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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California led a group of 12 state attorneys general in a suit to block the Ellisons and Paramount from buying Warner Brothers. In case you haven’t been following this saga, the Ellisons made a big deal of their support for President Trump in order to get the Federal Trade Commission to approve the merger. Now, the Wall Street Journal’s Holman Jenkins reports, the “Democrats inevitably counterattacked … Ideas are being desperately floated to restore peace—fire Bari Weiss, outreach to Kamala Harris. … a board to guarantee CNN’s independence?”

Obviously none of this has anything to do with the supposed anti-trust issue, the “silly claim that the companies are out to monopolize the dying cable TV and theatrical movie businesses.”

The lesson: Anti-trust is now completely a way for politicians to extract political support from businesses, and has nothing to do with protecting consumers from monopoly.

California is also leading four states in a $1.4 trillion suit against Meta, for allegedly misleading the public about the dangers of social media for teen’s mental health. They are piling on to an avalanche of private multimillion dollar suits.

Add up the ideas. Social media is addictive, like heroin and cigarettes, but not like video games and comic books. Social media is a pervasive danger to mental health. And “big corporations” knew this all along and conspired to lie about it.

Everyone is a victim. Dumb teenage behavior is mental health crisis. How 2022. The hysteria bandwagon has moved to young people using AI to cheat on homework, and won’t learn to read and add. But it’s not too late to grab Meta’s cash and spend it on $1 million homeless apartments or high-speed rail consultants rather than data centers, plus billions in legal fees.

Hilariously, the attorneys general charge that the company designed Facebook and Instagram “to maximize profits.” Which, of course, they can be sued for not doing.

Roundup, talcum powder, vaccines cause autism, big oil hid the secret of climate change… the tort system does not look great right now.

Phillips 66 announced it wants to build a $6 billion pipeline to export gasoline from Texas to California.

California used to produce and refine oil, and export it. But the state has pretty much shut that down, and now imports 75% of our oil and gasoline. Two refineries closed just last year. Gas averages $5.60 a gallon. With imports from Asia and the Middle East off the table, the only thing keeping California afloat has been imports by sea from Texas. But those are only possible thanks to the Trump Administration’s temporary Jones act waiver. Normally, shipments between US ports have to be on US ships, and there aren’t any. (Say “national security industrial policy,” and I’ll always answer “Jones Act.”)

So, thanks Phillips, for spending $6 billion pointless dollars to save California from self-inflicted wounds. And explain to me, California, just how moving oil extraction and refining from California to Texas does anything to help the climate.

Amazingly, Californias’ governor Gavin Newsom said he won’t block it. We’ll see if it survives the rest of California’s legal and regulatory thicket. The California part of the pipeline just involves making oil flow the other way, a sad commentary on California, but reducing the opportunity for environmental suits.

The point

You might dismiss all this as my three libertarian bar stories about incompetent government for the week. And they are.

But put it in the context of the AI debate, whether we should demand that “policy-makers” must “act now” to “steer AI in a direction that complements humans and benefits society.”

There is no such thing as a “policy maker.” I hate that word. There are politicians, lawyers, regulators, legislators, pressure groups, lobbyists, courts. And this is how they “steer” anti-monopoly, social media tech, and energy. Do you really want them to “steer” AI?

You go to war with the army you have. You steer AI with the regulatory state you have. You don’t get to invoke a wise, a-political, benevolent, technocratic aristocracy that, like communism, just hasn’t been done right yet.

[This is text for a “grumpy economist rant” that will come out sooner or later. Sorry for the repetition. Some read, some listen, I figure few do both.]

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Here is the best one-graph answer I have to this question, taken from a recent paper (also summarized in “Inflation.”) i is the interest rate, 𝜋 is the inflation rate.

The simulation begins in a conventional way. The higher interest rate pushes inflation down, going forward. Duh, you may say, I didn’t need economic theory for that. Higher interest rates lower output and employment and lower output and employment through the Phillips curve bring down prices and wages. The simulation sort of looks like the Great Data Point, 1980-1982, which dominates historical experience. Let’s get on it and raise rates, Mr. Warsh, you may say.

But then inflation turns around. In the long run, higher interest rates raise inflation. And, conversely, lower interest rates lower inflation.

Here you might say I have gone off my rocker, but you’d be wrong. This is a robust and nearly inescapable conclusion of basic economic theory, and it is a part of every (well, every one I know) contemporary economic model. It’s not that well recognized. Most modelers focus on the short run and don’t ask models what happens if interest rates rise and stay high. But it’s there.

The prediction comes from two central underlying propositions. First, the economy is neutral in the long run. This just means that real things don’t depend on units of measurement. Physics is the same in meters or feet. Economics is in the long run the same in dollars or yen. Today’s real purchasing power and employment is essentially the same as it would be if the dollar were worth the same amount as it was in 1947, rather than 6.3 1947 cents. (It is.)

Neutrality means in the long run a higher nominal interest rate must correspond to higher inflation, not a permanently higher real rate of return. Countries with high inflation have high interest rates. A positive correlation of interest rates with inflation also dominates US history.

Now, 1960s economics acknowledges neutrality, but holds that the instability you see in the first graph lasts forever. Interest rates and inflation move in the same direction because central banks quickly move interest rates to follow inflation, like a seal balancing a ball on its nose, not the other way around.

1970s economics, which made it to interest rate targets in the 1990s says no, and adds the second fundamental proposition: The economy is stable under an interest rate target.

If the economy is stable and neutral in the long run, there is not much you can do about it: higher interest rates eventually raise inflation.

Practical people rebel, but practical people have little experience with the long run. Economics is really helpful to sort out long run propositions. And a lot of evidence, especially the stability of inflation at the long quiet zero bound, argues also for long-run stability. (“Inflation” again is my latest summary.)

Summing up then, my top graph illustrates the basic and robust conclusion of today’s baseline economics: In the short run, higher interest rates drive inflation down. but the economy eventually becomes stable and neutral in a long enough run, and higher interest rates eventually raise inflation.

Mr. Warsh’s task, and that of the whole FOMC, then is not so simple. They are driving a bus careening down the highway, with some mighty crosswinds and bumps in the road. Moving the steering wheel to the left first sends the bus off to the right, but adds to a force that eventually pushes the bus back to the left again.

This picture also suggests we got to the current unpleasant situation of stubborn inflation. When the Fed started raising rates in 2022, my graph says that it brought inflation down faster than would otherwise have happened. But it did so at the cost of a small steady higher future inflation — as I warned at the time. So now we are living in the right hand side of my simulation, from the great interest rate rise of 2022.

So, bottom line, yes, the Fed could raise rates now and bring inflation down in the short run. But doing so would inevitably raise even further the baseline inflation that we are seeing now when the long run kicks in again.

Chris Sims described this prediction, and offered it as an explanation of the 1970s. Three times, the Fed raised rates to quash inflation. It worked in the short run, but then inflation returned. He called it “stepping on a rake.” Inflation only declined durably when fiscal reforms and microeconomic growth complemented the Fed’s interest rate rises. It’s 1979 again.

You may say, great, let’s jump on the neo-Fisherian bandwagon and lower interest rates to lower inflation. I’m actually a bit surprised that the voices for lower interest rates didn’t try that one. But the graph shows one of many dangers. Inflation would rise first, and who knows how long the long run would take to kick in.

Better fiscal policy lies in the background of durable disinflation. But there isn’t much the Fed can do about that.

Some whatabouts:

I ask the model what happens if the Fed raises interest rates, but Congress does not change taxes and spending. Many similar models implicitly pair fiscal austerity with interest rate rises, which produces different results. But to answer the question “what can the Fed do’’ about inflation, I here separate those two influences.

Stability in the end comes from “rational expectations,” which is contentious for the short run. But it’s harder to base an economic theory on the idea that people never ever catch on, never ever start thinking about future inflation rather than past inflation when they decide how much to pay for a mortgage, how much to borrow for a business loan, how much to save vs. go out to dinner. So, when they eventually catch on and start noticing the gulf between inflation and interest rates widening, as in my first graph, they wise up and the prices they charge and are willing to pay moves toward the interest rate not vice versa.

Part 2: Comments on the conventional analysis:

Most of the analysis of the current Fed can be boiled down to the standard forward-looking Phillips curve:

Inflation = Expected inflation + (small number) * employment + shocks.

This gets read with causality from right to left.

In this context, raising interest rates brings inflation down by reducing employment, a slow and painful process. “Shocks” could come along — the story that AI will raise productivity is the hope for a strong shock that raises both inflation and employment. Prayer might help. Microeconomic deregulation helps too.

That leaves us expected inflation, which is really where the discussion lies. If the Fed can talk or “forward-guide” expected inflation down, then it doesn’t have to do anything painful right away. Warsh is, wisely in my view, climbing down from extensive “guidance” about where the Fed will set interest rates in the future. He is replacing that with a Mario-Draghi like “we’ll do what it takes.” Given the uncertainties over how the Fed affects inflation (notwithstanding the above) that approach has a lot of appeal. Maybe interest rates won’t work, then the Fed will try QT. Or return to monetarism. Or something. But that approach requires that people believe that Warsh and the FOMC have an institutional commitment to low inflation, and the independence to survive whatever it turns out to take. Will they, if needed, repeat 1980-82? Will they be able to do so? If people believe that, then you get the lower expected inflation.

Eventually though, talk must be backed up by concrete belief that the Fed will act and act strongly. Deterrence is not cheap talk. Speak softly and carry a big stick. where’s the stick?

So most of the argument for raising rates now, then, is not that it will directly lower inflation by lowering employment. It is instead a display of toughness, designed to convince people that Warsh and the Fed are ready to do what it takes. But a short-run focused, tentative, timid, and contentious rate rise, ready to back off if the costs seem high.. well, that’s just what the Fed did in the 1970s.

Bottom line: There is nothing mechanical about higher interest rates lowering inflation. Good luck with that bus!

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We must act now!

Recently Stanford’s AI center spearheaded an open letter that gained a lot of attention.

The admirably concise letter starts “AI could drive an unprecedented transformation of our economy…It could bring risks, including large-scale job displacement.” The letter concedes that AI might also “bring major gains in living standards.” (My emphasis in all cases. Elvis could rise from the dead too.)

