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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Independence, Structure, and Risks Ahead for Central Banks

The Hoover Institution convened its annual Hoover Monetary Policy Conference May 7-8, 2026, with scholars gathering to explore themes of Independence, Structure, and Risks Ahead for Central Banks. Michael Bordo, John Cochrane and Valerie Ramey organized the conference.

The Federal Reserve is in a period of transition and structural challenges. The chairman of the Federal Reserve’s term has ended, and a successor has been confirmed. Inflation has not fully returned to target, and new shocks, a tariff wave, and a rise in the price of oil, have pushed inflation back up. Fiscal deficits remain large. The dollar’s share of global reserves and of foreign holdings of Treasury debt has been falling for two decades. And a wave of enthusiasm about artificial intelligence has begun to reshape expectations about growth, inflation, and interest rates, including much optimism but also much fear.

The conference took up a connected set of questions about whether central banks can remain independent, necessary, and accountable all at once, as risks old and new continue to appear and recede.

Where are the legal and institutional foundations of central bank independence strong and where are they exposed? How are fiscal pressures and the changing status of the dollar reshaping the environment in which monetary policy operates? What mandate, what tools, and what accountability framework should a central bank have? How should financial stability and bank supervision be recalibrated after the great inflation of 2021 and 2022 and the bank failures of 2023? And what does an era of localization, geopolitical competition, and an anticipated AI boom imply for inflation, growth, and interest rates?

Opening Remarks

Hoover Senior Fellow Valerie Ramey welcomed participants to the conference, which John Taylor and George Shultz launched more than a decade ago.

Condoleezza Rice, Hoover Institution director and the former secretary of state, spoke of the international setting. The world, she said, is in transition from one international economy to another. Eighty years of a system the United States and its allies built after the Second World War is being left behind. It was a positive-sum system in which wealth was produced by trade and cooperation, protected by American military power. Through the Cold War, she said, the international economy and national security ran on parallel tracks, because the Soviet Union was a military giant, but limited in an economic and technological sense. China has changed that. The two tracks have converged, and it is no longer possible to discuss the international economy without discussing national security.

The conference, she urged, should treat technology, national security, and the international economy as one conversation. She closed with a warning that the United States, long the gravitational center that held the postwar order in orbit, now seems to be one of the sources of instability. The United States, with its size and power, should at least not be a great source of global uncertainty.

Independence and Governance

Hoover Senior Fellow John Cochrane chaired the opening session, which examined central bank independence through practice, history, and present-day legal vulnerability.

Edward Nelson (Federal Reserve Board) surveyed how Fed independence has operated in practice, with a focus on the period from William McChesney Martin through Alan Greenspan. He distinguished instrument independence from goal independence. The Federal Reserve chair conferring with the executive on shared objectives is not a loss of independence, while setting the instrument under outside direction would be. On that test, he argued, there is only one clear-cut historical case of lost independence: the period before the 1951 Treasury Accord in which the Fed explicitly agreed to support the price of long-term bonds. In the years prior to 1951, the Federal Open Market Committee and the Truman administration fought openly about interest rates, with the FOMC urging higher rates in the years after World War II to curb high inflation. Nelson, looking at the extensive record, cast doubt on the oft-told story that President Nixon pressured the Fed to keep interest rates low in the runup to the 1972 election. As in many other episodes, the Fed kept policy loose of its own accord, based on Arthur Burns’s views that price and wage controls would be effective.

Gary Richardson (UC-Irvine) placed central bank independence in US constitutional history. An independent central bank is an old political idea, rooted in the founding-era debates over the First and Second Banks of the United States. The initial ambiguity over a central bank’s constitutionality was settled by Hamilton’s implied-powers argument in McCulloch v. Maryland. Richardson traced three great reforms: the quasi-private regional design of 1913, the centralized structure of 1935, and the clarified mandate and semiannual reporting of 1977. On the recent presidential challenge against Jerome Powell, he opined that the system is working as designed. The board did its job in resisting pressure, while the Senate and the Supreme Court did their jobs by doing relatively little. Little was enough, because if the Senate and the court do not act, the president cannot exercise control over the Federal Reserve.

