for them. We’ll see.

One might object that offering fixed-value floating-rate overnight debt would undermine monetary policy. But we have long left behind the idea that inflation control requires rationing liquidity. The Fed’s courageous and praiseworthy implementation of ample interest-paying reserves proves that. Federal money market funds don’t cause inflation. Indeed, if the Treasury offers fixed-value electronically-transferable overnight debt, then the Fed can dramatically shrink its balance sheet if it wishes to do so, without starving the economy of this essential security. As the Fed proved, sensible innovations are possible. Let’s bring Treasury debt out of the 19th century!

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2) Megan Leonhardt at Barron’s did a Q&A on interest rates and inflation, [link now fixed] following up on my post. She did a great job of boiling down a long conversation. Explainig long-run neo-Fisherism clearly, without equations, and without sounding like an idiot was a challenge. You may disagree on whether we achieved the latter. Carolyn Fong took this great photo.

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1) I did a three hour (!) lecture on fiscal theory for PhD students, sponsored by the macro-finance society. It mostly covers my most recent effort, “Inflation and Debt.” Though aimed at PhD students it’s very history heavy and equation light. The link has the lecture video and slides too. Thanks much to Stavros Panageas for organizing and just enough hard questions to keep it lively.

2) Megan Leonhardt at Barron’s did a Q&A on interest rates and inflation, [link now fixed] following up on my post. She did a great job of boiling down a long conversation. Explainig long-run neo-Fisherism clearly, without equations, and without sounding like an idiot was a challenge. You may disagree on whether we achieved the latter. Carolyn Fong took this great photo.

3) Gabriel Roca did a very nice and longer interview for Valor, a Brazilian magazine. I gather FTPL is pretty popular in Brazil, as it should be!

4) Finally, Thibault Schrepel hosted me for a wide-ranging and very fun interview on his Scaling Theory podcast (Apple podcasts, Spotify, Youtube). On x, Thibault picked a great summary quote

I asked John H. Cochrane the simplest question I could think of. How do you get economic growth? His answer: mind the store, get out of the way, let the innovation happen. When problems show up, regulate on the evidence. Then he adds the part that stings... nobody ever won an election with that.

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The question is, can you achieve the lower inflation long run without the higher inflation short run?

In my model, the contrary short-run effect came from long-term debt. So my last post said, get rid of long-term debt first, and then inflation goes down right away. Like so:

The long-term debt mechanism also opens another route to this immaculate disinflation, hence this follow-up post: Announce it ahead of time. The long-term debt mechanism only moves inflation because long-term bond prices move on the announcement of the new interest rate path (or, when expectations change to that path for whatever reason). Even with long-term debt outstanding however, a pre-announced, expected interest rate change does not move inflation in the opposite direction. Ideally, you announce the lower interest rates so far ahead of time that all currently sold debt will be paid off. However, the US maturity structure is short enough that 3-5 years in advance might be enough to avoid most of the contrary movement. If half the debt comes due in 3 years, you get half the size of the contrary effect when you announce interest rates will go down 3 years hence. (If people believe the announcement.)

Of course this one requires the Fed to go back to a lot more forward guidance and rule following than the direction it is currently heading. (And, I might add, wisely. You can’t give forward guidance about what you are going to do when you have no idea what you’re going to do.)

But there are other ways to go about it. Alan Greenspan said at one point he liked zero inflation, but was planning to get there “opportunistically.” That I think gets a flavor of what might work. If inflation goes down, take the opportunity, gently lower rates to meet inflation, don’t get all worried about bringing it back up again. If people know that’s how you will react, you can generate the expectation of gently declining interest rates.

It’s also important that the Fed will not panic and turn around to raise rates if a “transitory” shock comes along. That is quite unlikely, so this is still more theory than practical advice.