I’m interested that “job displacement” rather than, say, cybersecurity, dangerous viruses, and so on lead the “risks.” As I’ve said before and will again, this is extremely unlikely. We’ve had 300 years of astounding innovation that substitutes machines for humans. The unemployment rate is 4%. 2.5 million people lose their jobs every month in the US. And 2.6 million get new jobs. New technologies create new jobs. And should it happen there is no need to “act now,” no cat out of the bag that can’t be remedied if and when it happens. Unfounded fears of mass immiseration are nothing new. Remember only 5 years ago the hue and cry that due to self-driving trucks all the truck drivers would be destitute? Economists should know better on both counts.

The letter then demands “Economists, policymakers and technology leaders must act now to understand the economics of transformative AI.” Well, I’m all for understanding, but economists don’t seem to need much prodding, given the flood of work on AI. Which is getting about as far as we usually do in speculation about the unknown. Economists can barely agree on minimum wages and taxes. Climate estimates are all over the map. “Subsidize our research” isn’t a potent call to arms.

But here’s the important part. “We” and especially those “policy makers” must also act now” to “build the incentives, guardrails, and institutions needed to steer AI in a direction that complements humans and benefits society. “

Over 250 prominent people signed the letter, including many famous economists, Nobel prize winners, historians, public intellectuals, and tech titans.

I wrote a scathing tweet.

You must be kidding. Act now, before anybody has any idea what AI will do? Act now, when the last sentence trumpets that nobody understands the economics of transformative AI? Thank goodness nobody thought it was their business to “steer” the steam engine “to complement humans and benefit society,” and avoid “large scale job displacement” of horse-drivers and sailing ship mariners.

Most of all, I reject the basic premise about how our government and society work. Where are these dispassionate a-political technocratic “policy makers” who know how to “steer AI,” to guide new technology let alone the ones we have? This is the crowd that “steered” our catastrophic Covid policies, and is now “steering” a trade war. Look what a bang-up job they did on “steering” energy. They’ve already killed AI in Europe. Let “policy makers” fix the dumpster fires of their social programs, building restrictions, appalling public infrastructure, broken tax code, and failing schools before they “steer” some vague AI crusade.

What happened to America, land of limited government, rule of law, and individual rights, where economic life is not run by “policymakers?”

What happened to basic economics, especially for economist signatories? To regulate, you document a market failure, and then you document the capacity of a regulatory body to address it without inviting an avalanche of cronyism and protection. You don’t “act now” before you have any idea what you’re doing.

This sort of catastrophizing has a long and sorry history. Only 5 years ago they wanted to retrain manufacturing workers to code. Now coding is dead, and everyone wants manufacturing. Think of the population bomb, the resource crisis, nuclear power, GMO foods, stem cells.

Cheer up. These letters come and go, leaving behind only a small stain on the reputations of their signatories and institutions. (I feel sorry for the Nobel Foundation, whose reputation slides each time its laureates, recognized for narrow scientific achievement, sign such statements with the Nobel name next to their own.) In 2025 Nobel prize winners signed an “unprecedented plea” for governments to develop “moonshot” technologies” to “avert a hunger catastrophe in the next 25 years.” (Hmm Maybe AI is that moonshot! AI+GMO foods+nuclear energy abundance fueling desalination and fertilizer production+1.0 kids/woman+swiftly declining global poverty and this looks like a pretty lame catastrophe.) In 2021 101 Nobel Laureates demanded “a Global Fossil Fuel Non-Proliferation Treaty.” 16 Economics Laureates wrote a letter decrying Trump in 2024. 23 endorsed Kamala Harris, warning—strangely for economists— that tax cuts would increase inequality, and the economy would fail. (They also decried tariffs, which I don’t like either, but we have to admit that the confident predictions of economic disaster under Trump have not panned out. Neither has great revival, but nobody staked his or her Nobel reputation on Making America Grow Again.)

Two separate Nobel-economist letters predicted disaster should Javier Milei be elected in Argentina.

So this noise too shall pass. If you’re wrong about everything often enough, the world tunes out.

Gavin Newsom’s AI order

It turns out that “policy makers” AKA “politicians” don’t need open letters from us egg-heads to to “act now” on AI before anyone has any idea what it will do. They’re hard at work already.

To see what might come when “policy makers” act, let’s take a look at Governor Gavin Newsom’s executive order [N 6 26] on AI. Newsom is if anything in the sensible center of the Democratic Party, and given voter’s habit of throwing the bums out every four years, his order offers a glimpse of what might be coming.

The order also centers on the fear of widespread AI-induced unemployment — so far, I remind you, completely hypothetical and never seen historically.

The answers are straight from the 1930s. Even if they did any good then, AI unemployment is boom unemployment not great-depression unemployment. And the “whereas” section of the order long-windedly announces how many of these programs the state is already doing, which proves just how ineffective they are. California has an employment problem indeed. And it has nothing to do with AI, and everything to do with far too many labor market interventions already.

The order also directs the state to pay lots of people to write reports that nobody will read, including Stanford’s Human-Centered AI by name. (Congratulations!) It also directs government agencies to use AI to increase their efficiency. Maybe AI can write all the reports for free? AI agents to fill out thousand page environmental impact statements… I dream on.

Newsom demands a

review of policies and practices that provide displaced workers with a safety net, including severance…strengthening existing programs, including …subsidized employment programs…

Apparently the government needs to commission a review of its own programs. “Subsidized employment?”

expanding awareness of and enrollment in employment insurance programs..

Apparently the suffering masses need help to find free money.

identify, promote and enhance service opportunities,…for those experiencing long-term unemployment and other potential employment disruptions, connect unemployed workers to opportunities for training and upskilling,

Volunteering? Really? Displaced tech workers want to find meaning in life cleaning up highways? Add more job-training schemes to the dozens in place? (A second reminder on just how many job-training schemes taught manufacturing workers to code!)

review … the collective bargaining process,… including how worker voice is incorporated in adoption of emerging technologies,

More unions and “worker voice,” another novel idea from the 1930s. Maybe AI can bring back Pete Seeger and Woodie Guthrie. “They won all of the battles, but we had all the good songs.” Like useless firemen on diesel engines, and rules against automating ports, you know where that’s going.

support regions facing systemically high unemployment…

Unemployment in Fresno has nothing to do with AI. I can’t wait to see taxypaer support for the fashionable parts of San Francisco.

But I delay too much with snark. Here’s the crescendo, with revealing euphemisms

alter incentive structures…[to generate] AI development and deployments that advance the public good and address critical problems and emerging opportunities facing society.

Just think about what “alter incentive structures” means. Imagine the state’s definition of “public good” “critical problems” and “emerging opportunities.” Remember “vaccine equity?”

Finally towards the end we get the really good stuff:

public-private partnerships, voluntary or mandatory programs that direct a portion of revenue generated by AI companies

How would you like the governor to “direct” a portion of your salary? Want to do that “voluntarily?” That’s usually called taxes.

… securing dedicated access to computing power for research and development of AI that meets specified criteria for advancing the public good.

“Securing?” By means other than “buying.” “Commandeering” computer time? That’s interesting.

And finally, the kicker.

…expand and enhance worker ownership models…. employee-owned company structures… direct and indirect economic support for the formation of or conversion to employee-owned companies.

So that’s the answer to AI. The same warmed-over soft-communist idea that’s been running around faculty lounges ever since they had to admit that Stalin was a pretty bad guy. Worker-owned collectives. Run the company like a homeowners association. A well tried and well proven disaster. (UK, 1970s for example.)

So, what will the government do about AI if it responds to the “act now” call? Round up the usual suspects. The answer is always the same, it’s just the questions that change. AI poses an unprecedented challenge? Ramp up the New Deal!

The order includes a revealing sentiment.

workers and consumers should have a voice in the future of broad-based technological adoption;

Yes they should. And they do: via the products they choose to buy and use, and the companies they choose to work for and invest in.

This one sentence reveals so much — the view that people only have “voice” through the political process, which ultimately means by compulsion. It’s the antithesis of America.

****

PS:

I was also amused at the number of California state agencies mentioned that I had never heard of before. A partial list:

The Labor and Workforce Development Agency; the Jobs First Council; The Employment Development Department; local workforce development boards; Employment Development Department; California Volunteers; California Service Corps; Corps to Careers; Workforce Pell Grant program; Government Operations Agency; Office for Business and Economic Development (GO-Biz); Office of the Small Business Advocate (CalOSBA); The California Health and Human Services Agency; Office of Data and Innovation (ODI).

Well, I know where some of that “subsidized employment” goes!

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As we ponder the founders, we wonder: Would we have their wisdom and courage? Would we believe that winning independence from the greatest power of the time was even possible? Would we endorse the revolutionary idea of a republic, given how many republics had disintegrated from internal quarreling or the external pressure of empires? Would we endorse democracy with fellow citizens as quarrelsome and headstrong 250 years ago as they are today? Facing revolutionary mobs, might we have followed Mather Byles, who preferred to be ruled by “one tyrant three thousand miles away” rather than by “three thousand tyrants not a mile away’’?

The founders also stand out in their concern for the future. Though the republic was barely born and facing innumerable trials, they considered each act for its precedent, how it would contribute to a well-functioning government that could last centuries, more than its immediate advantage to one interest or another. How many of our politicians, thinking about, say, the size and powers of the Supreme Court, the rules and laws surrounding elections, the limits of executive power, or the Senate filibuster, think foremost about how these rules of the game will play out over decades as each faction takes power in turn, rather than about how it plays to immediate partisan advantage?

Alexander Hamilton exemplified both characteristics. As a financial economist, his prescient financial wisdom stands out to me.

Hamilton faced a situation that echoes today: The United States had a large debt after the Revolutionary War. How would the United States pay off that debt? Would it do so? We have a large debt today, after the war on the financial crisis, the war on COVID, and (to stretch the metaphor) the War on Poverty—expensive social programs all, each fought with prodigious borrowing. How will the United States pay off this debt? Will it do so? Hamilton’s thoughts bear on today’s issue as well.

Hamilton’s 1790 First Report on the Public Credit made the ultimately successful case that the United States should assume from the states and repay Revolutionary War debts. This farsighted and expensive act gave the US the ability to borrow later, enhanced our standing abroad, and inaugurated the financial foundations of our prosperity.

Hamilton starts by arguing that well-managed public debt can be a public benefit—so much so, indeed, that he might have had the government issue debt even if it did not need to do so. That’s a hard proposition even today. Many conservatives would like to see the debt paid off entirely.