David Wilcox (Peterson Institute for International Economics) offered a darker view. The pillars of Fed independence include the staggered terms of governors, the exemption from appropriations, and “for cause” removal protection. A current central vulnerability, he argued, sits in the reappointment of Reserve Bank presidents. Section 11(f) of the Federal Reserve Act lets the Board of Governors remove an officer or director of a Reserve Bank on language weaker than the “for cause” protection that shields governors. Also, a quirk of the system puts all governors up for reappointment in years numbered 1 and 6. A determined two-term president, guaranteed several board appointments, could in principle install governors willing to remove all dissenting Reserve Bank presidents. If a court ruled that Reserve Bank presidents lack effective “for cause” protection, he said, independence could falter by this mechanism.

Fiscal and Monetary Policy Interactions

Oliver Bush of the London School of Economics chaired the second session, on the interactions between fiscal and monetary policy. The three presenters shared a worry: that fiscal pressure is changing the ground on which monetary policy stands.

Michael Bordo (Hoover Institution and Rutgers University) covered two centuries of British fiscal history. He opened with the oldest question in fiscal policy: how should government debt be wisely used? In the UK, the classic “Treasury view” of fiscal discipline held that the government should borrow only in time of dire necessity, such as a war, but not otherwise. The government should then reliably repay, including restoring the currency to gold parity. In part, reliable repayment allows the government to borrow on good terms in the first place. Robert Barro’s tax-smoothing analysis is the basis of modern understanding of this view. The Treasury view dominated before the Great Depression and Second World War. Keynesian demand management displaced it, attaching to fiscal policy objectives that had little to do with wartime necessity or debt sustainability. Intentional deficits should stimulate the economy, with little concern over whether the expenditure was per se worthwhile or eventual repayment. The Treasury view was gradually restored in the 1980s and 1990s. The British record of very high inflation in the 1970s is a natural experiment in what happens when fiscal objectives drift from sustainability and in what it takes to recover the prior norm.

Barry Eichengreen (UC-Berkeley) documented the erosion of the dollar’s dominance as the world’s reserve currency. The US share of allocated foreign exchange reserves fell from 72 percent in 2001 to 56 percent in 2025, and foreign central bank holdings of US Treasury debt from roughly 40 percent to about 14 percent. He tied the risk of fiscal dominance to the trajectory of US debt and to political polarization. He anchored the analysis on the Bohn test, which asks whether the primary surplus responds positively to the debt ratio. Currently, low interest costs seemed to seduce our governments into borrowing, but large debts have not induced restraint.

Hanno Lustig (Stanford Graduate School of Business) argued that the special place of Treasury debt is evaporating. Before 2020, Treasuries provided a large convenience yield or liquidity premium. Investors accepted lower yields and paid higher prices than Treasuries’ fundamentals justify. In Lustig’s analysis, that convenience yield has evaporated, at least on the margin. Investors, in his reading, have moved from treating Treasuries as safe, liquid, money-like debt to pricing them as risky debt. Liquid asset provision can no longer substitute for fiscal discipline.

The session converged on the monetary policy question: how should central bankers proceed in the face of sustained fiscal pressure? There will be fiscal pressure to monetize debt and hold down both short and long-term interest rates, especially in the next crisis.

International Issues

Sebastian Edwards chaired the third session, which weighed the international issues: what the dollar’s reserve-currency status is worth, what the recent tariffs are doing to trade and prices, and what holds dollar dominance in place.

Arvind Krishnamurthy (Stanford Graduate School of Business) walked through a calibrated computation of what the dollar’s reserve-currency status is worth. The United States, he argued, exports safe dollar debt the way Taiwan exports semiconductors, and uses that exported value to buy consumption goods. If world demand for dollar assets disappeared, the dollar would depreciate by around 9 percent, and the natural rate of interest would rise by about a percentage point. The annual seigniorage, or the profit the US government or central bank earns by issuing currency, is around 1 percent of GDP. He said this seigniorage has a present value of roughly $33 trillion, almost a year’s GDP, built into bank capitalization, into housing finance through mortgage rates, and into the implicit tax burden through the value of government debt. It is worth recognizing the size of this asset, he concluded, before choosing to give it away.