I bring this up because, as in my last post, I am more sure that there is a contrary opposite movement than I am that the long-term debt mechanism is the central cause of the opposite movement. Just buying back the long term debt and then shocking the markets with lower rates leans very heavily on the long-term debt mechanism. But as I peer out in the mists of alternative models that might deliver the negative sign, the idea that they work because of unexpected changes in interest rates (and the path of expected future interest rates) seems a lot more robust. I can imagine lots of fictions that might produce a negative movement for unexpected interest rates but a positive movement for expected interest rates. Financial frictions for one, seem broadly more important for shocks than for slow expected movements.

We’ll never really know, of course, until we build those alternative models.

Slow and expected interest rate declines also give rise to much smaller output effects. Lowering interest rates to lower inflation also benefits from a positive fiscal effect. As the Fed lowers interest rates, with sticky prices, real interest rates go down, real interest costs on the debt go down, and inflation gets better. The Loyo mechanism operates in reverse. But, remember, I assumed constant fiscal policy. If Congress sees the lower interest costs and ramps up spending, the party is over.

By the way, lots of good economists (and a few valued correspondents) think that the long run positive effect is nuts. They agree with neutrality, but not stability. They feel that an interest rate peg, even with excellent fiscal policy, will lead to exploding inflation or deflation. The economic model for such instability is a harder question. Traditionally it comes out of adaptive expectations, which are fine in the short run but harder to argue for the long run. Still, I should be honest that even the long-run neutrality and stability, though a part of every economic model since 1990, is not something everyone agrees on.

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There is. It’s in the equations of my own best models. Which puts me in a quandary: Do I really believe the result, or do I hope that more work will overturn it?

(These thoughts are brought on by recent tweets and papers by Saki Bigio and Eric Mengus advocating lower rates for related reasons. Links below.)

What happens if the Fed raises or lowers interest rates and fiscal policy does not change? Italics, as that is the important and usually overlooked part of the question. Most models and authors presume that if the Fed raises interest rates, Congress raises tax revenue or cuts spending to pay the added interest costs on the debt. And that usually happens. We ask now, what can the Fed do all by itself?

I’ve been thinking about that question largely from the point of view of raising interest rates. Here is my best answer, taken from Inflation and Debt.

i is the interest rate, x is output, pi is inflation. Higher interest rates lower inflation, and with a lag not just an instant downward jump. Higher interest rates eventually raise inflation, however. My usual warning is thus “unpleasant interest-rate arithmetic:” Without tighter fiscal policy, monetary policy can only rearrange inflation, buying less inflation now by more inflation later. Unless fiscal policy finally gets around to solving its deficit problem. Along the way, higher interest costs on the debt add to the fiscal pressure for inflation.

The dashed lines represent the same experiment, but with the usual slow rate rise cycle rather than an instant upward jump. As you can see, that doesn’t make much difference. The key is a persistent rate rise that lowers long-term bond yields.

(The graph is Figure 6.3 p.99 of Inflation and Debt, and the calculations are in Inflation Dynamics with a Generalized Phillips Curve. It’s the response to the indicated interest rate paths, with a standard IS curve, the generalized version of the Lucas Phillips curve, long-term debt, and no change to fiscal surpluses.)

Now, inspired by Bigio and Mengus’ courageous willingness to stand up and say that something the current administration wants might not be totally idiotic, consider lowering interest rates. The result is, of course, just the previous graph upside down.

In the short run you get the conventional story: lower interest rates raise inflation and boost output. However, that turns around in the long run. Lower interest rates eventually lower inflation. Rather than focus on the short run with the long run as an unfortunate consequence, maybe we should focus on the long run with the short run as a difficulty to overcome.

The latter “Fisherian” result, that lower interest rates eventually lower inflation, has been a thorn in my side since I noticed it about 10 years ago. It’s present in standard new-Keynesian models too. It’s robust and hard to get rid of. It takes two basic ingredients: long-run neutrality and long-run stability. “Neutrality” means that in the long run nominal interest rates and inflation go together. Perpetual 50% inflation must mean 52% interest rates or thereabouts. That’s pretty hard to argue with. “Stability” means that inflation will eventually end up where the Fed puts the interest rate. That’s easier to argue with, but economic theory screams it, and so does the experience of the long zero bound. That central bankers and policy people look at you like you’re crazy for saying it doesn’t necessarily mean it’s dumb. It’s a long-run result, and central bankers don’t often see long runs.