It is a well known fact that in countries in which the national debt is properly funded and an object of established confidence, it answers most of the purposes of money.

How is government debt like money? For example,

Trade is extended by it [debt]. . . . the merchant can at the same time afford to trade for smaller profits as his stock, which, when unemployed, brings him in an interest from the government, serves him also as money, when he has a call for it in his commercial operations.

A business needs money. If money pays interest and is also a savings vehicle, the merchant can run his business more efficiently, not scrambling for cash, and at lower cost.

I thought Hamilton’s view a bit nutty when I first read the Report. Government debt is money? Hamilton was 250 years ahead of me. Today’s economists are rediscovering the proposition. US debt is a tremendously useful security. Today’s “dollar dominance” and “safe asset” is much to the benefit of the country. Government debt underlies our vibrant financial system.

Hamilton’s view was visionary. I do not believe it was “well known” then. I suspect he was underplaying its novelty to gain acceptance. Government debt at the time was risky, frequently defaulted, and was hard to buy and sell. The French Revolution going on at the same time was sparked by a grand default on government debt. Safe and money-like government debt as Hamilton envisioned developed in the nineteenth century, not the eighteenth.

Hamilton’s vision is even more astounding given the situation: Who is going to pay for the huge debts run up during the Revolutionary War? Why are we waxing on about debts that function as money when paying any of it back is the urgent problem?

Governments are always tempted to repudiate debts. New and financially strapped governments are especially tempted. Theoretical economics offers support for the idea in the form of a “just this once” repudiation. That theory is a little hazy on how “never again” is then credible. (California’s proposed billionaire tax is stated as a “just this once” tax, which nobody believes.) Hamilton went the other way. The United States will repay the debt. It will stand by its promises. And doing so will give the United States standing in the world, not least the ability to borrow at good terms in the future. Hamilton is thinking about the future, not about the current crisis. As ever.

Need America pay all of her debts? How about debt bought by a speculator at a deep discount, from a poor Revolutionary War soldier in need? Surely speculators should not profit. Even the redoubtable James Madison thought so. But maybe the seller just didn’t have faith in the United States. Maybe the speculator was a patriot, taking on a huge risk and helping the government by propping up the market. Trying to distinguish the moral worth of creditors is a fraught business—advice politicians might heed today.

Questions of this sort, on a close inspection, multiply themselves without end, and demonstrate the injustice of a discrimination even on the most subtle calculations of equity, abstracted from the obligation of contract.

“The obligation of contract.” The debt was issued with a promise it could be sold and bought. And the point: this nation honors its contracts and does not rewrite the terms after the facts. Even when it’s really hard.

It is agreed on all hands that that part of the debt which has been contracted abroad, and is denominated the foreign debt, ought to be provided for according to the precise terms of the contracts relating to it. The discussions which can arise, therefore, will have reference essentially to the domestic part of it, or to that which has been contracted at home. It is to be regretted that there is not the same unanimity of sentiment on this part as on the other.

Would today’s Congress prioritize repaying foreigners? Does it feel that the nation’s honor is at stake in repaying debts? We seem to rip up a lot of contracts these days with little concern for our honor. It would be wise to listen to Hamilton. In debt-ceiling controversies, for example, I wish Hamilton’s successors in office would say that the United States pays principal and interest on its debt ahead of anything else. They do not do so.

Hamilton was visionary, not clairvoyant, and not so pure. Arguably, he could not be. The United States could not repay all the Revolutionary War debt. The United States did discriminate between claimants, and did repudiate some debts. It let the Continental dollar inflate to nothing, along with bills of credit, essentially paper money issued by the states. The United States built a distinct reputation for repaying long-term interest-bearing debt, but not for repaying paper money. Paper money that holds its value is also a useful financial innovation, but it took another century to realize that.

Famously, Hamilton understood that federal assumption of state debts meant that the federal government would have to have the authority to raise taxes to repay debt. Also, assumption would create a class of bondholders interested in sound federal finances.

If all the public creditors receive their dues from one source, distributed with an equal hand, their interest will be the same. And having the same interests, they will unite in the support of the fiscal arrangements of the government.

We shall see if bondholders remain powerful enough to ensure sound finances and debt repayment from our government. Current political thought disdains political influence of wealthy security holders. Europe wishes to issue eurobonds without eurotaxes. They should read Hamilton.

Hamilton understood that debt can be dangerous:

(T)hese good effects of a public debt are only to be looked for when, by being well funded, it has acquired an adequate and stable value.

“Well funded” means the government reliably can and will repay the debt with tax revenues in excess of spending.

Persuaded as the Secretary is that the proper funding of the present debt will render it a national blessing, yet he is so far from acceding to the position . . . that “public debts are public benefits,” a position inviting to prodigality and liable to dangerous abuse.

Today’s “debt doesn’t matter,” “we owe it to ourselves, don’t worry,” and fellow travelers have a long pedigree, inviting our current prodigality and dangerous abuse.

[Hamilton] ardently wishes to see it incorporated as a fundamental maxim in the system of public credit of the United States, that the creation of debt should always be accompanied with the means of extinguishment. This he regards as the true secret for rendering public credit immortal.

“The means of extinguishment” means specific tax revenues or other institutional designs to guarantee repayment.

And he presumes that it is difficult to conceive a situation in which there may not be an adherence to the maxim.

Just wait 250 years. “If you can keep it,” a remark by another favorite founder, may apply to our financial as well as political future.

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Stephen Miran attracted a lot of attention with calculations that foreigners pay for tariffs. President Trump talks frequently about making foreigners pay for things. I also attended an interesting talk at which the speaker bemoaned China’s supposedly “predatory” trade practices.

The immediate criticism of Miran was over whether, indeed, foreigners bear the burden of tariffs. I think that misses the point. Suppose for the sake of argument that they do, 100%. Where do foreigners get the money to pay the tariffs? There is only one way to get the money—sell more things to the US!

Look past the money. Suppose China sends us 100 cars, and we send them 100 tons of wheat. We put in a tariff: For every car that China sells in the US, they have to give one car to the US government. China has to send us 200 cars in return for 100 tons of wheat. Or, we only export 50 tons of wheat to get the 100 cars. Either way, imports rise, exports fall. I’m not sure this is the outcome that trade warriors want!

The President has a businessman’s instinct for getting other people to pay more for your products, or just flat out send you money. But if foreigners send US dollars, where do they get the dollars? By sending us goods and services. If they send us Euros, what do we do with them? Buy European goods and services.

Look past the money. The only way foreigners can pay us, in the end, is to put things on boats and send them over.

It’s interesting that trade warrior’s intuition gets that being paid is good, but not that receiving goods is what being paid is all about.

I heard “predatory” trade practices a few times last week. The most interesting: The speaker acknowledged a question stating that colonialism was “predatory:” The UK forced China and India (so goes the claim) to put things on boats and send them to England. In the next sentence, the speaker claimed that allowing China to enter the WTO was the worst policy mistake of our generation, because of China’s “predatory” trade practices. China puts things on boats, and sends them to us, at artificially low prices, i.e. in return for goods of lesser value. Make up your mind, say I! Either colonial extraction was a great favor by England to China and India, by inducing China and India to develop export industries, or the exact same act is a favor to us not to them.

There’s lots more to trade. Even if Miran’s “optimal tariff” argument is right, and foreigners do pay us, and acknowledging that means they put stuff on boats or trucks and send it to us, is that good? Is the US position in the world to use our “market power” including military force, to get the rest of the world to put things on boats and send them to us for free (at the margin)? If you don’t want to send the Marines to Mexico to take some of their worker’s belongings, just why is doing the same thing by trade policy a good thing overall?

Anyway, it’s always helps to ask where the money goes for a few steps, and to look past the money and figure out what a policy means in terms of underlying real goods and services.

The catastrophic failure of 2008 shows where Kevin Warsh should start

(With Amit Seru)

New Federal Reserve chair Kevin Warsh wants to make fundamental reforms to the central bank. Fixing financial regulation should be high on his list.

The U.S. financial regulatory regime failed catastrophically in 2008. The financial crisis was, at its heart, a classic bank run. Financial institutions lost some money on their assets. People ran to pull their deposits and other short-term investments, leading to a wave of failures. Only a $475 billion bailout from the Treasury Department kept the biggest banks from failing and avoided complete financial collapse.

In the wake of this disaster, leaders had the decency to admit that regulation failed and reforms were needed. But the resulting changes — the Dodd-Frank law and the Fed’s subsidiary regulation — simply piled on the previous approach that focused on managing asset riskiness.

The focus should instead have been on run-prone liabilities. Corporate assets such as data centers and rockets are far riskier than bank assets such as loans and debt securities. Why are the safer assets so much more heavily regulated? Because tech companies are financed by equity. When shareholders lose money, it is not a systemic crisis. Banks are financed with short-term debt (deposits) that can suffer contagious runs and invite government rescues.

The Dodd-Frank reforms were supposed to end bailouts. But in the turmoil of 2020, skeptics were proved right when the Fed and Treasury undertook a second bailout. The central bank intervened in Treasury markets, bailed out money market funds, lent directly to cities and states, and put a floor on corporate debt prices.

In 2023, Silicon Valley Bank collapsed, leading to another bailout. The bank issued large uninsured deposits and invested in long-term Treasurys. When interest rates rose, the value of those Treasurys fell and depositors ran. To stop the run, the Fed and Federal Deposit Insurance Corp. guaranteed uninsured deposits. That guarantee implicitly extends across the banking system — nearly $9 trillion.

Absent that support, many more banks might have gone under. The post-2008 supervisory apparatus — stress tests, liquidity rules, supervisory teams and model-based oversight — missed an elephant in the room: simple interest-rate risk matched to uninsured deposits. It has failed.

The SVB affair was fueled by earlier Fed errors. In the 2010s, banks tried to create segregated accounts and narrow banks. Both innovations back deposits entirely with reserves, eliminating runs and the need for deposit insurance and bailouts. By giving large depositors a risk-free place to park money, they would have forestalled the SVB fiasco. But the Fed has not allowed either innovation, in part to protect the profitable deposit franchise of big banks. Stablecoins — cryptocurrencies tied to tangible assets — are now entering to try to provide the same service, but so far are hobbled because they are not allowed to pay interest.

In the face of onerous regulation, banks retreated from making loans. Fintech companies and private credit stepped in. These unregulated non-banks voluntarily fund themselves with stable long-term financingand substantially more equity. Fintech companies quickly sell off their loans and hold little risk.