Stephen Redding (Stanford University) gave a trade economist’s account of recent trade policy. The average import-weighted US tariff had fallen below 2 percent by the mid-2010s. The tariff waves of 2018 and 2019 and of 2025 and 2026 raised protection toward levels last seen under Smoot-Hawley in the 1930s. He documented a “great reallocation” of US import sourcing, with China’s share down from a 2015 peak above 20 percent to around 11 percent, substituted by Vietnam, Taiwan, and Mexico, though indirect exposure to China remains. The direct price-level effect of the tariffs, he judged, is real but modest, on the order of half to a full percentage point on the consumer price index. It has mostly been absorbed by US consumers, importers, and retailers. He noted a puzzle: tariffs should raise the exchange rate. The difference between savings and investment drives the overall trade balance, so a higher exchange rate leaves the dollar price of imports the same. But the dollar did not appreciate on the day of the largest 2025 tariff announcement. That outcome might be explained by a breakdown of the flight-to-safety pattern Lustig had described. Raising tariffs makes the United States a riskier lender, which lowers the exchange rate.

Kenneth Rogoff (Harvard University) broadened the framework to consider political economy, drawing on his recent book Our Dollar, Your Problem. Macroeconomists neglected political economy, he said. The 2010s consensus that inflation was dead and rates would stay low was a product of that abandonment. Krishnamurthy priced one advantage of dominant-currency status. Rogoff added others. Sanctions are a first one: dollar dominance allows the United States to inflict pain on other countries through sanctions, though overuse induces those countries to construct alternatives. The information that flows from so many transactions touching the dollar is another advantage. Dollar swap lines, in which the United States lends dollars to foreign central banks, are part of the dollar’s anchoring of the global financial system: we are essentially other countries’ lender of last resort. The dollar’s status carries costs too. There is the “exorbitant duty,” by which the dollar appreciates in bad times and the United States suffers losses on its foreign asset holdings, though it benefits from cheaper goods. And there is the requirement of a military, because in his view no country sustains a dominant currency without a dominant military. Rogoff read 2015 as the peak of dollar dominance. He was skeptical that artificial intelligence is disinflationary. The Fed sets inflation over the long run, he said. The real question is what AI does to the real rate of interest. Like most productivity shocks, if AI raises productivity that should push up the real rate, to induce people not to spend now riches that lie ahead, and to save in order to provide the investment funds that AI will need.

Mandate, Tools, and Regulation

Hoover Senior Fellow Valerie Ramey chaired the fourth session, which discussed interactions between the Fed chair and other officials, and focused on the scope of and nature of central bank mandates.

Thomas Drechsel (University of Maryland) discussed his research that uses meeting calendars to track how Fed officials interact with other government officials. Who do Fed chairs actually meet and talk to, and how often? A notable finding: Chair Powell met with members of Congress dramatically more than his two predecessors, most often with the leadership of the Senate Banking Committee or the House Financial Services Committee. Powell, in Drechsel’s reading, proactively built relationships with Congress. Drechsel also used presidential calendars extending back to 1933 to record the frequency of interactions between presidents and Fed chairs. He reported that President Nixon and Arthur Burns met 160 times, while President Clinton met Fed officials only six times. Inflation, however, was much less of an issue in the 1990s. Relevant to Fed independence, he found that more frequent interactions led to higher subsequent inflation even after accounting for current inflation.

Luis Garicano (London School of Economics) used the European Central Bank (ECB) example to argue that a narrow legal mandate is necessary but not sufficient. The ECB has drifted from its narrow price-stability mandate and has vastly expanded the scope of its activities. The ECB uses two open-ended rationalizations: protecting “monetary transmission” through “dysfunctional” or “fragmented” markets and ensuring “financial stability.” Garicano traced three resulting dominances: fiscal dominance through quantitative easing and spread-compression tools, financial dominance through emergency and subsidized lending, and climate dominance through treating climate risk as a price-stability risk. Moral hazard is the result. Europe expects bailouts, so politicians do not clean their fiscal houses. The November 2025 French pension-reform reversal is a clean illustration.

The ECB has greater independence but weak accountability. A central bank needs both. Though the ECB has a narrow-written mandate, the oversight committees of the European Parliament are ineffective to control the ECB’s slow expansion of that mandate to include sovereign bailouts, fiscal transfers, and other interventions.

Carolyn Wilkins (Princeton University) argued that the analytical framework for monetary policy is reasonably mature, while the one for financial stability is not. Monetary policy has a measurable mandate. Financial stability does not. Success is when nothing happens, and the costs are visible while the benefits are only counterfactual. Wilkins also argued that a central bank’s everyday balance-sheet operations should be subject to governance different from the extraordinary balance-sheet tools it deploys in financial stress or when interest rates hit the lower bound. Durable independence, she argued, rests on institutional design, citing the Bank of England’s separation of its prudential-regulation chief from its Monetary Policy Committee, and on independent external evaluation. No student, she observed, should set and grade their own exam.

