Thank you for the great article! It is amazing, what you can get from this equation. I am a little bit confused with the open market operations and their inflation effect. Isn't money short-term government debt and therefore the central bank buying government debt for money "exchanging green for red m&m's"? Or I am confusing money with something else in this context?
Yes, exchanging B for M, with i=0 or small I effects, has no effect on P in (6). When reserves pay interest, there is no i term on the right hand side and it really is red vs. green debt. Red vs. Green M&Ms, or a $10 and 2 $5s in return for a $20 are great parables for the ineffectiveness of QE. QE also changes the maturity structure of government debt, which can have some effects.
There's a reason why it's illegal for me to print my own dollars... IT DILUTES THE VALUE OF EVERYONE ELSES DOLLARS. No different if the fed does the same with numbers on a page created out of thin air and the government spends far beyond tax receipts. That should be illegal too. (Lot's of folks getting paid to produce nothing of value)
Please spell out what each implies about central bank behavior. Like maybe (it's not my model, so you tell me), central bank inflation targeting generates interest rates that encourage the eventual surpluses. Also don't we need to know if deficits are financing consumption or investment?
From the framework provided by FTPL, a good question to ask is: "What are the determinants of government surplus expectations?"
I was thinking along the following lines. Why would anyone finance government spending?
When it comes to private bonds, it is easy to understand that the financing decision is based on the confidence that the firm will be able to honor the coupon established in the contract (thinking in terms of perpetuity).
If we apply this reasoning to public bonds, the decision to finance government spending is based on the confidence that the government will be able to honor the coupon — that is, real surpluses.
This means that the government cannot finance spending by printing money. Because the increase in the money supply causes an increase in the price level and reduces the purchasing power of the return on investment.
Therefore, the feasible alternative would be to adjust the public accounts by increasing tax revenue — which may enter the Ricardian equivalence problem.
However, if we ignore Ricardian equivalence, and start from an economy in which the design of the tax collection system is the most effective, and the Laffer curve is at its maximum point, then any increase in debt would cause an explosion in the expectation of future inflation. After all, if the government cannot finance its spending through taxation, then it will finance it through an increase in the monetary base.
However, what if some component of government spending is directed to items that increase total factor productivity?
In this case, it is possible to interpret government spending as an investment, so that the return is given through a reduction in the price level (or an increase in output at the same price level).
It would be interesting to add a production function that (F_t(A,K,L) - F_t+1(A,K,L) = ∆A.
1) about inside money: is it not added there, because it makes no difference? it is not government debt and does not add any frictions in the dynamics etc.(?)
2) in the money-financed government with no bonds: where does the steady inflation come from? you say that m = py/v as a rule, where y is constant ("g=0") and v also fixed (right?). So the change in p determines change in m? The present value of surpluses and seignorage revenues determines the price level, but what creates then inflation?
"1) If the government sells debt and raises future surpluses at the same time, the debt sale has no effect on bond prices, interest rates, or inflation. It raises revenue that the government can use to fund a deficit. The future surpluses then slowly pay off that debt."
"The former is like an equity offering. The company issues shares, and promises higher future dividends. The price per share is unaffected, and the firm raises revenue that it uses to make investments that in turn create the future dividends."
Nope. The interest payments that the federal government makes are legally protected (see US Constitution, 14th Amendment), unlike the dividends a company can offer, then rescind.
"2) If the government sells debt without raising future surpluses, then the government creates future inflation, lowers the bond price, raises the interest rate, and raises no revenue."
"The latter is like a share split: the firm doubles the number of shares without raising expected dividends. That halves the stock price, but raises no revenue."
Again, nope. If the government sells debt without raising future surpluses, the percentage of federal receipts used to service the interest payments rises, approaching the Ponzi limit - again without affecting bond prices, interest rates, or inflation.
1) could you elaborate this Point? How does this contradict the Point that in both cases the present value of discounted future Returns(interest or Dividende) matter?
Professor Cochrane, have you ever discussed FTPL in the context of entitlement reform, specifically privatization of Social Security? I’m thinking of a reform under which the government issues debt and deposits the proceeds into personal accounts to fund future benefits. Future government surpluses would increase by the reduction in future SS benefit payments, which I think would be a highly credible.
This could be a voluntary program. For pre-retirees, ongoing FICA contributions (in whole or in part) would also be deposited into these accounts. Given that the balance remaining at death would be heritable, some individuals might be willing to accept an initial deposit less than the actuarial PV of their future SS benefits accumulated to-date (at some risk-adjusted discount rate). I also believe many individuals would willingly accept less in exchange for an account over which they have some control over investment direction. Such reductions in the initial deposits to personal accounts would mean that the issue of new debt would be smaller than the increase in future surpluses.
The choice of discounts applied to the PV of future benefits would be controversial, but different discounts could be tested to guage uptake. However, the issuance of debt would be gigantic, so some would undoubtedly fear an impossible strain on the credit market. Perhaps the transition could be staged over time to make it less “shocking”, but that would complicate matters.
I think something similar could be created for Medicare beneficiaries, who would have some proportion of their expected future benefits in a private account which they could use to pay for private or public coverage. Again, the increase in federal debt would be balanced against an increase in future surpluses.
I’d love to know whether there is a previous post or paper in which you addressed this topic, or any other FTPL treatment of SS privatization of which you’re aware.
Thank you for the great article! It is amazing, what you can get from this equation. I am a little bit confused with the open market operations and their inflation effect. Isn't money short-term government debt and therefore the central bank buying government debt for money "exchanging green for red m&m's"? Or I am confusing money with something else in this context?