Instead of embracing these crisis-insulated institutions, the Fed is considering a reduction in already low bank capital requirements, to help banks recover lost market share. At the Fed, deregulation has come to mean less capital, not fewer rules.

The Fed cannot rewrite Dodd-Frank by itself — only Congress can do that. But the central bank can revise the subsidiary regulations and review its discretionary implementations. Periodically sunsetting and reviewing each rule would be a good start.

Warsh need not reform the big banks. He can instead allow new and innovative competitors to emerge that provide financial services without run-prone funding. He should focus on simple truths: A crisis is a run and only a run is a crisis. Somebody losing money on a risky investment is not a crisis.

Detailed plans to transition to a safe, deregulated and innovative financial system are sitting on the shelf. Risky investments should be funded by equity and long-term debt. Deposits and other runnable liabilities should be backed by safe, liquid assets or much larger capital cushions. Such plans can end private sector financial crises forever. They just need a visionary leader who is willing to put the plans into place.

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It’s not really fair to say that central banks are stuck in adaptive expectations. They have heard about expectations since 1980, and they do think about expectations. They don’t, however, think that expectations react quickly to news, even though expected inflation in the model does react quickly to news. They then preserve the traditional property of the model, that higher interest rates lower inflation going forward, and avoid rational expectations indeterminacies.

Here is my effort to describe how central bankers view the world. This is section 4.10 of the new draft, and an invitation to send me comments about anything in the draft. Usually my job here is to write words about equations. Today the point is to write some simple equations about words.

Sluggish Expectations and the Policy View

Today’s policy world has a more nuanced view than the 1970s adaptive expectations I described above. A distillation of the current policy view might be called “sluggish expectations.”

This view acknowledges that expectations are important, but does not tie them rigidly to past experience (adaptive) or to the model’s predictions of the future (rational). In this philosophy, expectations vary through time and in response to various forces, many external to central bank actions. Expectations eventually respond to experience of inflation, though not in a predictable way. Faith that the central bank will eventually do something can “anchor” expectations through a period of inflation. But that faith and “anchoring” can evaporate, at which point a spiral breaks out. Expectations can also move in response to news about the future such as fiscal matters and other shocks, thus accommodating some of the many historical episodes adduced by forward-looking rational expectations. But this happens rarely, and usually only in large tumultuous episodes.

Central banks also measure expectations in surveys and bond markets. They treat these measures as somewhat exogenous disturbances that they should react to, as well as measures of people’s faith in central banks’ future actions that central banks should try to control by actions and statements.

Most of all, expectations do not react quickly to interest rates, even when the model predicts that actual inflation will react to interest rates. The expectations of the model are still different from the expectations in the model. Economists armed with the model could make a lot of money. That sluggish property preserves most of the traditional doctrines I captured above with adaptive expectations, but with nuance.

(Doctrines: Under adaptive expectations 1) Inflation is unstable under an interest rate peg. 2) Higher interest rates lower inflation, going forward. 3) By following the Taylor rule, central banks stabilize an economy which is naturally unstable. Under rational expectations 1) Inflation is stable under an interest rate peg. 2) Higher interest rates, on their own, raise expected inflation going forward. 3) Inflation is neutral in the long run. 4) Inflation is indeterminate under an interest rate peg. 5) By following a Taylor rule, central banks destabilize the economy and select a single equilibrium.)

To describe this view, I write out a little model,

Here x is output, i is the nominal interest rate, π is inflation, π^e is expected inflation, σ and k are parameters, and the u are disturbances. The first equation is the “IS” equation. It says that higher real interest rates depress output. The second equation is the Phillips curve. It says that higher expected inflation or higher output push inflation up. Those are core central bank beliefs.

Eliminating output x_t, inflation is related to interest rates by

The IS curve gives output directly. I add “demand” and “supply” disturbances, which move inflation and output around and to which the central bank responds. (With adaptive expectations π_t^e=π_t-1 and this is an unstable equation. With rational expectations π_t^e=E_tπ_t+1 it’s stable. That’s the basis for the above doctrines.) The same equation holds at time t+1, and you can verify that the expectations in the model are not the expectations of the model.

Higher inflation expectations π_t^e raise inflation and output right away. So worrying about survey and market expectations is important. But, to our central doctrines, there is no unstable spiral under an interest rate peg so long as expectations do not move, so long as they stay “anchored.” Inflation and deflation starts to spiral when current inflation or deflation starts to feed in to expected inflation. Then an initially slow inflation or deflation can suddenly pick up speed.

That’s why central banks “look through” inflation surges, so long as they believe expectations remain “anchored.” A spurt of inflation coming from shocks to the disturbances u will go away on its own. That inflation may lead to a permanently higher price level, but central banks, having interpreted their mandate as a forward-looking inflation target with bygones bygone, do not care about that.

In 2021, for example, the Fed saw inflation surge. But as its forecasts, survey forecasts, and bond market expectations projected a return to 2% inflation, the Fed saw no urgency to move. The Fed only moved when it saw measures of inflation expectations start to creep up. It then interpreted the swift decline of inflation not as a real interest-rate effect—since real interest rates were still sharply negative, and no recession followed—but as a sign that expectations had been re-anchored by the mere threat of action. Similarly, in discussing how to adapt to tariffs, a “temporary” inflation shock and a one-time price level increase, Waller (2025) argued that the Fed should again “look through” the shock and not respond.

This view also lacks an economic nominal anchor—nothing like the M in MV=PY or B/P = EPV(s) to tie down the price level. The closest it comes is to view anchored expectations as the anchor for actual inflation, with no anchor for the price level. And at best that anchor comes from faith that the Fed would if necessary repeat 1980 in the event that inflation got out of control. Yet the Fed is curiously silent about such energetic measures. Are we at anchor or just floating in a calm sea?

Central banks can always raise interest rates, but they cannot lower rates much below zero. Thus, central banks have greater fear of downward de-anchoring and deflation spirals. Central banks were much more worried about the small deflation in 2008 in the zero bound era than they were about an upward inflation spiral in 2021. (They may also view the costs of deflation as larger than those of inflation.) Likewise, many analysts could attribute the swift inflation decline in 2022 while interest rates stayed well below inflation as a case of re-anchoring expectations, showing what the Fed might do in the future, while worrying earlier that deflationary expectations could become de-anchored and the Fed powerless.

In sum, the contemporary policy view still predicts that inflation and deflation spirals can break out. The absence of a spiral in the zero bound era remains a puzzle. “Expectations did not move” is a little easier epicycle to explain the lack of a spiral, but that ignores the constant contrary worry at the time.

So long as expectations are sluggish, higher nominal interest rates lower inflation. See the coefficient -σk in the last equation. Writing it as

you can see that if expectations rose one-for-one with the nominal interest rate, inflation would rise and output would not move. That non-reactive quality, rather than the rigid adaptive scheme, is crucial to the Fed’s ability to lower inflation with higher interest rates.

However, higher interest rates only move inflation immediately in this little model. As long as inflation does not feed in to expectations, today’s interest rate only affects today’s inflation. There are, so far, no “long and variable lags.” In the adaptive expectations model a small initial inflation gets an expectational snowball going to create more future inflation.

I think the current policy view squares that circle in three ways. First, one can sprinkle lags into these equations to produce some dynamics. For example, people reason that higher interest rates take time to lower demand, via some unspecified friction. Second, lowering future inflation with sluggish expectations requires persistently high interest rates. High interest rates today lower today’s inflation, then high interest rates in the future lower future inflation. This may be a reason that central banks tighten and loosen in long waves. Third and most of all, the time and contingency it takes for inflation to feed in to expectations explains why the lags are both long and variable. A one-period adaptive expectations model produces too fast and too reliable a mechanism. Here, after a period of persistently high interest rates, resulting in a period of persistently low inflation, inflation breaks through people’s attention span. Only then, which may be a year or more later, do people wake up, change expectations, and monetary policy really has its effect.

In this view, expectations are also amenable to suasion by central banker speeches, policy frameworks, and “forward guidance.” If central bankers can talk down expectations, that improves the inflation-output tradeoff of the Phillips curve. The central bank can then lower nominal rates and enjoy lower inflation with no output cost. At the zero bound, central banks try to talk up expectations, such as by announcing a higher target or forward guidance. Indeed, since the Phillips curve in the 2010s seemed flat, with k near 0, much of the central bank view focuses on expectations alone as the determinant of inflation. Most of the art of central banking amounts now to expectations management. (Or at least it did through the end of the Powell era. Kevin Warsh has written about scaling back such efforts.) Alas, speaking loudly without a stick has often failed in the past to contain or boost inflation. Eventually if inflation does not do what central bankers want, they need something more than additional speeches.

****

When Kevin Warsh was nominated in January to be Federal Reserve chair, the monetary policy debate was over how quickly to lower interest rates. The Fed forecast that inflation would return to the central bank’s 2 percent target, already suggesting that interest rates should ease. The debate was over faster cuts. Artificial intelligence, the story goes, will swiftly raise productivity, making everything cheaper. Therefore, the Fed should quickly lower interest rates to steady prices and let wages rise.

Now, one could debate how soon and how reliably AI will create such bounty. One could also debate whether deflation (falling prices) with steady wages induced by AI-led productivity is a problem at all.Everything would become a lot more “affordable,” of course. There’s also an argument that higher real (after adjusting for inflation) interest rates are needed to induce savings and investment to build AI. Whether the Fed should act in anticipation of a productivity bonanza is another question.

But today the Fed faces essentially the opposite problem, a stagflationary shock that looks eerily like 1979. Inflation never really went away. It is now surging, thanks to tariffs and energy costs via a conflict with Iran. Should the central bank fight that inflation by raising rates, swiftly incurring President Donald Trump’s wrath and risking a weaker economy? Or should the Fed once again look through a price-level rise, hoping that the economy will stabilize at higher prices, and swiftly incurring the wrath of regular people already unhappy about today’s high prices?

Warsh, who was confirmed by the Senate last week as chair, has advocated that the Fed reduce its balance sheet by selling assets. Most economists believe reserves past $2 trillion or so have little long-run effect on the economy. But the Fed may be tempted to reduce reserves until bank operations are squeezed, in order to tighten without raising interest rates, a version of monetarist restraint. The United States tried a similar idea in 1980, imposing credit controls by tightening bank regulation. They produced financial chaos and stagnation.