Risks, Challenges, and Opportunities

Hoover Senior Fellow Ross Levine chaired the fifth session, which ranged from the forces reshaping the macroeconomy to the size of the Fed’s balance sheet to the reorientation of financial stability policy.

Marvin Barth (Thematic Markets) gave a market forecaster’s account of what drives global markets. Four forces, in his telling, are jointly pushing up potential growth, neutral rates, and inflation persistence. The first is localization, where automation makes producing near high-value customers cheaper than a global supply chain. Globalization becomes the first casualty of artificial intelligence. Second, self-fulfilling expectations: flexible average inflation targeting unhinged inflation expectations. Third, global entropy. The West forgot that power comes from the capacity to manufacture. China did not. And finally, the politics of rage, which he argued cannot be educated away. Barth pressed the issue of Fed accountability. Actual growth has outpaced the most optimistic FOMC trend estimates for over a decade, he said, and the Powell Fed has had the lowest rate of dissent since the 1951 Treasury Accord.

Darrell Duffie (Stanford Graduate School of Business and Hoover) explained that reducing the Fed’s balance sheet, now above $6 trillion, is not so easy. The balance sheet is constrained by liabilities more than by assets. Reserve balances, about $2.9 trillion, are the dominant liability. Why does the system need that many reserves when only $10 billion sufficed in 2007? Post-crisis liquidity regulation has sharply increased the minimum necessary reserves. This regulation has effectively told the largest banks not to lean on the Fed for intraday liquidity, so they must always have enough reserves to cover payments. For example, banks cannot rely on borrowing from the Fed or intraday overdrafts to match payments that come even an hour before receipts. Duffie offered four ideas for cutting the demand for reserves, in ascending order of difficulty: temporary open-market operations to smooth daily swings; getting banks to use the Fed’s intraday-liquidity facilities without stigma; building a liquidity-savings mechanism like those of other major central banks; and tiering the interest rate on reserves. In the final of the four measures, banks would earn less than the key overnight lending rate on reserves stored at the central bank, above an agreed-upon amount. Duffie did not opine on whether lowering reserves is desirable; his analysis just concerns how to do it if it is so wishes.

Christina Skinner (US Treasury) described how the Financial Stability Oversight Council has been reoriented under Secretary Scott Bessent. The council was created on the view that systemic risk could be handled by extending bank-like regulation beyond banks. That view, she said, has turned out to be a flop. Over time the council drifted into a ratchet of ever-greater precaution that became self-defeating: a system built to eliminate volatility suppresses the dynamism that makes the system resilient. The reorientation rests on two propositions: First, growth is a foundation of financial stability, not in tension with stability, so regulation cannot be judged only by its effect on measured risk inside the financial sector. Second, financial stability is inseparable from economic security, because the sources of systemic risk increasingly sit where finance and geopolitics meet.

Policy Panel

Hoover Senior Fellow Paola Sapienza chaired the closing policy panel, consisting of four Federal Reserve officials. The panelists, asked to offer big-picture structural thoughts, ranged over bank supervision and private credit, the discipline of forecasting, the rate implications of an AI boom, and the structure of Reserve Bank operations.

Michelle Bowman, vice chair for supervision of the Federal Reserve Board, set out an agenda for helping the regulated banking system to compete with private credit in corporate lending. The bank share of corporate lending has fallen from 48 percent in 2015 to 29 percent in 2025, and private credit is now about $1.4 trillion. In her view, post-2008 capital and liquidity rules went too far in places. Current rules treat bank lending to private credit funds more favorably than lending directly to creditworthy corporations. Her proposed response has three pillars: reduced capital requirements, including a proposed cut in the risk weight on investment-grade corporate lending from 100 percent to 65 percent; a preserved role for private credit; and a new data collection on the largest banks’ lending to non-depository financial institutions. Bowman also gave a candid account of the supervisory failures around the Silicon Valley Bank collapse of 2023. The bank had more than thirty supervisory findings, only a handful about the material risk that brought it down. Even those were not acted on. She reported that the Fed has commissioned an outside review.