Yes, exchanging B for M, with i=0 or small I effects, has no effect on P in (6). When reserves pay interest, there is no i term on the right hand side and it really is red vs. green debt. Red vs. Green M&Ms, or a $10 and 2 $5s in return for a $20 are great parables for the ineffectiveness of QE. QE also changes the maturity structure of government debt, which can have some effects.
I was always puzzled by the IOR policy, too.
There's a reason why it's illegal for me to print my own dollars... IT DILUTES THE VALUE OF EVERYONE ELSES DOLLARS. No different if the fed does the same with numbers on a page created out of thin air and the government spends far beyond tax receipts. That should be illegal too. (Lot's of folks getting paid to produce nothing of value)
Please spell out what each implies about central bank behavior. Like maybe (it's not my model, so you tell me), central bank inflation targeting generates interest rates that encourage the eventual surpluses. Also don't we need to know if deficits are financing consumption or investment?
From the framework provided by FTPL, a good question to ask is: "What are the determinants of government surplus expectations?"
I was thinking along the following lines. Why would anyone finance government spending?
When it comes to private bonds, it is easy to understand that the financing decision is based on the confidence that the firm will be able to honor the coupon established in the contract (thinking in terms of perpetuity).
If we apply this reasoning to public bonds, the decision to finance government spending is based on the confidence that the government will be able to honor the coupon — that is, real surpluses.
This means that the government cannot finance spending by printing money. Because the increase in the money supply causes an increase in the price level and reduces the purchasing power of the return on investment.
Therefore, the feasible alternative would be to adjust the public accounts by increasing tax revenue — which may enter the Ricardian equivalence problem.
However, if we ignore Ricardian equivalence, and start from an economy in which the design of the tax collection system is the most effective, and the Laffer curve is at its maximum point, then any increase in debt would cause an explosion in the expectation of future inflation. After all, if the government cannot finance its spending through taxation, then it will finance it through an increase in the monetary base.
However, what if some component of government spending is directed to items that increase total factor productivity?
In this case, it is possible to interpret government spending as an investment, so that the return is given through a reduction in the price level (or an increase in output at the same price level).
It would be interesting to add a production function that (F_t(A,K,L) - F_t+1(A,K,L) = ∆A.
Where A(Debt).
1) about inside money: is it not added there, because it makes no difference? it is not government debt and does not add any frictions in the dynamics etc.(?)
2) in the money-financed government with no bonds: where does the steady inflation come from? you say that m = py/v as a rule, where y is constant ("g=0") and v also fixed (right?). So the change in p determines change in m? The present value of surpluses and seignorage revenues determines the price level, but what creates then inflation?
"1) If the government sells debt and raises future surpluses at the same time, the debt sale has no effect on bond prices, interest rates, or inflation. It raises revenue that the government can use to fund a deficit. The future surpluses then slowly pay off that debt."
"The former is like an equity offering. The company issues shares, and promises higher future dividends. The price per share is unaffected, and the firm raises revenue that it uses to make investments that in turn create the future dividends."
Nope. The interest payments that the federal government makes are legally protected (see US Constitution, 14th Amendment), unlike the dividends a company can offer, then rescind.
"2) If the government sells debt without raising future surpluses, then the government creates future inflation, lowers the bond price, raises the interest rate, and raises no revenue."
"The latter is like a share split: the firm doubles the number of shares without raising expected dividends. That halves the stock price, but raises no revenue."
Again, nope. If the government sells debt without raising future surpluses, the percentage of federal receipts used to service the interest payments rises, approaching the Ponzi limit - again without affecting bond prices, interest rates, or inflation.
https://fred.stlouisfed.org/graph/fredgraph.png?g=1uQYu
1) could you elaborate this Point? How does this contradict the Point that in both cases the present value of discounted future Returns(interest or Dividende) matter?
Dr. Cochrane, I got your book. And I must say I am very grateful that you did not waste resources by choosing a font that is large enough to read.
Professor Cochrane, have you ever discussed FTPL in the context of entitlement reform, specifically privatization of Social Security? I’m thinking of a reform under which the government issues debt and deposits the proceeds into personal accounts to fund future benefits. Future government surpluses would increase by the reduction in future SS benefit payments, which I think would be a highly credible.
This could be a voluntary program. For pre-retirees, ongoing FICA contributions (in whole or in part) would also be deposited into these accounts. Given that the balance remaining at death would be heritable, some individuals might be willing to accept an initial deposit less than the actuarial PV of their future SS benefits accumulated to-date (at some risk-adjusted discount rate). I also believe many individuals would willingly accept less in exchange for an account over which they have some control over investment direction. Such reductions in the initial deposits to personal accounts would mean that the issue of new debt would be smaller than the increase in future surpluses.
The choice of discounts applied to the PV of future benefits would be controversial, but different discounts could be tested to guage uptake. However, the issuance of debt would be gigantic, so some would undoubtedly fear an impossible strain on the credit market. Perhaps the transition could be staged over time to make it less “shocking”, but that would complicate matters.
I think something similar could be created for Medicare beneficiaries, who would have some proportion of their expected future benefits in a private account which they could use to pay for private or public coverage. Again, the increase in federal debt would be balanced against an increase in future surpluses.
I’d love to know whether there is a previous post or paper in which you addressed this topic, or any other FTPL treatment of SS privatization of which you’re aware.