Indeed, in the models I played with for a long time, higher interest rates led to higher inflation right away. Getting inflation to go down at all in the short run took work, and getting inflation to go down slowly took more work. I heaved a sigh of relief when I finally got this far, in which inflation goes up temporarily before going down. That ought to dissuade enthusiasts from arguing that one should lower interest rates to lower inflation. Sure, but you have to wait out the inflation surge first, and you’re not likely to keep your job if you do that.

However, my little model relies crucially on long-term debt to get inflation to go up before it declines. Here is the same model with one small change: The government only issues overnight debt:

Now lowering interest rates brings inflation down both in the short and long run!

So, finally, I get to the point: Suppose you’re a government, and you want lower inflation. You face the unpleasant possibilities outlined by the first two graphs. Well, reprogram the simulation. Why not first buy back all the outstanding long-term bonds and issue short term bonds instead? Now you get the option of the third graph!

Lower interest rates not only bring down inflation through the Fisher mechanism. They also lower interest costs on the debt, which lowers the fiscal pressure. This is the opposite of the Eduardo Loyo mechanism that bedeviled Brazil.

In sum, in this model, the best I know of to address this sort of question, the government should first drastically shorten the maturity structure of debt, and then lower interest rates persistently. Inflation will come down directly.

Buying back all the long-term debt at low prices and then disinflating also makes a lot of money for taxpayers. It has all the benefits in reverse of the policy I was arguing for in the 2010s, rolling all the debt into long-term bonds to lock in low rates.

Maybe Bessent and Warsh are cleverly working together!

The economist’s conundrum

So why am I writing a blog post and not a WSJ oped arguing for even larger treasury purchases and then lower rates? Well, here is the conundrum. The result is clear in the model. But do I “believe it,” whatever that means? Well, only sort of. In 10 years of wrestling with it, I have come to believe the long-run proposition. Lower interest rates forever, and everything else constant (in particular the government does not go on a borrowing and spending binge) inflation will eventually decline. Eventually. I also mostly “believe” the first two graphs. Monetary policy can have the usual effects in the short run before becoming neutral, stable, and Fisherian in the long run. And I believe the overall lesson: That’s a contingent result. There are episodes in which higher interest rates have raised inflation.

Where my faith comes up shy is to believe that by reducing the maturity structure of the debt, the government can reliably eliminate the short vs. long run tradeoff. I keep hoping for some more general model with some better mechanism to make inflation go the wrong way in the short run. But I don’t have one. Now, I know the dangers of reasoning by intuition outside of a model, by reasoning that surely somebody will build a model in the future that validates intuition. But I also know the dangers of reasoning that takes a given model seriously and literally.

Should I have more courage? Think of the great economists who reasoned far outside of conventional wisdom based on their model. Milton Friedman, in 1968, used theory alone to deduce that there was no permanent tradeoff between inflation and unemployment, never mind Phillips’ celebrated empirical curve and the unanimous professional opinion at the time. He stood up in front of the whole American Economic Association, and said that if the government tries to lower unemployment by accepting inflation, it will only get more of both. They laughed. He was spectacularly right. But of course we can also think of the hundreds of economists who offer policy advice based on simple models, only to discover that the models were too simple and they left something out. I only wish I knew what that something was.

The larger question: how quickly should new economic theory make it to policy? I generally think economists are too quick to advocate policy based on new theory. We’ve seen many theories come, shine bright for a while, then be discovered to have fundamental problems. The same holds for “facts.” This caution holds especially given that policy seems to have a hard time implementing tried and true simple theories like free trade, no price and rent controls, and so forth. The Fed rightly has moved cautiously on some of the wilder predictions of new-Keynesian models and those are 30 years old. Thank goodness it did not implement MMT. On the other hand, conventional wisdom often gets stuck in a rut, and needs a simple theory to get out. Friedman 1968 is the great counterexample.