Mary Daly, president of the Federal Reserve Bank of San Francisco, described how the San Francisco Fed disciplines its forecasting with structured data. In view of the poor accuracy of past forecasts, especially to spot inflation ahead in 2021, such reflection is welcome. After the global financial crisis, facing natural-rate-of-unemployment estimates as high as 9 percent, the San Francisco Fed built labor-market dashboards that scored each data series against its historical norm in order to see patterns spread across multiple indicators. In time, the conclusion was that the labor market was more flexible than the high estimates assumed, with the natural rate closer to 5.6 percent. After the inflation miss of 2021 and 2022, the San Francisco Fed built an inflation dashboard on the same principle. Applied to the current tariff shock, the dashboard shows little persistence, which gave her confidence that looking through it was reasonable. As of the spring data, she said, the dashboard is starting to show red. She is watching supply-chain indicators, because clogged supply chains take a long time to clear. The Fed, she said, must discipline its models and qualitative assessments with incoming information disciplined by history.

Austan Goolsbee, president of the Federal Reserve Bank of Chicago, addressed a pressing question: how would a productivity boom induced by AI affect interest rates? Goolsbee presented an exercise in a standard new-Keynesian model. One important lesson: an unexpected rise in productivity growth and an expected rise have opposite implications for rates. An unexpected boom raises output above potential, but the disinflationary effect dominates and the policy rule calls for lower rates. That is the mid-1990s case. An expected boom, the case the AI consensus implies, is different. Forward-looking households start to consume immediately, anticipating their great future wealth and incomes, before capacity has expanded. Demand threatens to overheat the economy. The natural (non-inflationary) rate rises. The rule calls for higher rates. In the model analysis, it is important to act quickly, as a central bank that waits for inflation to appear makes the outcome worse. Later, he agreed that uncertainty about the productivity effects of AI might argue instead to wait to see any effects before reacting. Surveys put expected AI-driven productivity gains at roughly a percentage point a year for the next decade, so most of the boom is expected to be still ahead. Productivity growth is a boom for the economy, he said. What it means for interest rates is more subtle, and the bigger the hype, the bigger the concern.

Christopher Waller, governor of the Federal Reserve Board, spoke about the structure of Reserve Bank operations. The Fed’s decentralized regional design reinforces independence by representing a full range of views, and that should be preserved. But back-office functions like IT, human resources, and payments do not depend on geography, and there is no reason in his view to run them in twelve different ways. Waller proposed centralizing and standardizing them, with one Reserve Bank acting as a contractor to the others, the Board overseeing rather than deciding, and the Reserve Banks keeping operational control. The change requires a shift from a “bank first, system second” mindset to a “system first, bank second” one. The Reserve Bank presidents, he said, have already developed a framework along these lines in some areas of their operations such as check clearing.

Dinner Address

Tyler Goodspeed, a former chairman of the Council of Economic Advisers, delivered the dinner address, “Firefighters and Arsonists: Monetary Policy and the History of Recession.” Drawing on his new book that extends US and UK recession chronologies back to 1700—132 recessions in all—he argued that the “boom-bust” view of business cycles fails every test one can put to it. The contours of an expansion carry no information about the recession that follows.

Expansions never die of old age. No leading indicator forecasts recessions reliably over four centuries. And recessions do not cleanse: if anything they discriminate against the young, against dynamic firms, and against research and development. Each recession, in Goodspeed’s telling, is an expansion that failed in its own way.

Naming a recession after some excess in the preceding expansion is pattern-seeking where there is no pattern, and it is not innocuous: it tempts us to sedate healthy expansions in the false belief that doing so prevents recession.

However, how policymakers handle unforecastable recessionary shocks can make matters better or much worse. His illustration was 2008: in his view, the fundamental shock was the energy price surge in early 2008. That surge led to the mortgage problems, as many recessions spill over to real estate. But what could have been a garden-variety postwar energy recession became far worse when British authorities, over a September weekend, abandoned the classic Bagehot playbook. They blocked a stronger bank from acquiring Lehman Brothers. Lehman failed, and then a widespread systemic run developed which even massive bailouts could not stop.

Goodspeed closed the conference on a positive note: expansions are living longer as households, firms, and to some extent governments learn to absorb shocks. He also emphasized that growth during the years of expansion matters far more for eventual prosperity than the painful episodes of temporary contraction.