Warsh wants to reexamine the Fed’s models and overall approach. This is wise. Inflation, peaking at 9 percent in June 2022, was a failure that the Fed has not satisfactorily accounted for. It was not an individual failure. The Fed’s actions were backed by consensus in and outside the central bank. It was a collective, conceptual, institutional failure. The models don’t work. The forecasts don’t work. But there is no off-the-shelf alternative. Nobody really knows how monetary policy works, and certainly not with the complex technocratic expertise that the Fed pretends. Other forecasts do not reliably outperform the Fed’s.

The Fed should instead act with more humility. Recognize the fog in which it is trying to steer the ship. Refrain from acting (again) based on forecasts and what-if analyses that have proved unreliable.

Bigger challenges lie ahead. Because the national debt is beyond 100 percent of gross domestic product, every percentage point that the Fed raises interest rates increases interest costs on the debt and thereby the deficit by 1 percent of GDP. Neither Congress nor the president will be happy about that.

Fiscal pressure on the central bank will mount. Today’s precedent for reduced Fed independence is the era from World War II to 1951, when it was obliged to hold down long-term rates for fiscal reasons, not 1972, when President Richard M. Nixon pressured the Fed for election-year ease.

Countries that run uncontrolled deficits soon face higher borrowing costs. The Fed will feel pressure to hold down those costs. “Moderate long-term interest rates” is, after all, part of the Fed’s legal mandate. With the precedents of massive bond buying in the 2010s and again in 2020, it will be hard to resist. Rising yields will also tempt financial repression. The Fed will be tempted to force banks, insurance companies and other institutions to hold Treasury debt, impose capital controls and so on.

That’s the optimistic scenario. In the next crisis, 2020 will replay at a larger scale. The Treasury will want to borrow trillions for bailouts, stimulus and likely military investment. But bond investors will be skittish, having suffered a substantial loss due to inflation last time they lent to the U.S., and with still no plan for the government to start repaying debts. Inflation expectations are primed to jump, so inflation itself can break out even more quickly. Pressure for the Fed to monetize government debt will be immense.

There is a limit to how much the Fed should resist. If Congress and the president want massive money-printing to finance a crisis response, should the central bank really force the government to borrow at much greater cost, spend differently, sharply raise taxes, restructure debt or withdraw from a confrontation? Tax, spending and foreign policy, even if unwise, are far outside the Fed’s limited mandate.

I would rather see a Congress impose a strong price-stability mandate, with restrictions on bond-buying, but one that Congress suspends in times of crisis, as it did under the Troubled Asset Relief Program in 2008. Meanwhile, the Fed needs to face squarely its role in facilitating the fiscal blowout of 2020 and begin to think about resisting next time.

Many challenges lie ahead. But challenges are opportunities. Great leaders are forged by their wisdom in the face of adversity. And every time the president tweets his disapproval, Warsh’s reputation for independence will grow.

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The G7 (Group of 7) economic confab is on in the lovely Evian-Les-Bains, France. A group of distinguished economists produced a report on just what problems the world economy faces and what the G7 should recommend. (Front page here, report here)

The theme:

our global economy is threatened by deep imbalances,

“Imbalance” is usually an economic fallacy. Everything balances. It usually balances somewhere that someone doesn’t like, but that’s a different thing.

What are these “imbalances” and other problems for the G7 to solve?

Predatory competition, industrial overcapacity, underinvestment, excessive debt and deregulation, the retreat of international solidarity, and weak private investment in developing countries…

“Predatory competition?” The very first economic problem in a long report is a longstanding economic fallacy—that large companies drive out competitors and then raise prices to become permanent monopolies. Yeah, Ford and GM locked up the world’s car market in the 1950s. Look up a minute, especially in France. Do you see unrestrained competition among titanic industries, hell-bent on “predation?” Or do you see a vast expanse of government-protected crony-capitalist oligopolies, interspersed with a few upstart companies trying hard to sell you better products? How is the new iPhone “predatory?”

Trade and Growth are good. But for the report, growth must be “balanced,” and trade “reciprocal” What does that mean?

“Overcapacity, underinvestment?” Those seem just a little contradictory, don’t they? If you’re underinvesting, it’s hard to get overcapacity. I presume that the overcapacity is not in the same place as the underinvestment, so it means investment isn’t going where the authors would like it to go. Perhaps capacity and investment are driven by crass considerations such as profitability, rather than addressing “imbalances” which somehow do not create profit opportunities. Likewise, could that “weak private investment in developing countries”—which are really the not-developing countries, of course—have something to do with the general economic dysfunction that makes investment unprofitable?

“excessive debt and deregulation.” Well, I’m on board with excessive government debt. But “excessive deregulation?” Really? In a report written by top economists? In Europe?

“the retreat of international solidarity?” Yeah, we’re not getting along these days, but how is that a problem diagnosable or remediable by economists?

Well, let’s read the report, “the result of several months of work by economists recognized for their expertise in international macroeconomics”

Trade and growth are good. Whew, no “degrowth” here. But only “balanced” growth and “reciprocal” trade. I never saw those in any economics textbook. What do they mean?

Growth is “balanced” when it is durable, resilient, and consistent with national security. Trade is “reciprocal” when it is mutually beneficial for countries.

All that hedging is a way of saying except we don’t like trade deficits. In economics, growth is growth. More is good. How can voluntary trade not be mutually beneficial? China’s not holding a gun to your head to buy that new bicycle. “For countries” must allude to some state interest different from the prosperity of the citizens. But this was supposed to be an economists’ report.

Finally we get to some actual international macroeconomics:

The rise of excessive current account deficits and surpluses reflects increasingly unbalanced growth dynamics in China, the European Union (EU), and the United States (US). China has chronically low domestic consumption, the EU suffers from persistently weak levels of productive investment, and the US has enduring fiscal deficits that are too large relative to economic conditions.

Leaving aside “excessive,”and “imbalanced” which economists have little capacity to measure, there is an important and under-appreciated good piece of economics here. A country, say China, that wishes to save more than it can profitably invest at home, must save by buying assets abroad. (One reason it might want to do that is that few people have children, so the country as a whole must save for its old age.) To buy assets abroad, China must put goods on boats, send them abroad, and take pieces of paper in return. Those pieces of paper promise that someday people in the US will work hard, put things on boats, and send them to China in return for our pieces of paper. Good luck with that, China. Vice versa, a country, say the US, that wishes to consume and invest but does not wish to save can print up those paper promises, and get the Chinese to send both consumption and investment goods. Eventually, though, we have to pay that back by putting goods on boats to support the Chinese in their old age. Or default, devalue, or say “terribly sorry, the stock market crashed.” If properly invested, repayment is more likely. If we simply consume the bounty, then repayment has to come from our children voting themselves big taxes. Good luck with that, China. (You can see a certain doubt in my mind just who is exploiting whom in this game.)

So trade deficits (and more generally current account, which includes goods and services) are balanced by capital account surpluses. “Unbalanced” is an oxymoron. Current-account deficits reflect consumption and savings decisions, not “predatory competition,” tariffs, industrial policies, subsidies, and all the other microeconomic distortions that privilege one exporter vs. another. At least all those economic fallacies, so common in the US today, are absent.

International economists used to worry about the Feldstein-Horioka puzzle: Why did countries, in 1980, largely finance investment from their own saving rather than borrow abroad? Why were current-account deficits and matching capital-account surpluses so small? Trade opened. The world started to look like our model. And now it becomes an “imbalance” needing “policy makers” such as the worthies at the G7 to intervene.

Positing that somehow China’s desire to save rather than consume is “excessive,” what do our G7 advisers propose? “Rebalancing growth” of course, in an endless parade of passive verbs:

Addressing global imbalances [euphamism for trade deficits] requires rebalancing growth…China’s growth can be rebalanced by increasing ‘investment in people’ as prioritized in its 15th Five-Year Plan. This calls for public support for healthcare, safety nets, repairing balance-sheets damaged by the property market crisis…

I can just imagine what a good belly laugh Xi Jinping and his buddies are having at that one. So, dear Europe, you bankrupted your governments with welfare states that provide unaffordable health care, pay money to people not to work, pay retirees full salary for 30 years, supported by non-existent children, and bail out anyone whose “balance-sheet” got “damaged” by a speculative investment, all to artificially subsidize consumption. In the process you destroyed growth as well as pulled in our exports. You really think we are dumb enough to follow you down that road to stagnation, voluntarily, all for “international solidarity?” Ha ha. (Allusion to the wisdom of five-year plans by economists is even curiouser.)

More deeply, where is the market failure? I know how we distort our economies to consumption, but how is China doing the opposite? Ultra-low rates at state banks do the opposite. And, in the end, why do we care? Yes, politics hates trade deficits these days, and has been gung ho on mercantilism since the 1500s. Is that any reason for economists to advocate “rebalancing?”

The European Union should raise its growth potential by implementing key recommendations of the Draghi report, including deeper integration of goods and services markets to increase scale, and further capital markets integration to expand long-term risk capital. The United States can strengthen growth resiliency by reducing its public deficit and reinforcing financial stability. Policy measures to put public debt on a sustainable path are essential.

Yes, EU growth is a real problem. And the Draghi report outlined some important steps. I’m all for deeper integration of goods and capital markets. But ahem, one of the major recommendations of the Draghi report is to unbundle the mass of regulatory red tape and legal vetocracy that stymies getting anything done in Europe, along with job protection and other policies that stop risk taking. Why the silence? Oh, yes, “excessive deregulation” is Europe’s problem. What about Europe’s catastrophic energy policies, that shipped carbon-emitting industry to China? Nobody’s “global imbalance” forced that one. Thank goodness at least they do not sign on to Draghi’s recommendation for debt-financed public investment, like the brilliant Superbonus.

Yes, whatever “resiliency” means, US fiscal and financial policy are a mess. But it’s easy to say “fix them.” Duh, these have not gone un-noticed. How you fix them matters. Raising marginal tax rates to European levels will help to produce European growth.

But listen to the sound of silence here. If you don’t like trade deficits, and find, correctly, the root in China’s saving and our consuming, maybe our domestic policies that subsidize consumption and discourage investment are just a little bit at fault? The US and EU borrowed money, and sent checks to voters on a consumption binge. We heavily tax the return to capital, and then wonder why people consume rather than invest. Doctor heal thyself, before recommending that the patient take your own poison.