Two things I know for sure: Nobody else really knows. And the standard view of a mechanistic relationship between inflation and interest rates is wrong. Any power of higher rates to lower inflation is fleeting and contingent. Contingent on just what is an interesting question. It is a lot more possible that this model is right than you might have thought.

Bigio and Mengus

Saki Bigio and Eric Mengus make related points. Bigio writes on x.com here, ablonger essay here, and in the paper “Sticky Inflation: Monetary Policy when Debt Drags Inflation Expectations” with Nicolas Caramp and Dejanir Silva. Eric Mengus writes on x.com here, and in the paper “Fiscal Dominance: Implications for Bond Markets and Central Banking” with Jean Barthélemy and Guillaume Plantin.

Both are, like myself, attuned to today’s crucial question, what can the Fed do without a change in fiscal policy, under the gun of large debt and deficits, in the face of a skittish bond market? Bigio:

raising rates without any commitment from the Treasury to restrain deficits cannot resolve anything

Bigio’s advice:

The Fed should do quite the opposite: lower rates and front-load inflation into the present.

That looks a lot like my second graph.

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Try out your high school French on the lovely video by Mattheiu Pigasse. It really is beautifully done. Short, clear, eloquent, hits all the arguments.

This affair is particularly interesting because the conventional macroeconomics and central bank view is hard pressed to explain just what’s wrong. Try this response by Olivier Blanchard, brilliant theorist and doyen of French macroeconomics. He explains that interest paid by France to the ECB is returned by the ECB to France, concluding that the default would have “no effect.” “… annuler la dette francaise detenue par la BCE n’aurait aucun effet.” I think Blanchard means no fiscal effect, but not that doing so would have an inflationary effect. And he left out the main issue, default on the principal payments.

You do smell a rat, no? If this works, why not have the ECB buy up the rest of French debt first, and then cancel the whole thing? And Italy, Greece, Spain, everyone but pathetically thrifty nordic countries who have some weird moral attachment to repaying their debts. Why not borrow even more, hand out free houses and cars to every voter, and then have the ECB buy and default? The euro system holds over a trillion euros of gold reserves. There literally is a Scrooge-McDuck pile of gold in the ECB’s basement. Why not just mint those into coins and pass them out? That sure would be popular!

Well, obviously no, but just why not?

Pigasse knows the obvious objection: it might cause inflation, just like 2021-2022. But no, he says. The big deficits happened in 2020, while inflation started in 2021. (Anytime someone refers to deficit spending as capital being “mobilized,” watch your wallet.) And everyone knows that inflation was due to “supply-chain shocks,” “energy shocks,” and so on, not unbacked money and debt.

Here he deftly exploits the gaping hole in today’s central bank and policy view of inflation. Much of the Fed and many macroeconomists also blame the 2021-2022 inflation on “shocks,” not massive deficits or the Fed and ECB’s multi-trillion purchases of those debts. More deeply, the standard policy view holds that inflation comes from the Phillips curve: from “tight” labor markets, from expectations, and from nebulous “shocks.” So talk down expectations, don’t worry so long as unemployment doesn’t get too low, pray for no “shocks.” And in the end the ECB can always control inflation by raising interest rates. If your intellectual framework doesn’t have a place for backing, off down the slippery slope you go.

So who cares if the central banks hold any assets? If nobody cares, then this French Magic Money Tree really does work. And we can repeat the post-covid green-new-deal “inflation reduction” debt financed blowouts without fear. Just let central banks buy the new debt again.

People are apparently happy to hold the approximately 4 trillion euros outstanding, the argument goes, and they would be just as happy to hold those euros whether or not the ECB holds any assets matching the euros. They probably have no idea what’s on the ECB balance sheet anyway.