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The conference:

Independence and Governance

Moderator: John Cochrane, Hoover Institution

Presenters: Edward Nelson, Board of Governors of the Federal Reserve System
(paper)(slides)

Gary Richardson, University of California, Irvine
(slides)

David Wilcox, Peterson Institute for International Economics
(paper)(slides)

Fiscal and Monetary Policy Interactions

Moderator: Oliver Bush, London School of Economics

Presenters: Michael Bordo, Hoover Institution and Rutgers University
(paper 1) (paper 2)(slides)

Barry Eichengreen, University of California, Berkeley

Hanno Lustig, Graduate School of Business, Stanford University
(slides)

Director Remarks

Condoleezza Rice, Director, Hoover Institution

International Issues

Moderator: Sebastian Edwards, University of California, Los Angeles

Presenters: Arvind Krishnamurthy, Graduate School of Business, Stanford University
(paper)(slides)

Stephen Redding, Stanford University
(paper)(slides)

Kenneth Rogoff, Harvard University

Mandate, Tools, and Regulation

Moderator: Andrew Levin, Dartmouth College

Presenters: Thomas Drechsel, University of Maryland
(paper)(slides)

Luis Garicano, London School of Economics
(slides)

Carolyn Wilkins, Princeton University
(slides)

Risks, Challenges, and Opportunities

Moderator: Ross Levine, Hoover Institution

Presenters: Marvin Barth, Thematic Markets
(slides)

Darrell Duffie, Graduate School of Business, Stanford University
(slides)

Christina Skinner, U.S. Department of the Treasury

Policy Panel

Moderator: Paola Sapienza, Hoover Institution

Presenters: Michelle Bowman, Board of Governors of the Federal Reserve System
(speech)

Mary Daly, Federal Reserve Bank of San Francisco
(speech)

Austan Goolsbee, Federal Reserve Bank of Chicago
(speech)(slides)

Christopher Waller, Board of Governors of the Federal Reserve System
(speech)

Dinner Address: ”Firefighters and Arsonists: Monetary Policy and the History of Recession”

Moderator: Michael Bordo, Hoover Institution and Rutgers University

Presenter: Tyler Goodspeed, ExxonMobil Corporation
(slides)

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Even the Clark Center Finance Experts Survey, in which I participate, thought this interesting and plausible enough to ask:

SpaceX IPO
a) The large demand of passive investors for shares in SpaceX in the days after the IPO will cause substantial overvaluation of the stock.

b) Rebalancing of investors' portfolios to make room for SpaceX will cause measurable price pressure on other large growth or technology stocks in the days after the IPO.

Now, you ought to be suspicious. After all, in classic finance theory, every investor holds exactly the market portfolio, just like index funds do. But there is no “overvaluation.” That theory may be incorrect as a description of the real world, but it isn’t logically wrong. “Overvaluation” can’t be automatic. There must be a Modigliani-Miller benchmark in which there is no effect at all, and getting an effect must need some Modigliani-Miller violation. But just where? It wasn’t immediately obvious to me either, so I write this post.

Start with a simple case. SpaceX’s current investors own its stock, worth $2 trillion. The rest of us own $75 trillion of US stocks, or $56 trillion S&P500. The current owners sell, say $1 Trillion of their shares to the rest of us. But where do we get the money? And what do they do with the money? Well, most obviously, we get the money by selling some of our shares of other companies. And they use the money to buy shares of other companies. In the end, after this has all percolated through many trades, they own $1 Trillion of SpaceX and an extra $1 trillion of other stocks; we own $74 trillion of other stocks and $1 trillion of SpaceX. To question b, we “rebalance” towards SpaceX, but they “rebalance” to buy the stocks we sell. The prices might not be exactly the same, as we are all better diversified. But that’s a second-order effect, and not the sort of mechanical effect that was speculated here.

The economic lesson:

• Think equilibrium, watch the money all the way to its final resting place, and remember money is a veil, all that matters is the final allocations.

You might object that SpaceX is not just selling shares so its owners can diversify. SpaceX wants to raise money for new investment, to build more rocket ships. But the same logic goes through. Suppose SpaceX is currently only worth $1 trillion. It wants to sell an extra $1 trillion of shares for a total $2 trillion valuation, and use the funds to invest in more rocket ships. The founders don’t sell any shares at all. SpaceX initially takes in cash in return for shares, and then spends the cash on rocket ships. The rockets are the assets justifying the higher ($2 trillion, not $1 trillion) valuation.