They say the problem with France’s economy is that the French language has no word for entrepreneur. It certainly has a lovely word for dirigisme, in full flower in the report’s discussion of financial affairs:

Financial sector imbalances, especially those involving large gross flows, maturity and currency mismatches, and excessive leverage, can generate systemic risks.

Financial sector imbalances should be addressed through prudential policies and enhanced IMF and Financial Stability Board (FSB) surveillance, improved data collection on cross-border exposures of non-bank financial intermediaries (NBFIs) and on crypto assets, system-wide stress testing that incorporates international linkages between banks and NBFIs, and international cooperation on emergency liquidity provision.

The IMF plays a central role in assessing excessive imbalances and conducting bilateral and multilateral surveillance. Continued close cooperation and information sharing among the IMF, WTO, and FSB will strengthen the global capacity to manage both macroeconomic and sectoral imbalances. Complementary data efforts and analysis on non-market practices by the OECD and on cross border exposures by the BIS are highly beneficial.

There you go with that “imbalance” again. I buy a lot of chocolate at Whole Foods. Is that an “imbalance?” How do you measure? Who is to tell? “Large gross flows” are an “imbalance” just because they’re large? Why do firms take on “currency mismatches” and “excessive leverage” if not because they know they’ll get bailed out in the end? Define “systemic risk,” please, and no, it does not mean somebody might lose money.

“Prudential policies” “surveillance” of anything financial, measuring “international linkages,” means applying the Basel/Dodd-Frank apparatus that so spectacularly failed in SVB, in 2020, in Credit Suisse, on an international scale. “Emergency liquidity provision” means Uncle Sam and the ECB to print money every time someone loses money. Isn’t the screaming “vulnerability” and “imbalance” in the Eurozone especially exactly the moral hazard that the ECB’s failed supervision and “emergency liquidity provision” leaves it on the hook for massive sovereign debts? (Selling my book of course, here.)

And of course, who is to do that? The alphabet soup of international organizations, straight off a string of policy successes. I guess they will write more reports like this one. With AI to help, the stream of drivel should expand mightily.

OMG, here it is a few thousands of words in and I’ve only gotten through the executive summary. It doesn’t get better.

*****

Thoughts

What do we learn? For one, I learn the sorry state of the G7 and related international policymaking blob such as the IMF, WTO, FSB, and OECD. Hoover is undertaking a large “commons” project to re-envision international cooperation in economics and national security. It presumes that these sort of organizations and events have outlived any usefulness. I find that presumption amply confirmed.

This post is painful to write. The economists whose names appear on it are truly outstanding. Many are also friends, or at least were until about 5 minutes ago. I want to shake them. What are you doing? How did you lend your good name to this vapid report?

The report brims with between the lines euphemisms, many of which I point out by taking the literal language seriously. “Predatory competition?” yes, I know you mean China and competitive mercantilism. “International Solidarity?” We all know who you’re talking about.

This report violates everything that economics ought to be. Back in Econ 1 you were taught that an “imbalance” or other problem needing policy intervention had to stem from some market failure, or perhaps the unintended consequence of previous interventions. Where do all these “imbalances” come from? No word. Does anyone have the competence to understand the international economic and financial system, diagnose and measure “imbalances?” Hayek is rolling over in his grave. Economists don’t know the gross flows of tomatoes, or the imbalance between the strawberry and blueberry markets. The report pretends to some deep technocratic understanding, of which the fancy words are descriptors for laypeople. No, it’s all made up.

You can tell that the answer and desire for expanded policies drove the question, from all the missing elephants in the room: Western regulation, welfare state, tax disincentives, subsidies and worthless industrial policies. Reforming the current mess and putting out our dumpster fires is so much harder than advocating brave new policies from ever expanding international organizations.

It looks like my friends and colleagues were given a political agenda, “imbalances,” and told to support it. They should have said no.

If you enjoyed my little rant, read Bob Lucas’ masterful review of a report to the OECD in 1977. Bob inspired me long ago. I do not come close to Bob’s masterful style or withering analysis. But as for the alphabet soup economic policy discussion, well, plus ça change, plus c’est la même chose. You will be surprised at just how little things have changed in international Marco policy discussion.

Why should billionaires live high on the hog while so many still live such wretched lives? “Tax the rich, feed the poor / Til there are no rich, no more” sang the rock band 10 Years After in 1971. It’s a centuries-old answer looking for new questions. (They made a lot of money on that song! The song is more like Lennon’s “Revolution,” expressing some skepticism. I remembered the lyrics as “till there are no poor no more,” but the actual lyrics are more accurate descriptions, both of the intention and the likely effect.)

However, the vision of high lifestyle amid destitution imagines great inequality of consumption. The current outrage, and demand for confiscatory taxation, is over inequality of wealth. (And that, largely mark-to-market wealth driven by high prices.) There is a big difference.

The hard fact: Our billionaires, and now trillionaire, own wealth that is almost exclusively stock in companies they created. That wealth is almost entirely left reinvested in those companies. And the companies produce great products, innovate, and employ thousands. Just what is the problem, you might ask, but that’s not our point today.

For example, suppose Elon Musk consumes $10 million a year. It’s hard for any human to consume that much. Still, that’s 1/1000 of 1% of a trillion. At 10% per year, Musk earns that much in less than an hour.

The wealthy do not swim in Scrooge McDuck pools of money that can be handed out. And even if they did, that money, redistributed, would swiftly drive up prices rather than feed everyone. Musk’s trillion is not the ready inventory of a huge grocery store that can be handed out to feed people. And if it were, once the store was empty, the poor would be hungrier again, and there would be no store to buy from.

What would the government do if it took over Musk’s SpaceX stock? At best, the government would use SpaceX earnings to buy and hand out, say, food, rather than invest in the company. Others must then produce food and not rocket ship parts. That means reorienting the productive capacity of the economy away from investment and to consumption. It means less capital going forward. Certainly no rocket ships or AI, and all the benefits those stand to bring.

But most of SpaceX value is not a stream of profits like a railroad’s. Most of its market value is investor’s hope that in the future SpaceX will dream up new and profitable ventures. That value would go poof the minute the government took it and stopped investing. It may go poof anyway.

Perhaps you think the government, by taxing Musk and demanding cash, can force Musk to sell his stock to others who won’t implode SpaceX’s value. But where do others get money to buy SpaceX stock? In the end, it must come from other company’s earnings that won’t be invested in other companies. Again, the economy reorients from investment to consumption. Tax the rich feed the poor, till there are no businesses no more.

Perhaps you think the government can manage SpaceX “for people, not for profits.” It used to. And NASA, though one of the best government agencies, was never able to do what SpaceX can do. Socialism never did turn much of a profit for consumers.

The world’s rich consume very little of their wealth. The worlds’ poor consume a lot of whatever they have. Being poor is not fun. If we split up Musk’s $1 trillion and gave about $100 in Tesla stock to each of the world’s nearly 10 billion people, it’s a good bet they would not be content to consume only 1/10 of a cent extra per year.

There are plenty of other reasons that wealth taxation will not help. Even the billionaires’ wealth, even if it could be transferred and consumed without destroying the seed corn of our economy, is trivial.

This is simply false, and innumerate. 15% of a Trillion is $150 billion. The US alone spends $1.8 Trillion on anti-poverty programs each year, to little effect.

The biggest reason it will not work is the simple one: incentives. If you tax wealth, you tax the activities that create wealth.

Taxing billionaires is not enough. Piketty, Saez, and Stiglitz now want the rest of us to “degrowth” in order to transfer resources to the poor. That doesn’t add up either. Degrowth means producing less too. What are the poor to eat? Penury and depopulation used to be embarrassments of the socialist left. I guess they now features.

I too would love to raise the prosperity of the world’s poor. The goal is not the issue. The issue is whether the wealth tax will help or hurt.

What helps? This graph from Max Roser at Ourworldindata makes the point beautifully:

The x axis is GDP per capita, not time. The y axis is the share living in extreme poverty. In fact, our lifetime has seen the greatest decline in global inequality and global poverty ever seen. What helps the poor? Growth. Capitalism and growth. Degrowth and wealth taxation will push us right back up that slope.

(Thanks to a tweet by Cliff Asness, which I cannot find, where I got this idea.)

What about the large and increasing shock accounting literature? If you read the abstracts, those papers seem to say that supply or relative demand “shocks” were the central cause of inflation, and monetary and fiscal policy had relatively little to do with it. Here are my thoughts. Comments welcome, as I don’t fully understand every paper ever written on the subject. This is a section of an update to “Inflation” that I’m working on, and a counterpart to the last post on supply and demand shocks.

Shock Attribution and Counterfactuals

There is a large and growing academic literature on the causes of the 2020-2022 inflation. Bernanke and Blanchard (2023), Comin, Johnson, and Jones (2023), Smets and Wouters (2024), Bianchi, Faccini, and Melosi (2023), Alves and Violante (2026), Kaplan and Miyahara (2026), and Andolfatto and Martin (2026) are excellent recent examples. In a superficial reading, many of these efforts seem to disagree with my conclusion that an unfunded fiscal expansion was the main cause of inflation. Instead, they seem to attribute inflation to supply, demand, or other shocks. That impression mostly comes from misreading what the calculations actually say.

These and other authors write down specific models based on an IS curve, a Phillips curve, and rules for monetary and fiscal policy.1 The authors add “shocks” to each equation. The shock is just whatever number makes the equation hold exactly. Shocks are seldom independently measured. “Supply” shocks, in particular, are usually shocks to the Phillips curve, which expresses inflation as a function of expected future inflation, output or employment, and the shock. A “supply” shock is an inflation shock, and we really are saying that inflation was caused by an inflation shock.

Solving the model, one can express movement in any variable such as inflation as a sum of past shocks to each of the equations. Then, we can add up how much inflation comes from “demand” (IS curve), “supply” (Phillips curve), monetary (interest rate policy rule), and fiscal (surplus = function of other variables) shocks.

Now, the story I have told agrees that there were large economic dislocations during the pandemic, which show up as shocks to the structural equations of economic models. The government responded to these shocks with monetary and fiscal accommodation, a river of transfers and low interest rates. That response caused inflation. Leaders in charge of fiscal and monetary policy did not wake up one morning and send people $5 trillion worth of checks out of the blue.

The models separate each equation into a rule—how a variable responds to other variables—and the shock. Given my story, the fiscal blowout and monetary tardiness that caused inflation may well have been largely the “rule” part of policy, not the “shock” part, and so are not captured by shock accounting.