Well, let’s work through what obviously must be true—that assets matter. Yes, people are happy to hold the current supply of euros. And perhaps monetarists are right, they do so because of the liquidity value of money, having nothing to do with its backing. But suppose one day that inflation breaks out again. People don’t want to hold so many euros, and try to trade them for goods and services instead. And this time, central banks want to do something about it. So, the ECB has to soak up some of that money. But with what? When the central bank has assets, government bonds, it can sell the government bonds, take back the excess money, and stem the inflation. What will the ECB do if it has no assets to sell? Well, then the eurozone governments have to give the ECB assets that the ECB can in turn sell in order to soak up euros. They have to tax their citizens. The euro is, ultimately, backed by taxes. The government bonds that the ECB holds now are just claims to those taxes set aside ahead of time so we know for sure the ECB will be able to do it.

Or, take a more current view that the ECB will stem inflation by raising interest rates. The ECB must then pay higher interest to banks. Where do the interest payments come from? The ECB might just print ever more unbacked euros to pay interest on the unbacked euro deposits it has now, but you can tell that won’t last very long. The ECB has to collect interest on its asset holdings, or again receive fiscal transfers from member states to do it.

So, yes, a French default to the ECB ultimately must mean either everyone else in the eurozone ponies up tax revenues to restore the ECB balance sheet, or inflation, which taxes everyone else’s money holdings. There is no magic money tree. Printing money is not “mobilizing” capital. Default is default, and somebody loses. And if you don’t have a view of inflation in which central bank balance sheets matter, you’re missing something crucial. If you don’t have a view of economics in which French taxpayers ceasing to pay interest and principal on their bonds means somebody else loses exactly the same amount, either in real terms or via inflation, (and especially in a full-employment economy) you’re missing something important.

Have I mentioned lately that there is a really wonderful book that explains the fiscal foundations of the euro in great detail? And only $35 list price!

In related news, and thinking also about the US interest rate surge, do you notice who is really quiet lately? That would be Kevin Warsh’s Federal Reserve. Interest rates are surging and we are not hearing the usual complaint about dysfunctional or fragmented markets from the Fed. The Fed is not buying US treasury bonds to hold down long-term interest rates. That silence is significant. The first purpose of central banks is to commit against monetizing debts.

Update:

Of course I’m corresponding a lot with my Crisis Cycle coauthors on this! Garicano emphasizes the political economy point. If countries can default on today’s debts to the ECB, tomorrows’s debts will be larger.

As we mention in Crisis Cycle, when Greece finally defaulted it defaulted an everything but ECB held debt! The ECB was paid in full. Good job ECB (and credit to Klaus who was deeply involved). That was a nice precedent to wall off sovereign default from euro-wide inflation or euro-wide ECB recapitalization.

I think the consequences of sovereign default to the ECB, or “cancellation” if mutually agreed, are clear enough to many members of the eurozone, starting with Germany, that it would quickly be the end of the euro. Which would be a pity.

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US long term interest rates are surging. What’s going on?

I usually don’t do market commentary. It doesn’t last long. And Hayek taught us that if we knew why strawberry prices go up and down, let alone interest rates, communism would have worked. Market prices aggregate the millions of pieces of information dispersed around the world, and give us a signal what to do. But they don’t reveal why prices move.

Today, I’ll make an exception. I don’t know why interest rates are going up, but we can look at the possibilities.

Perhaps investors expect more inflation in the future? If investors expect to be paid back in money that’s worth less, they demand a higher interest rate. One piece of evidence against that is that indexed bonds, the TIPS, have risen in tandem, and the spread between regular bonds and indexed bonds does not seem to have widened. Still, the TIPS are not perfect measures either.

Perhaps investors expect the Fed to raise rates in order to fight inflation? Long-term interest rates are the average of what people expect future short-term interest rates to be, plus risk premium, so long-term interest rates rise when people expect the Fed to tighten. Forecasting a successful tightening cycle would explain rising rates but no rising inflation expectations.