Again, though, there is a natural equilibrium in which other companies invest less. The flow of our savings that was going to finance their investment goes to SpaceX instead. Again, there is no first-order change in valuation. Slightly higher marginal product of capital in SpaceX might raise all expected returns. Alternatively, the new money might come from additional savings, but that would need expected returns on all securities to rise. Both of these effects mean a small decline in prices.

There are second-order effects. But that’s not the sort of flow effect the question has in mind.

One can go on, but I think you see the point.

Now, a contrary story:

Suppose we are all good mean-variance CAPM investors, and we hold the market portfolio. If SpaceX offers 1,000 new shares, isn’t the price indeterminate? If the price is $1 per share, $10 per share, or $100 per share, we each hold that fraction of the new market portfolio. Doesn’t that mean that demand is totally inelastic — we’ll buy 1,000 shares at any price?

In classic theory, we end up holding the market portfolio. But we don’t set out to do that. We each are trying to maximize the mean/variance efficiency of our portfolios. We read those SpaceX revenue forecasts. If the market price is $10 per share (say), we offer to buy far more than the offered shares. If it’s (say) $1,000 per share, we say no thanks. The price settles down at the present value of dividends. Since we have the same information, we all settle on the same portfolio, which is why we all settle on the market portfolio in the end. But our behavior out of that equilibrium is not passive. The demand curve for SpaceX stocks is not vertical.

Here, you see the worry about passive investing. If everybody said “well, I’ll just end up holding the market portfolio, why bother doing any research,” then indeed the demand curve would be vertical and any price clears the market. Index funds are inelastic demanders. The market depends on someone out there doing the research and offering a sloping demand curve.

Is index investing therefore bad? Lots of commenters say so. I’m suspicious. (I am one!) It’s reasonable to think that “fundamental” investors make a bit more money than we do, in return for their services. (This is also the standard theory of finance.) If more of us become passive, the returns to that activity rise. Again, don’t just think partial equilibrium. If you become passive and inelastic, someone else will become active and more elastic. The overall elasticity of demand is not obviously less because people specialize in active or passive modes. That studies of active management find so little profit suggests that fundamental analysts are doing a pretty good job and we don’t miss them.

Stocks are like the wine shop: I go down and buy by a $20 bottle of Cabernet. If I want really good wine I look in the $40 bin. I don’t know anything about vineyards and vintages. But thanks to the efforts of the wine connoisseurs who know what they’re doing and set the sloping demand curve, the more you pay the better wine you get, on average. Thanks.

It’s not obvious that a lot of dumb active money makes the market more efficient. People like me shouldn’t be valuing stocks, or vineyards.

The economic lesson.

• Don’t just think equilibrium, think about the forces supporting the equilibrium

Supply and Demand

It is true that when stocks are added to the S&P500, and index funds buy, their prices go up a bit. AI says the recent estimates are 4 to 5%. That’s a small change in expected return. A 5% price rise is a 5% decline in return, not a 5 percentage point decline in return. So if the average return was 6%, it is instead 5.7%. That’s not nothing, but it isn’t enough to set up a permanent short position. It’s in the range of the value of liquidity seen in other markets.

But that is a MM violation, needing some friction. A lot of finance now thinks a lot in terms of such static demand (or supply?) curves. You may have been tempted to start thinking “what is the latest estimate of the S&P inclusion effect?” And then contrast it with the opposite, “what is the latest estimate of the elasticity of demand for large tech stocks?” (The usual story is, after all, that selling a lot of stock all at once pushes prices down, not up.)

But demand curves live on top of basic budget constraints, MM theorems, and efficient markets. The practitioners of supply and demand finance do not think in such simple terms, with money piling up here and there not finding its eventual home, and budget constraints and equilibrium conditions forgotten. They understand “demand systems” live on top of these fundamental effects. But some readers may think all you need is a “demand curve” for SpaceX stock, untethered from substitutes and incomes, and an “inclusion effect.”

Corporate finance long hewed to a good methodology: State the MM violation. Sure, the world does not obey MM, but first understand the usually counterintuitive MM theorem (for example, firm value is the same whether the firm issues debt or equity), then understand why it might be false, and interpret facts with that eye. Often the MM theorem works better than practitioners thought. It’s a good discipline.

In any case, I bet on a price less than infinity.