“Cause” refers to all the counterfactuals along the way, not just to the initial spark. Had supply and demand shocks not happened, there would not have been inflation. But had monetary and fiscal policy reacted differently, there would equally not have been inflation. Monetary and fiscal policy are not blameless, helpless in the face of a shock.

Following shock-accounting logic, one really should say that a lab-leak shock (or, if you prefer, a wet-market bat-eating shock) caused inflation. But that fact does not mean that we must focus entirely on lab safety and ignore monetary and fiscal policy if we wish to avoid inflation in the future.

You should also be suspicious on economic grounds as well as statistical philosophy of an interpretation that omits monetary and fiscal policy. Every well-specified economic model has a nominal anchor, which is almost always located in monetary or fiscal policy. Supply and other shocks are the carrots that lead the horse of monetary and fiscal policy to pull the cart of inflation. The horse pulls the cart, not the carrot.

Since shocks are almost always measured as the error in an equation of the model, what shocks one measures depends sensitively on the model. These shock-accounting methods must take models literally, not as the quantitative parables that they are. The calculations can then seize on model predictions that we may not feel are robust, or that we may not wish to emphasize in our account of the episode.

For example, Kaplan and Miyahara (2026) specify a new-Keynesian model with heterogenous agents. Unlike many other papers, they include explicit fiscal foundations and the possibility of funded vs. unfunded debt, and they include data on fiscal deficits to measure fiscal policy. Therefore they can find fiscal shocks, which many shock-attribution exercises can’t do even in principle. They also include the stepping on a rake long-term debt mechanism. Still, Kaplan and Miyahara don’t attribute inflation primarily to fiscal shocks. In their model, as in my figure 3.1 (see last post), a fiscal shock causes an immediate inflation jump. But in the data, the first big deficits happened in 2020, while inflation only ramped up in early 2021. Their model concludes that the fiscal shock cannot have caused the inflation.

Now, most users of such models do not view an immediate inflation jump as a robust and trustworthy prediction of the model. Maybe people held on to their Covid-era transfers until the pandemic eased, we say. Maybe “pent-up” demand or “excess” money holdings were spent six months later, we say. Many analysts allow “long and variable lags” when interpreting data via such simple models. Though a simple model describes instant inflation, we know that more complex models can account for a six month lag and we account for that informally. Most empirically oriented models include ad-hoc lags in IS and Phillips curves to produce lagged responses. Below, I give an example of a modified Phillips curve that produces such a lag. In a HANK setup, delay might result from greater idiosyncratic income volatility during the pandemic.

But formal shock attribution does not allow this sort of hand-waving and loose interpretation of a six-month lag. If inflation didn’t happen instantly with the shock, the shock did not cause the inflation, period. That is logically impeccable, treating the model as a literal description of reality. But once you understand the evidence, and the necessary and valuable simplification inherent in economic models, you might want to weigh the evidence less decisively.

I offered a different story (or epicycle or excuse if you wish) for the lag between the first fiscal expansion and inflation: Initially, people expected the additional debt to be repaid, as recession and crisis borrowing usually are repaid. People changed their expectations of repayment in early 2021 when they saw the unusual additional fiscal largesse of that year, and learned of the government’s plans for permanent additional spending.

None of the above papers can detect such a shock. Kaplan and Miyahara, for example, assume a single value for the fraction of any deficit that is expected to be repaid, applied both in 2020 and 2021. Now, one should rightly resist too many epicycles, complications, model extensions, shocks, and ex-post excuses. I certainly cannot complain that other authors didn’t come up with that story. One may dislike my story for many reasons. But now we understand how we come to different conclusions. (Bassetto and Miller (2025) tell a related story, that a bit of inflation causes people to get more information, which if negative can cause inflation to surge.)

Shock accounting is useful. It is useful to know that the pandemic saw big errors in the Phillips curve or technology side of a given model, unlike similar decompositions of 2008 in which “demand” (preference or financial intermediation) shocks predominate. That finding corroborates my interpretation that we got inflation because leaders thought incorrectly that they were seeing a demand shock. But do not interpret shock accounting to say what it does not say.

Since “cause” means counterfactuals, one can address the roles of monetary and fiscal policy in these frameworks by asking counterfactual questions. What alternative outcomes would we have seen if monetary and fiscal policy had acted differently; if they had followed different rules, facing the same set of economic shocks, or if governments had introduced policy shocks to offset shocks in other equations?

For example, Kaplan and Miyahara (2026) calculate counterfactual outcomes, including one with no unfunded fiscal stimulus. Absent the stimulus, they find that a larger deflation and GDP decline would have occurred as a result of the initial demand shocks. When supply (productivity) shocks hit, Kaplan and Miyahara find that a short-run inflation would still have occurred, but the long-run price level would not have risen as much.

In many other models, unfunded fiscal shocks are ruled out a priori, or the nominal anchor is implicit so we can’t evaluate alternative policies. In particular, a standard new-Keynesian model specifies passive fiscal policy. It thereby assumes that there is no such thing as an unfunded fiscal expansion. Equivalently, it specifies that surpluses adapt to inflation determined by other shocks to the model, so what I call a fiscal shock is defined as a fiscal rule response.

An Example

To make these points concrete, I reduce the typical new-Keynesian model down to the flexible-price limit, consisting of a Fisher equation combining IS and Phillips curves, and an interest-rate policy rule following the Taylor principle. Adding disturbances,

Eliminating the interest rate i_t, the equilibrium condition is

Iterating forward with ϕ > 1, and imposing a rule that expected inflation may not explode, the solution is

Adding

inflation and output are expressed as a sum of underlying shocks ε_t and δ_t.

We can recover a time series of the disturbances and thus shocks from data on interest rate and inflation by inverting the model solution,

Now we can compute what fraction of inflation and interest rate outcomes come from the real disturbances u_t and shocks ε_t vs. the policy disturbances and shocks v_t and δ_t.

In this model, if data followed i_t = ηπ_t, interest rates rising somewhat less than inflation, then we would say that a monetary policy shock accounts for inflation. If data follow the policy rule, i_t = ϕπ_t, we would say that the real shock accounts for inflation. Though interest rates moved strongly, they followed the rule, not a shock. In a counterfactual analysis, we can say that if the central bank had followed a different rule, with larger reaction ϕ, the model predicts less inflation for a given real shock.

Inflation that came with no movement in interest rates, as we experienced in 2021, would be attributed to a real v_t =−ϕπ_t combined with a monetary-policy shock u_t =−(ϕ−ρ)/(ϕ−η)ηπ_t.

Not moving can be a shock. However, when two shocks happen at the same time, authors often attribute one as the reaction to the other, so the shock attribution could come out differently. The correlation of such shocks is part of the assumed rule.

Actual decompositions get different results because they use different (and much more realistic) models. In particular, they avoid the implication of a big monetary policy shock arising from high inflation and no change in interest rates because the policy rule reacts to the pandemic contraction in output or employment, and moves slowly with lagged interest rates on the right hand side.

Where is fiscal policy? What if the inflation were due to a big fiscal expansion, as I have argued, undertaken either as a predictable reaction to events or as a “shock,” much bigger than usual given those events? Where is the nominal anchor anyway?

A full specification of this model includes government debt. The price level is connected to the expected present value of surpluses, and unexpected inflation is connected to the revision in that present value,

New-Keynesian models assume “passive” fiscal policy, that surpluses respond to inflation as determined above. Thus all fiscal policy, even the trillions of the covid and post-covid eras, is assigned as part of the “rule” not the “shock,” so shock-attribution analysis ignores it.

Supply and Demand Shocks

To get a sense of this analysis recall the effects of fiscal, supply and demand shocks, and monetary policy shocks. (These are the same as in the last post, making slightly different points today.)

A “demand” shock is a shock to the IS curve, a change in the natural real interest rate or in the consumer’s impatience or discount factor, a u_d,t. This shock raises output and inflation.

The “supply” shock is a shock to the Phillips curve, an increase in inflation given future inflation and output. I graph a negative supply shock, which is also inflationary. The path of inflation is, here, exactly the same as it is for the demand shock. Output, however, declines. Negative supply shocks are stagflationary. Again, with no change to monetary or fiscal policy, the price level returns to its previous level.

The monetary policy shock lowers inflation and output temporarily,, but inflation eventually rises. I didn’t plot the price level, but that rises in the long run as well.

Now, a shock accounting exercise looks at data, and tries to figure out which shock or combination of shocks happened at each date. My simple model, like many models, doesn’t allow for any lagged inflation effects: inflation jumps on the day of the shock, then recedes. It doesn’t build up. So, the shock accounting exercise can’t attribute next month’s inflation to today’s shock.

The main piece of information that a shock accounting exercise can use is the relative size of inflation, output, fiscal surplus, interest rate, and other variables. Easy: how do you tell if inflation comes from supply or demand? You look whether output goes up or down. But how do you tell demand from a fiscal shock? They look nearly the same. The huge difference lies in the long run price response. But as I reverse-engineer it, the long-run response is not really used in the shock accounting exercise. That exercise looks at how each equation fails in the moment. How does information that the price level rose three years later feed in to the shock estimate? It does, a little bit: A shock today rises the baseline from which we estimate shocks in the future. But I can’t see how the fact that the price level rises in the future feeds back to shock estimation today. The overall fit of the model, trying to minimize shocks, shows up in parameter estimates. The fact of a huge deficit says fiscal shock, but only if you look at deficits (many shock accounting exercises don’t) and only if you take a stand on whether deficits can be partially unfunded (many shock accounting exercises assume all deficits are funded, hence non-inflationary by assumption).

I won’t do a formal fitting exercise here but looking at the graphs I think we can tell as story somewhat parallel to Kaplan and Miyahara (2026). The main difference, they assume that all fiscal shocks have the same repayment fraction; I add the idea of a “fiscal shock” coming in 2021 as expected repayment changed. Also, I’ll allow myself a little bit more long-and-variable-lag flexibility.