Perhaps we’re just returning to normal. That’s the Wall Street Journal’s interpretation. Over the course of history, 2-3% real interest rates on top of 2-3% inflation is perfectly normal, so 4-6% nominal interest rates are perfectly normal. It’s the 2010s with negative real interest rates that is weird. The Journal blames “extreme monetary and fiscal policies.” I don’t see how those produce low real rates for two decades. Other stories include demographics and “savings glut,” a wave of middle age people saving for retirement, and “safe asset demand” by countries building up reserves after the crashes of the late 1990s. My view is simply poor investment opportunities and low growth in an overregulated economy until AI came along. Low growth means low real interest rates. r =delta + gamma g (real interest rate = discount rate + (coefficient) times growth) for my economist friends; lower g means lower r. r = mpk (real interest rate = marginal product of capital). Lower mpk means lower r. Take your pick, there are lots of stories why “r star” might rise now.

Or, maybe, here come the bond vigilantes. You knew this was coming, right? Unsustainable fiscal policies can only go on so long. Eventually bond investors decide that the US will not in the end do the right thing after trying everything else, and default, expropriation, taxation, capital controls, or sharp inflation is on its way. They stop buying long-term bonds especially, and look to the comfort of short term bonds.

For insight, I plot some of the international pattern. (Sorry, Fred only goes to June for the other countries.) It’s a global phenomenon. And it lines up roughly with fiscal policies. The US actually looks a lot like the UK, everyone’s favorite advanced-country fiscal and economic stagnation basket case. So much for exorbitant privilege, the idea that the “reserve currency” status of the dollar means we can borrow at low rates. But Germany isn’t far behind, and Japan has shown the steepest increase as its fiscal problems seem finally to be catching up to it. The only country doing well is Switzerland. The exception proves the rule. It’s possible to have very low interest rates. Switzerland has about the most solid non-inflationary debt repayment policies on the planet. Their interest rate is almost too low, perhaps suggesting some worry over deflation and uncontrollable appreciation of their splendid currency.

That’s chilling. If we’re seeing a flight from sovereign debt, it’s a global flight from sovereign debt. And such a crisis is certainly a possibility. Where does a crisis come from? Debt that nobody knows how to repay, shady accounting, short-term debt that is being rolled over on the hope of a greater fool, and a potential crisis that nobody can imagine happening. Check, check, check, check.

Still, though I worry about this as much as the next person, it seems to me a real flight from debt needs a spark, and it’s awfully quiet. My main fear remains that in the next crisis, the US tries to borrow an immense amount again, and then the well runs dry.

Illiquidity, dysfunction, plumbing, supply and demand, and other technical factors are a usual story. For some reason there is limited demand for long-term treasury debt. The ECB has been propping up sovereign bonds for a long time on these stories. The Fed intervened massively in March 2020, not (heavens) to monetize trillions of new treasury issues, but on broken-plumbing stories.

Recently the Treasury and Fed together intervened to give Japan dollars to buy Yen rather than let Japan sell Treasurys. And in more recent news, the US Treasury is trying to prop up the long-term treasury market by buying up long-term Treasuries and issuing short-term Treasuries instead. One can read that as an “illiquidity” policy. It only moves yields at all if there is some sort of maturity-specific demands. And it did move yields. But we’ll see how long it lasts. If the rise came from the beginning of flight from sovereign debt or any of the other more fundamental forces, it won’t last long.

It looks like the Bessent Buyback announcement lowered yields 8 basis points (0.08%) for one day. That fits my priors on downward-sloping demand, segmented markets, liquidity, etc., but my priors are deeply in the skeptical range. Also, these are reactions to the announcement of future bond purchases. In QE the announcements had effects, the purchases did not. But actual downward sloping demands with poor arbitrage suggest the opposite. We’ll see what happens.

The two stories are not totally distinct however. The beginning of a global sovereign debt retrenchment would show up first in a feeling of limited demand. Countries and businesses both are driven to borrowing more and more short-term as insolvency approaches. Investors, seeing trouble demand a larger risk premium for longer term debt. The issuer, who doesn’t plan on going bankrupt, thinks the risk premium is too large, and it is if bankruptcy doesn’t happen. So both sides settle on short term debt. Moving to short maturity structures is a classic symptom of trouble ahead.