Updates:

Thanks to many correspondents.

One points out that even the S&P500 inclusion effect is not uncontroversial. Inclusion is not automatic, and the humans in charge want companies that will stay in the index for a while rather than cross in and out for a while. Thus inclusion may reveal some information of their analysis.

Another wise correspondent writes (slightly edited)

Logically impeccable. A tad blithe about real world complexities. The melt up worriers imagine

A) many holders being locked up and unable to diversify so market cap and float diverge a lot.

B) various institutional and risk aversion constraints on shorting.

C) there being influxes of dumb and momentum money.

D) indices for agency problem reasons eg nasdaq wants the listing are violating their usual policies.

I think that when people close to a thing have a strong concern there are two approaches

A) Explain how if you understand the model they are confused.

B) Figure out why they might be right even if simplest model suggests otherwise.

The better Chicago tradition is the latter.

Put differently. Squeezes happen. People with experience think we might be setting up for one. They might be right or wrong but Modigliani Miller lectures are beside the point.

Point taken, and an invitation to humility is always welcome. As I hinted, I do think we start from MM and then think about frictions. And markets do a lot of crazy things on occasion. However, when I hear talk that ignores the MM basic logic I worry as well. It was widely believed by “people close to a thing” that actively managed money could outperform indexing. Experts outperform darts everywhere else. But it turned out not to be true. Reality is surely in between. Anyway, we shall see if the frictions or the MM wins here.

A final correspondent writes

All true, but I suspect the basic empirical point matters more: SpaceX will have a very low free float. The main indexes will weight it by free float. Even the Nasdaq index will weight it far below market cap. So in fact there won’t need to be very much selling/buying to rebalance the indexes.

To clarify: You can have the equivalent of a short squeeze if the index was proportional to total market capitalization, but many shares were unavailable to trade. (Insiders’ shares are locked up for a while after IPO.) But most indices only require a tracking fund to buy an even fraction of available shares, not those locked up in various places. Nasdaq has a bit heavier weight, but not the full and unavailable market capitalization.

Final point. Why are we bending the rules? Not because index funds are screaming “you will force us to buy this stuff at too high prices.” Because index funds want in too!

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****

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?

…

(Read the rest at Washington Post, this link should take you past the paywall. Full version here in a month.)

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The Celebration Honoring John Taylor collects essays resulting from a one-day conference we had last fall. You can read the chapters for free at the link too, or order the hard copy. (Stanford and Hoover colleagues, I have a lot of free copies in my office if you want one.)

My contributions include the overview, “John Taylor’s Contributions to Economics and Monetary Policy” with Michael Bordo and Jon Hartley, and “The Taylor Rule in Macroeconomic Theory.” The rule went a lot further than Taylor envisioned, giving stability in old Keynesian models, local determinacy in new-Keynesian models, and buffering shocks in fiscal theory models. “The Taylor rule is always the answer, though the questions keep changing” is praise in this context. Taylor often made that point: The rule is not exactly optimal in specific models but it is pretty darn good in lots of models. The Taylor rule also recommends acting in response to actual inflation and output rather than forecasts. Given how many mistakes the Fed has made lately in reacting to false forecasts, that might be pretty good advice.

I don’t mean to slight the many other great contributions. You will learn a lot about macro and monetary economics from this lovely book.

Finishing the Inflation Job and New Challenges for Monetary Policy is the conference volume resulting from the 2025 Hoover Monetary Policy Conference with that title. The conference website has videos. Again, you can find the chapters for free at the link, and Stanford colleagues are welcome to stop by and clean out the box in my office.

The first chapter contains particularly thoughtful comments from Chris Waller on central bank independence, from Loretta Mester on the policy process, a lovely essay from Charlie Plosser, who sadly passed away just after this conference, and a thoughtful statement from Kevin Warsh that Fed-watchers will want to read. Digital assets, private credit, geoeconomic risks, fiscal pressures on monetary policy, the ever-revealing policy panel, and a lovely dinner talk on history all are relevant today. I guess monetary policy doesn’t move much faster than book publishing! My contribution, “Fiscal Constraints on Monetary Policy” packages thoughts on a substantial and unrecognized challenge ahead. It’s 1951, not 1972.

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Update: Here is an excellent summary by Marcos Falcone on the Cato substack.

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From Jesper Rangvid Disclaimer, this is thought provoking fun, not serious analysis.

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