To create a massive output fall with a slight deflation, it’s reasonable that the pandemic featured a deflationary demand shock and a slightly smaller inflationary (negative) supply shock. I call it a snowstorm shock: the stores are closed, and nobody wants to go out. What many missed, it’s also a transitory, V shaped shock. As the pandemic eased, the demand shock eased and the supply shock grew larger, turning in to the beginnings of inflation. The government responded with fiscal stimulus. This raised the level of output, but added to inflation. As it became clear that the fiscal expansion would not be repaid, the inflation really took off. A year later, the Fed stepped in, adding the monetary policy response. This brought down inflation initially, at the cost of the persistent inflation we now see. The tell-tale that inflation was really due to the fiscal stimulus and monetary policy is that the price level remained in the end 20% larger. Supply and demand shocks cannot do that.

Ultimate initial impulses are not important. Causes are about what if something else had happened. Clearly, if fiscal policy had not responded as it did, we would not have had a permanent 20% price rise. We might have had a lot lower output in the pandemic. We would have had transitory bouts of inflation or deflation.

The big issue here is not which calculation is right or wrong. All models make assumptions, and all tie data to mechanisms through models. The point is that one must understand how model-based calculations work, what questions they are and are not answering, what restrictions they put on the data, and weigh the evidence. “Our calculations show supply shocks caused inflation” does not really say what it sounds like it says.

One cannot take summary conclusions as proof by black box.

1

For example,

Take a stock New-Keynesian model, adding FTPL with short-term debt. The model is an IS curve with a “demand” shock, a Calvo Phillips curve with a “supply” shock, an interest rate rule, and unexpected inflation = the revision in present value of future surpluses. With sticky prices, the real interest rate can vary. Interest costs on the debt can vary, and the present value of surpluses is lower when real interest rates are higher.

Here is the response of that model to an unfunded fiscal expansion—a decline in surpluses—with no change in interest rate. Inflation surges, but then goes away. In the long run the price level rises. Bondholders lose by a period of low real interest rates — inflation above the nominal rate. In the short run the present value relation B/P = present value of s holds, though B and P have not changed, because the lower real interest rate balances the lower surpluses s. Output surges, following the Phillips curve.

That’s old news. The supply shock:

This is an AR(1) shock to the Phillips curve, with no change in interest rate and no change in surplus — no change in monetary or fiscal policy. A “supply” shock is really just an inflation shock. Inflation = expected inflation + (constant) times output + shock. So, no surprise, inflation surges. Output declines. It’s a stagflationary shock, and we move away from the Philips curve.

Here is a “demand” shock to the IS curve, again with no change in monetary (interest rate) or fiscal (surplus) policy

The inflation is exactly the same. This time, following the Phillips curve, inflation produces a strong output response as it did in response to the fiscal shock.

A lot of papers invert the model solution to find which shocks caused inflation in 2021-2022. As you can see, since the inflation pattern is broadly similar, that hinges on the joint behavior of output and inflation. I won’t delve in to that issue here.

Nominal anchors

What about the nominal anchor? When people say “supply” or “demand” (or “greed” or “monopoly” or “price-gouging”) cased inflation, I, like many economists, respond: Don’t confuse relative prices with the price level. The price level always in the end comes from monetary or fiscal policy. But here we have “supply” and “demand” shocks moving inflation, though there is explicitly no change in monetary or fiscal policy.

You can see a big difference in the fiscal shock vs. the supply and demand shocks: only the fiscal shock permanently changes the price level. Not shown, higher interest rates also raise the price level in the long run. So it seems that the nominal anchor is a weak force, that applies in the long run. Supply, demand, and other relative-price shocks can move inflation around in the short run. Maybe inflation is, for a while, just the sum of price changes. When A raises a price, maybe it takes a while for money supply or fiscal theory to drag B’s price down.

That’s tempting, but it’s false. Remember discount rates. With sticky prices, the real interest rate or discount rate part of the present value formula changes. Higher discount rates, or higher interest costs on the debt, lower the present value of surpluses and raise the price level.

Look for example at the response to the demand shock. The period of negative real interest rates (inflation above nominal rate) is initially balanced by the later period of positive real interest rates. There is, initially, no change to the present value of surpluses and no change to the price level. Later, some of the period of negative real interest rates has passed. Now higher real interest rates dominate the present value. The (still unchanged) surpluses are discounted at a higher rate. The price level is higher. Real interest rates eventually revert, so the present value and the price level eventually go back to where it started.

So the price level is always controlled by the nominal anchor, even in these simulations. Real and relative-price shocks do not of themselves change inflation. We don’t go back to thinking of inflation as just the sum of price and wage decisions. But the nominal anchor is the discounted value of surpluses, not surpluses themselves. Other shocks, by inducing changes in the real rate of interest, induce changes in the nominal anchor. Monetary and fiscal policy would have to actively offset those changes if they wished to produce a steady price level.

You could still view the undiscounted nominal anchor as a long-run attractor. The discount rate soaks up other shocks so that the present value relation still holds. In that way you could still think of supply and demand shocks themselves causing inflation, and the real interest rate just soaking up variation so that the present value relation holds. But equalities are equalities and it’s dangerous to think about which one causes which, which equation is stronger than another, and which direction causality runs.

The importance of discount rate variation in the present value formula in all of thse responses offers a good reason why fiscal theory is not immediately noticeable to practical people.

The situation is a bit like that in monetarist thinking based on MV(.)=PY. without a change in M, you think, there can be no change in PY. But if there are shocks to V, then though M still controls PY at the margin, PY can change with no change in M. In this situation, however, we have much less modeling just how V does depend on other events. It does look a lot more endogenous in the short run, and M a longer-run weak nominal anchor. My new-Keynesian model is much clearer about how real interest rates enter the present value of surpluses. But perhaps the endogenous-velocity sort of intuition is more important in reality.

Shock Accounting

I initially offered the first graph as the central story of 2021-2022 inflation. The huge unfunded fiscal expansion of the pandemic and post-pandemic years caused a surge of inflation. Later (see “Inflation,” I don’t want to repeat all the graphs) the Fed raised interest rates, which brought inflation down more swiftly at the cost of the persistent small inflation which we see now.

But the first graph predicts a surge of output as well. Well, said I, the government did this fiscal expansion precisely to stimulate output, because other shocks were lowering output. I left that vague. Supply and demand shocks offer a chance to be more precise about that.

The inflation path in the supply and demand shock is exactly the same. So, imagine a simultaneous positive demand and negative supply shock. You can add up the responses. I call the pandemic a snowstorm shock. People don’t want to go out to dinner, and the restaurants are all closed anyway. The two inflation paths cancel, leaving a huge output decline. The government responds to that output decline with the unfunded fiscal expansion. Now we get the inflation of the first graph, with a moderated output decline.

Shock-accounting exercises offer a nuanced version of that story. A larger demand shock comes first, so there is a little bit of deflation. The supply shock comes second, setting off inflation. Most of those efforts count fiscal policy as a passive response, so don’t call it a shock, but it’s there.

But in the end, these miss the point. In our episode, the price level rose 20%. The only way the price level can rise permanently is with a monetary or fiscal policy shock. In this case, the fiscal expansion is clearly the culprit. Or the savior. The government did trade off more inflation for less output decline (see first graph).

***

The model:

I use theta = 0 and ui = 0 to make these graphs.

***

New Federal Reserve chair Kevin Warsh wants to make fundamental reforms to the central bank. Fixing financial regulation should be high on his list.

The U.S. financial regulatory regime failed catastrophically in 2008. The financial crisis was, at its heart, a classic bank run. Financial institutions lost some money on their assets. People ran to pull their deposits and other short-term investments, leading to a wave of failures. Only a $475 billion bailout from the Treasury Department kept the biggest banks from failing and avoided complete financial collapse.

In the wake of this disaster, leaders had the decency to admit that regulation failed and reforms were needed. But the resulting changes — the Dodd-Frank law and the Fed’s subsidiary regulation — simply piled on the previous approach that focused on managing asset riskiness.

The focus should instead have been on run-prone liabilities. Corporate assets such as data centers and rockets are far riskier than bank assets such as loans and debt securities. Why are the safer assets so much more heavily regulated? Because tech companies are financed by equity. When shareholders lose money, it is not a systemic crisis. Banks are financed with short-term debt (deposits) that can suffer contagious runs and invite government rescues.

The Dodd-Frank reforms were supposed to end bailouts. But in the turmoil of 2020, skeptics were proved right when the Fed and Treasury undertook a second bailout. The central bank intervened in Treasury markets, bailed out money market funds, lent directly to cities and states, and put a floor on corporate debt prices.

…

The rest here, and full version in a month.

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As the new CPI data came out hot, I can’t resist updating the comparison to the 1970s. Is it fair? Much is different. Much is not.

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Don’t kill the golden goose

It’s easy to reduce income inequality: Imprison the billionaires. Burn the evil capitalist businesses that generate their wealth and seduce us with wonders—iPhones, software, electric cars, Amazon, Walmart, miracle drugs, and so on. There, feel better?

Our billionaires kept a fraction of the benefit they generated for us by starting these innovative businesses. Their great wealth remains reinvested in those companies to serve us even better in the future. Just what is the problem?

It is right to worry about people of lesser means. But how does a kid who works at a carwash in Fresno even know how many billionaires there are, or what their net worth is?

We should worry about opportunity. Teachers’ unions destroyed his schools. Construction restrictions make moving to good jobs impossible. Business regulations, taxes, minimum wages and occupational licenses limit his opportunities. Social programs trap him by taking away a dollar of benefits for each dollar of earnings. To provide opportunity, start by getting out of the way.

Many people who worry about inequality hope to improve this kid’s life by taxing the innovators to send him a few more government checks—so long as he stays poor. But there aren’t enough billionaires to make a dent in the government’s ravenous appetite. And what a horrible vision: entrenched misery and idleness, in a stagnant society devoid of innovators, made only a bit better by a dwindling government check and dysfunctional social-service programs.

Others who decry inequality want taxes to reduce the political power of the wealthy. But that hands even more power to the government. Fairly won inequality does not threaten democracy. Confiscatory taxation does. Don’t kill the golden goose.

*****

Forgive my brevity, there was a severe word count limit on this one. For an older and more comprehensive view, see this essay.

The other contributors were Emanuel Saez: “Tax the billionaires,” (to whom my first sentence is dedicated, with initially more colorful options), Raj Chetty: “Focus on upward mobility” (yes), Heather Boushey “Break monopolies” (Unions, more government spending), and Glenn Hubbard “Retrain workers for an AI-dominated economy” (I like Glenn a lot, but it was only 5 years ago that there was huge enthusiasm for retraining everyone to learn to code.) But you’ll have to go to WSJ for those.

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