Or maybe not. As I said, the global sovereign debt crisis has been proclaimed many times, and hasn’t happened yet. But with no change in fiscal policy or growth, it will happen sooner or later.

So, inflation? Expected tightening? Back to normal? Iliquidity and plumbing? Or the beginning of the end? I don’t know either, but at least fleshing out the stories ought to help.

PS. As you can tell, I’m pretty reluctant to take firm positions on where the economy is headed and what macroeconomic policy should do. I am only too aware of how limited our understanding is. (Microeconomics seems much clearer, but maybe current policies are that much more obviously dunderheaded!) However, one of the few times I loudly opined on macroeconomic policy, it was to pound my fist on the table in 2015 that the US should borrow as long-term as possible, to lock in the ultra-low interest rates. There was a lot of opposition to that view at the conference where I presented it. I’m glad to say it looks pretty good now! I’m also modestly proud of having been deeply skeptical that r<g would last and render government debt a free lunch.

[This is the third in a sequence that mirrors the “grumpy economist weekly rant”. Fair warning.]

Update:

It occurs to me two days later, that there is a much simpler explanation for the Treasury buybacks. Everyone focuses on ephemeral short-run liquidity and price support and market manipulation stories. But how about this: The treaasury, and the administration, think they’re going to kick off fantastic economic growth and low inflation. Thus, they believe interest rates will soon fall. If you are managing the treasury debt, and you think interest rates will soon fall, you want to buy back your long debt at a super-low price. This is the opposite of my call for many years that the Treasury should issue more long-term debt because interest rates might rise. The treasury might be wrong on this forecast, but given their forecast of where they think interest rates and inflaiton will soon go, it would be inconsistent not to go short.

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What are the effects of a wealth tax? Is it possible for the government to spend billionaires’ wealth without destroying the companies and jobs that produce their, and our wealth? To think about that we need to understand incentives, budget constraints, and equilibrium.

Incentives: If you invest an extra dollar today, how much extra do you get in a year? A 5% wealth tax drags down the rate of return by 5 percentage points. If you earn 10% on your investments, but then pay a 5% wealth tax, you only get a 5% after-tax rate of return. Starting from a 10% return, a 5% wealth tax is the same as a 50% tax on interest, dividends, and capital gains.

And that’s likely an understatement. 10% is an optimistic forward-looking return. Disincentives depend on the total distortion, including all taxes, not just one tax at a time. The wealth tax applies on top of corporate taxes, property taxes, and taxes on dividends, interest, and capital gains. Inflation acts as another wealth tax, running 3% a year now. My guesstimate is that the government takes all the return and more.

Incentives matter, even to billionaires, and especially to would-be billionaires. Should they bet the farm on a new venture, investing time and effort as well as their money? Should young Elon Musk take his $175 million PayPal payout and retire on it, or plow it all into electric cars and rockets? We often think of saving vs. consumption here, but I think we underestimate the disincentive to take risk and invest effort that comes from progressive taxation. If the government taxes away the upside to investing, people take less risk. High-risk investments produced America’s prosperity. Low-risk, low-reward, small-scale European investments produce European stagnation.

Budget constraints, equilibrium: Billionaires do not have a pot of gold that can be costlessly handed out. Billionaires’ wealth stays re-invested in companies. Redirecting their wealth to social spending lowers national investment and raises national consumption, dollar for dollar. That’s not even hidden; it’s the point. But less investment mechanically means less capital for the future, fewer businesses, less productivity, lower wages.

In equilibrium, less investment also drives up interest rates as people with profitable ventures look for investors. Companies could finance investment with foreign money, but that raises the trade deficit, which is at least not a popular idea in political circles. We also have to pay back the foreigners some day. And maybe we don’t want China owning all our businesses.

Avoidance. Elon Musk’s $42 billion tax bill pays for a lot of tax lawyers, accountants, and lobbyists. Take businesses private, and argue with the IRS about what they’re worth. Hide individual ownership and value in complex cross-linkages, trusts, and LLCs. Structuring businesses to avoid taxes rather than generate profit might be the most insidious effect of high taxation.

We have a wealth tax, the estate tax. It tries to charge 40% of wealth once in a generation, or about 1% a year. (You pay double if you pass it to grandkids, so really about once every 30 years.) The estate tax attracts a beehive of perfectly legal avoidance. (Avoidance, not evasion. “Tough enforcement” and audits do nothing here.) Though the estate tax applies above a lowly $11 million, the CBO reports that it yields only $18 billion, or 0.1 percent of GDP. A recent study—by wealth tax backers—reports that the estate tax collects only three to four hundredths of a percent (0.03%–0.04%) annually of the Forbes 400 wealth, not 1% or so.

The government is broke, you might say. It needs new revenue to lower the deficit, pay down the debt, build infrastructure and fund military investment. Not a chance. The carve-up-the-golden-goose bill also includes the Door-Dash takeout order. It includes “a $3,000 direct payment to every man, woman and child living in a household making $150,000 or less.” $1.1 trillion for Medicaid and Obamacare subsidies. Free dental, vision and hearing. $856 billion of government-provided homes to “abolish homelessness.” A childcare entitlement. A minimum salary for teachers. And so on. This is proudly a bill to turn investment into consumption.

Economists Emanuel Saez and Gabriel Zucman offer an “economic analysis,” on Sander’s website, and on University of California letterhead. Do they rebut any of this? No. They don’t mention economic disincentives. They don’t mention the shift from investment to consumption. They don’t address the obvious question: How do we eliminate billionaire wealth but sustain the economy those billionaires created? They just add up, that if everyone sits still, the tax will cut billionaire wealth in half in 15 years. They thus validate my suspicion of a deeply negative rate of return. And they thus, inescapably, say that the wealth tax cuts by the same amount the value of the companies that produce that wealth.

If we get different answers, it usually means that we’re asking different questions. And we are. Sanders’ press release starts with “the urgent need to confront the obscene level of income and wealth inequality…” and that “so few people [hold] so much … power.” Saez and Zucman starts with the curious assertion that “democracies become oligarchies when wealth becomes too concentrated,” and continue “the billionaire wealth tax is the most direct policy tool to curb the growing concentration of wealth.” Well, the French guillotine or a socialist nationalization would be more direct, but you get the point.

The wealth tax is not about economics at all. It’s about envy, destroying billionaires. And it’s about grabbing their power for the government. They want to get rid of billionaires even if it impoverishes the rest of us.

Another day, we can debate causality. I think they have it backwards. Oligarchy causes wealth concentration in Russia. Immense money and power concentrated in the US government generates crony capitalism. Free market wealth did not install Putin, nor did it create US crony capitalism under the regulatory state.

But now you know what the wealth tax is really about. And why it’s not going away.

[This is another essay written for the “Grumpy economist weekly rant”, where it will come out sooner or later. Again, I presume most of you either read or listen so the repetition will not be too annoying.]

Update:

I should clarify that the disincentive to risk, as opposed to saving, comes from progressivity. This tax is only progressive (so far) at the $1 billion boundary. So it only further disincentivizes risk when that boundary is in sight.

What’s the right answer? A consumption tax, preferably (in my view) via a VAT, but the exact form doesn’t matter all that much. Getting rid of the income tax machinery also gets rid of all deductions and exclusions in one fell swoop without having to fight about each one: employer provided health insurance deduction, home mortgage deduction, energy subsidies via tax deductions, and the whole non-profit mess. It can be progressive, or do your redistribution by writing checks.

What’s the right question? There is only one question — long run growth. Redistributing Rockefeller’s wealth would not have made your family better off. We’re all immensely better off because of long-run growth. Even if your concern is entirely at the lower end of the economic spectrum, long-run growth is the question. Ask of any policy, what does this do to long-run growth? For the wealth tax, not much!

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